The Political Economy of Redistribution Under Asymmetric Information

This paper examines the political economy of redistribution when voters have asymmetric information about the redistributive preferences of politicians and the latter cannot make credible policy commitments. The candidates in each party are endogenously selected by a process of Nash Bargaining between the competing factions. In equilibrium, there is "partial convergence" of redistributive policies, support for "Director's Law", the possibility of "policy reversals" across the parties, and "inter term tax variability" (political budget cycles) during the tenure of a politician. The effect of inequality on the magnitude of the redistributive activity depends in important ways on the incentives and constraints facing politicians.Signaling, Inequality, Redistribution, Political Business Cycles

Charitable Giving and Optimal Public Policy in a Competitive Equilibrium with Multiple Equilibria.

In a competitive-equilibrium analysis of giving to charity, we show that strategic complementarity between individual giving and aggregate giving can lead to multiple equilibria. This provides a possible explanation for observed heterogeneity in giving. It is possible, but not necessary, that at a low equilibrium in giving (LE), an increase in subsidy reduces giving (perverse comparative statics) while at a high equilibrium (HE) the comparative statics are normal (subsidies promote giving). The perverse comparative statics at LE preclude using subsidies to move the economy to HE. We show how temporary direct government grants can engineer a permanent move from LE to HE. Once HE is established, the optimal mix of private and public giving is determined using a welfare analysis. We show that the Nash non-cooperative outcome is virtually identical to the competitive-equilibrium, even for relatively small numbers of givers. The competitive-equilibrium approach is more tractable and plausible, and more general because it does not rely on a symmetric equilibrium. We also show how our results are applicable to redistributive and public good contexts.Multiple Equilibria; Aggregate Strategic Substitutes and Complements; Competitive and Non-cooperative Equilibria; Direct Grants; Charitable Redistribution; Voluntary Contributions to Public Goods; Optimal Mix of Public and Private Giving.

Fairness and Direct Democracy

The median voter model (direct democracy) has wide applicability, but it is based on selfish voters i.e. voters who derive utility solely from 'own' payoff. The recent literature has pointed to fairness and concern for others as basic human motives that explain a range of economic phenomena. We examine the implications of introducing fair voters who have a preference for fairness as in Fehr and Schmidt (1999). Within a simple general equilibrium model, we demonstrate the existence of a Condorcet winner for fair voters using the single crossing property of voters’ preferences. In a fair voter model, unlike a selfish voter model, poverty can lead to increased redistribution. Mean preserving spreads of income increase equilibrium redistribution. Greater fairness leads to greater redistribution. The introduction of selfish voters in an economy where the median voter is fair can have a large impact on the redistributive outcome. An empirical exercise using OECD data illustrates the potential importance of fairness in explaining redistribution.Redistribution; other regarding preferences; single crossing property; income inequality; American Exceptionalism

Optimal income taxation in the presence of tax evasion: Expected utility versus prospect theory

The predictions of expected utility theory (EUT) applied to tax evasion are flawed on two counts: (i) They are quantitatively in error by huge orders of magnitude. (ii) Higher taxation is predicted to lower evasion, which is at variance with the evidence. An emerging literature in behavioral economics, most notably based on prospect theory (PT), has shown that behavioral economics is much better at explaining tax evasion. We extend this literature to incorporate issues of optimal taxation. As a benchmark for a successful theory, we require that it should explain, jointly, the facts on the tax rate, tax gap and the level of government expenditure. We find that when taxpayers use EUT (respectively, PT) and the optimal tax is derived from a social welfare function that also uses EUT (respectively, PT), then, the calibration results are completely at odds with the facts. However, when taxpayers use PT but the social welfare function uses standard EUT, there is a very close match between the predictions and the facts. This has important implications for context dependent preferences but also for the newly emerging literature on liberalism versus paternalism in behavioral economics.Prospect theory; Expected utility theory; Tax evasion; Optimal taxation; Normative versus positive economics; Context dependent preferences; Liberalism; Paternalism

A Note On Generalized Hyperbolic Discounting

In a major contributions to behavioral economics, Loewenstein and Prelec (1992) set the foundations for the behavioral approach to decision making over time and derive the generalized hyperbolic discounting formula. Here we show that their assumption ‘common difference effect with quadratic delay’ cannot be weakened to ‘common difference effect’.Intertemporal choice; Generalized hyperbolic discounting

A general theory of time discounting: The reference-time theory of intertemporal choice

We develop a general theory of intertemporal choice: the reference-time theory, RT. RT is a synthesis of ideas from the hyperbolic model and subadditivity of time discounting. These models are extended to allow for a reference point for time as well as wealth. RT is able to account for all the 6 main anomalies of time discounting: gain-loss asymmetry, magnitude effect, common difference effect, delay-speedup asymmetry, apparent intransitivity of time preferences, and non-additivity of time discounting. We provide a class of utility functions compatible with RT. We show how RT can be extended to incorporate uncertainty and attribute models of intertemporal choice.Anomalies of the discounted utility model; Hyperbolic discounting; Prospect theory; gamma-delay; alpha-subadditivity; SIE value functions

Rebuttal of Hashimzade, Myles and Tran-Nam (2009) “New Approaches to the Economics of Tax Evasion”

In a recent, 58 page, paper, Hashimzade, Myles and Tran-Nam (2009) .New Approaches to the Economics of Tax Evasion.survey alternative approaches to tax evasion. Their central conclusion is, in their own words (p. 56): .What they [the non-expected utility models] do not do is change the relationship between the tax rate and the level of evasion..We show that their central conclusion is incorrect. We also show that their representation of our work [(2007) "Why Do People Pay Taxes? Prospect Theory Versus Expected Utility Theory", Journal of Economic Behavior and Organization, 64: 171.192 ] is highly misleading, and incorrect.

A Simple Model of Optimal Tax Systems: Taxation, Measurement and Uncertainty

The neglect of administrative issues is a serious limitation of optimal tax theory, with implications for its practical applicability. Under uncertainty, the problems for optimal tax theory are compounded when the full set of tax instruments is neglected. These twin issues are addressed in this paper, by focussing on a fundamental implication of administrative problems, namely, that the tax bases are measured with some error. Consumption taxes can perform the ‘social insurance role of taxation’; a role previously ascribed only to income taxes. A combination of income and consumption taxes can hedge income and measurement-error risks better, relative to the imposition of these taxes alone. The optimal taxes are decreasing in the imprecision with which the corresponding tax base is measured. The taxpayer engages in precautionary savings, in response to uncertainty arising on account of income and measurement problems. Differential commodity taxes, tailored to the measurability characteristics of the different tax bases, dominate uniform commodity taxes. Furthermore, the paper provides a simple, tractable framework for optimal tax theorists interested in diverse kinds of uncertain situations.Social Insurance; Measurability of tax bases; Yardstick Competition; Differentiated taxes

Hyperbolic Punishment Function

All models in Law and Economics use punishment functions (PF) that incorporates a trade-off between probability of detection, p, and punishment, F. Suppose society wishes to minimize the total costs of enforcement and damages from crime, T (p; F). For a given p, an optimal punishment function (OPF) determines an F that minimizes T(p; F). A popular and tractable PF is the hyperbolic punishment function (HPF). We show that the HPF is an OPF for a large class of total cost functions. Furthermore, the HPF is an upper (lower) bound for an even larger class of punishment functions. If the HPF cannot (can) deter crime then none (all) of the PF's for which the HPF is an upper (lower) bound can deter crime. Thus, if one can demonstrate that a particular policy is ineffective (effective) under the HPF, there is no need to even compute the OPF. Our results should underpin an even greater use of the HPF. We give illustrations from mainstream and behavioral economics. Punishment functions; Optimal punishment functions; Becker proposition; Law and economics; Behavioral models of crime and punishment.