By Francesca Lancia and Alessia Russo
This paper investigates the conditions for the emergence of implicit intergenerational contracts without assuming reputation mechanisms, commitment technology and altruism. We present a tractable dynamic politico-economic model in OLG environment where politicians play Markovian strategies in a probabilistic voting environment, setting multidimensional political agenda. Both backward and forward intergenerational transfers, respectively in the form of pension benefits and higher education investments, are simultaneously considered in an endogenous human capital setting with labor income taxation. On one hand, social security sustains investment in public education; on the other hand investment in education creates a dynamic linkage across periods through both human and physical capital driving the economy toward different Welfare State Regimes. Embedding a repeated-voting setup of electoral competition, we find that in a dynamic efficient economy both forward and backward intergenerational transfers simultaneously arise. The equilibrium allocation is education efficient, but, due to political overrepresentation of elderly agents, the electoral competition process induces overtaxation compared with a Benevolent Government solution with balanced welfare weights.
This paper takes a careful look why dynamically inefficient schemes like a pay-as-you-go social security system or investment in education can survive politically. The interesting result is that it can happen even when there is only self-interest among members of different generations. The mechanism is that young households subsidize education of the children to obtain higher future productivity, which they can partially capture by getting social security payments when old. There is always a majority of people in favor of such a scheme as long as it is viewed as a whole package.