By Youngsoo Jang
How do differences in the government’s political and commitment structure affect the aggregate economy, inequality, and welfare? I analyze this question, using a calibrated Aiyagari’s (1994) economy with wealth effects of labor supply wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. I compare four economies: a baseline economy, an economy with the optimal tax with commitment in all steady states, an economy with the optimal tax without commitment, and a political economy with sequential voting. I obtain two main findings. First, the commitment structure shifts the government’s weighting between redistribution and efficiency. A lack of commitment leads the government to pursue a more redistributive policy at the expense of efficiency. Second, given a lack of commitment, the political economy with voting yields greater welfare than the economy with the time-consistent optimal policy. In the latter case, a lack of commitment hinders the government from implementing a more frugal policy desirable in the long run; instead, it cares more for low-income and wealth households, resulting in a substantial efficient loss. However, in the political economy with voting, the government considers only the interests of the median voter, who is middle class and reluctant to bear larger distortions from a higher tax rate and larger transfers. These findings imply that in terms of welfare, policies targeting the middle class would possibly be better than those exquisitely designed for the general public.
That institutional design matters for policy setting in nothing new, including for Aiyagari models. It easy to imagine why: you change the welfare function between a voting equilibrium and one based on average welfare, for example. This paper shows that the ability of the government to commit matters as well.