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Working Papers

September 2006, No. 06-9

The Political Economy of Labor Subsidies

Marina Azzimonti, Eva de Francisco and Per Krusell

We explore a political economy model of labor subsidies, extending Meltzer and Richard's median voter model to a dynamic setting. We explore only one source of heterogeneity: initial wealth. As a consequence, given an operative wealth effect, poorer agents work harder, and if the agent with median wealth is poorer than average, a politico-economic equilibrium will feature a subsidy to labor. The dynamic model does not have capital, but it has perfect markets for borrowing and lending. Because tax rates influence interest rates, another channel for redistribution appears, since a decrease in current interest rates favors agents with a negative (below-average) asset position.

By the same token—and as is typically the case in dynamic politico-economic models with rational agents—the setting features time-inconsistency: the median voter would like to commit to not manipulating interest rates in the future. Under commitment, and under the assumption that preferences admit aggregation, we show that labor subsidies subsist only for one period; after that, subsidies are zero. That is, under commitment, the median voter takes advantage of the voting power once and for all. His wealth moves closer to that of the mean (which is zero), but afterwards he refrains voluntarily from further subsidization. Under lack of commitment, which we analyze formally by looking at the Markov-perfect (time-consistent) equilibrium in a game between successive median voters in the same environment. Instead, subsidies persist—they are constant over time—and are more distortionary than under commitment. Moreover, in the situation without commitment, the median voter does not manage to reduce asset inequality, unlike in the commitment case.

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