Working Paper: CEPR ID: DP4918
Authors: Frederick van der Ploeg
Abstract: Democratic countries with substantial inequality and where people believe that success depends on connections and luck induce political support for high tax rates and generous welfare states. Traditional wisdom is that such policies harm the economy, but there is not much evidence that countries with a large welfare state and substantial redistribution have worse economic performance and welfare. One important reason is that governments have been careful to invoke the principles of reciprocity and mutual obligations in the design of the welfare state. Unemployment benefits conditioned on work experience, no misconduct and search effort harm the economy less. Indeed, conditional benefits may even boost employment in an economy with efficiency wages. A second reason is that people care about relative incomes and become unhappy if others earn and consume much more than they do. This explains why people do not seem to get happier, even though societies grow richer and richer. With such consumer rivalry the government wishes to correct for the rat race, even if there is no need for redistribution, by taxing labour. A third reason is that in modern economies many distortions are present and removing one at a time may worsen economic performance. Conversely, increasing tax progression in economies with non-competitive labour markets induces wage moderation and boosts employment. A final reason is that countries with large welfare states typically introduce various pro-growth policies as well.
Keywords: altruism; demand management; design of welfare state; happiness; mutual obligations; redistributive taxation; relative incomes; second best
JEL Codes: H20; H53; J50; J60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| conditional unemployment benefits (J65) | improved economic performance (O49) |
| conditional unemployment benefits (J65) | boost employment (J68) |
| conditional unemployment benefits (J65) | reduce incidence of shirking (J65) |
| consumer rivalry (L13) | discontent in wealthy societies (P17) |
| progressive taxation (H29) | alleviate negative externalities of consumer competition (D62) |
| welfare state design (I38) | positive economic outcomes (D78) |