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Demographics and competition for capital in political economy

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Abstract

We examine the possible impacts of demographics on outcomes of competition for capital in political economy. For this, we develop a multi-region overlapping generations model, wherein public good provision financed by capital taxation is determined by majority vote. When population is growing, younger people represent the majority, whereas when it is decreasing, older people are in majority. We uncover the possible externalities arising from political processes as well as capital mobility and show that an inefficiently high capital tax rate is more likely to emerge in an economy with decreasing population than in one with growing population.

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Notes

  1. See Wilson (1999), Brueckner (2003), Zodrow (2003), and Wilson and Wildasin (2004) for surveys.

  2. We can also confirm such differences and time trends by looking at the median age (OECD 2013).

  3. The voter turnout of sixties is more than twice that of twenties in 2017 (http://www.soumu.go.jp/senkyo/senkyo_s/news/sonota/nendaibetu/ accessed on September 2, 2019.)

  4. Another significant factor would be possible raises in the retirement age, which increase the working generations. However, they occur in accordance with increases in longevity, which increase retired generations and offset the effects of raises in the retirement age.

  5. Following the tax competition literature a la Zodrow and Mieszkowski (1986) and Wilson (1986), we assume that capital tax is levied on firms, not on households. Under this assumption, capital taxation works via its negative impact on the demand for capital by firms and their production, wages, and thus lifetime consumption of the current young, but not of the current old. The other positive impact works directly via funding public good provision.

  6. Montén and Thum (2010) considered the effects of demographics on the inter-generational conflict under tax competition. They focused on conditions under which gerontocracy improves the young generation’s welfare. Hence, efficiency issues are out of their scope.

  7. Also, there exist studies that used overlapping generations models involving political process to investigate a macro economy. See, e.g., Alesina and Rodrik (1994), Persson and Tabellini (1994a), Casamatta et al. (2000), Razin et al. (2002), Galasso and Profeta (2007), Conde-Ruiz and Profeta (2007), Mateos-Planas (2010), and Cremer and De Donder (2016). These studies focused on a closed economy, whereas we focus on efficiency of policies in an open economy.

  8. Since we focus on the inter-generational conflicts, we assume that individuals of generation t are homogenous. If we introduce individual heterogeneity, as shown by the existing studies reviewed in Introduction, the decisive voter’s capital endowment affects the equilibrium tax rate. Then the overall inefficiency depends on the relative effect of inter-generational conflicts to individual heterogeneity.

  9. We ignore space within and across countries. In reality, a country might compete for capital more fiercely with nearby countries than with distant countries. Although it would be significant to introduce space explicitly, it complicates the analysis and would be beyond the scope of this paper. See, e.g. Agrawal (2015) and Agrawal and Hoyt (2018) for analyses on spatial aspects of taxation.

  10. Even if we assume a difference in the preference for public good consumption between young and old individuals, our main results are qualitatively unaltered. See online Appendix A.

  11. We follow the tradition of capital tax competition in assuming that capital tax is imposed only on the firms’ capital input, which enables us to compare our results with those shown in the existing works.

  12. Even if one introduces labor mobility, capital tax competition still results in inefficient capital taxation. See Brueckner (2000, 2004) for this point.

  13. This statement owes to the assumption that capital is perfectly depreciated in one period, which ensures that the tax rate at period t does not depend on the former tax rates. Otherwise, the future government’s budget constraint should include tax revenues from accumulated capital, which is also affected by the current tax rate chosen by the current government. This means that in making decision, the current government might count effects from its choice of a tax rate on future governments’ decision.

  14. When \({\overline{L}}_{it}={\overline{L}}_{it-1}\), we assume that a government chooses to maximize \(U_{it}\) or \(u_{iot}\) with equal probability. If it chooses to maximize \(U_{it}\) (resp. \(u_{iot}\)), the results are the same as those under \({\overline{L}}_{it}>{\overline{L}}_{it-1}\) (resp. \({\overline{L}}_{it}<{\overline{L}}_{it-1}\)). For the sake of expositional simplicity, we omit this case.

  15. We employ this assumption for expositional simplicity. Even if each national government considers the effect of capital taxation on r, it doesn’t consider the effects on other countries’ welfare, implying that capital taxation causes a distortion . See online Appendix B for details.

  16. Derivation is given in online Appendix C.

  17. If utility is separable in private good consumption and public good consumption and the rate of return on savings is given exogenously, we obtain an expression qualitatively the same as (9).

  18. Derivation is given in online Appendix C.

  19. If we assume non-price taking governments, an economy with decreasing population may have a lower capital tax rate than an economy with growing population because non-price taking governments care about the effect of an increase in capital tax rate on an old generation’s income from savings. See also online Appendix B.

  20. We can alternatively assume that the social welfare consists only of the utility of current generations without altering any of our results.

  21. See online Appendix D for details.

  22. To ensure the existence of an optimal tax rate, we assume that \(\sum _{i=1}^{\infty }\beta ^{t}{\overline{L}}_{t}<\infty\), which implies that \(\beta (1+n)<1\).

  23. The outcome of second-best optimum is related to the Ramsey paradigm of dynamic optimal taxation summarized by Atkeson et al. (1999). Atkeson et al. (1999) showed that in steady state, the second-best optimal tax on capital income is zero. In this paper, if we assume that \(\alpha =0\), (18) yields \(\tau _{it}=0\).

  24. To clarify the effects of externalities related to the political process, in online Appendix F, we compare our results to those obtained in the case of a benevolent government that sets the capital tax rate to maximize the country’s welfare.

  25. If a supragovernment exists and can make national governments coordinate, it can eliminate the inefficiency arising from capital mobility (Gonzalez-Eiras and Niepelt 2017). However, it can’t eliminate the inefficiency arising from the political process.

  26. The assumption of positive population size (\(n>-1\)) ensures that \(\tau _{o}^{*}\) and \(r_{o}^{*}\) are positive.

  27. Proof is given in online Appendix E.

  28. Online Appendix F clarifies the effects of externalities related to the political process, i.e., the Public good and Gerontocracy externalities by assuming benevolent governments that are often assumed in standard tax competition models.

  29. See Ogawa et al. (2016) for a brief survey on asymmetric tax competition.

  30. If all countries are assumed to differ in their population growth rates, analysis becomes complicated. Still we can derive qualitatively similar conditions to those obtained under the two group case.

  31. Under a more general utility function, one would expect that countries with different population growth rates set different tax rates.

  32. For proofs of Corollaries 1 and 2, see online Appendix G.

  33. For derivations of \(r_{t}^{*}\), \(\tau _{h}^{(iii)*}\), and \(\tau _{l}^{(iii)*}\) and proof of Proposition 4, see online Appendix G.

  34. In fact, we have the second case when \(\gamma\) is large. When \(\gamma\) is sufficiently small, we have the first and the last cases. In fact, if we set \(\gamma =1/2\), the first case holds true when \(\alpha\) is sufficiently large and the last case holds true when \(\alpha\) is sufficiently small.

  35. See online Appendix H for a supplemental table and details on data. We also show a figure providing a positive relationship between median age and corporate income tax rates.

  36. Formal analyses are available in Appendices I and J.

  37. For contributions on endogenous number of children, see, e.g., Barro and Becker (1989), Becker et al. (1990), and Galor (2011). They mainly focused on its macroeconomic impacts, and inter-governmental issues were out of their scope.

  38. Sato and Yamamoto (2005), Sato (2007), and Aiura and Sato (2014) developed models with endogenous demographic structure and individual geographical mobility. However, they ignored policy issues.

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Acknowledgements

This study was conducted as a part of the project “Spatial Economic Analysis on Trade and Labor Market Interactions in the System of Cities” undertaken at the Research Institute of Economy, Trade and Industry (RIETI). This work was also supported by Ohbayashi Foundation, JSPS KAKENHI Grant Numbers 15H03344, 16H03615, 17H02519, and 18H00842, RIETI (Grant No. 303-002-15). We thank two anonymous referees, Makoto Hasegawa, Andreas Haufler, Michael Keen, Hubert Kempf, Ben Lockwood, Yukihiro Nishimura, and Kimiko Terai, and participants at the International Symposium of Urban Economics and Public Economics held at Osaka University, the North American Regional Science Council, SWET, and seminars held at the University of Tokyo and Tohoku University for their helpful comments.

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  1. Faculty of Economics, Kindai University, Higashiōsaka, Japan

    Tadashi Morita

  2. Faculty of Economics, University of Tokyo, Bunkyo-ku, Japan

    Yasuhiro Sato

  3. Graduate School of Economics, Osaka University, Toyonaka, Japan

    Kazuhiro Yamamoto

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  1. Tadashi Morita
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Correspondence to Yasuhiro Sato.

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Morita, T., Sato, Y. & Yamamoto, K. Demographics and competition for capital in political economy. Int Tax Public Finance 27, 865–889 (2020). https://doi.org/10.1007/s10797-019-09587-0

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