DP1419 Unequal Societies
This paper seeks to explain the significant variations in the social contract observed across nations. It shows how countries with similar technologies and preferences, as well as equally democratic political systems, can sustain very different average and marginal tax rates. Similarly, it provides an explanation for the striking difference between the US and European systems of education finance and health insurance. With imperfect credit and insurance markets some redistributive policies can have a positive effect on output, growth, or more generally ex-ante welfare. Aggregate efficiency gains, in turn, imply a very different political economy from that of standard models: the extent of political support for such redistributions decreases with the degree of inequality, at least over some range. Moreover, capital market imperfections make future earning a function of current resources. Hence there exists potential for multiple steady states, with mutually reinforcing high inequality and low redistribution, or vice versa. Temporary shocks to the distribution of income or the political system can then have permanent effects.
