DP7084 Tax Contracts and Government Formation

Author(s):	Hans Gersbach, Maik Schneider
Publication Date:	December 2008
Keyword(s):	contract theory, government formation, voting
JEL(s):	D72, D82, H55
Programme Areas:	Public Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=7084

We introduce tax contracts and examine how they affect government formation and welfare of voters in a democracy with proportional elections. A tax contract specifies a range of tax rates a party is committed to if in government. We develop a new model of party competition in which parties choose tax rates, public-good provision, and perks, and we show that the introduction of tax contracts has two effects: a perks effect and a policy-shift effect. The former plays a central role in societies with a low degree of political polarization, where it tends to reduce politicians' perks. If a society is highly polarized, tax contracts can yield more moderate political outcomes. However, there are also circumstances in which tax contracts induce more extreme policies.