The completion of the single European market in the 1990s will remove most remaining barriers to trade in inputs and commodities and may affect the allocation of taxation among tax bases. This may lead to a convergence or divergence of fiscal policies and possibly to `political' effects over and above the `economic' ones.

In Discussion Paper No. 501, Research Fellows Torsten Persson and Guido Tabellini present a model of a two-level non- cooperative game, in which policy-makers in two countries set taxes and voters choose among policy-makers. Both countries' economic and political features are reflected in the equilibrium policy, which may change when the environment changes, e.g. when the mobility of resources increases. Both countries raise distorting taxes on capital to finance transfer payments. Wealth is distributed unevenly, which provides scope for a majority rule equilibrium with positive taxes and redistribution. The population votes to appoint a policy-maker who then sets capital taxes, taking account of those in the other country. The pivotal vote is cast by the individual with the median endowment, who chooses a policy-maker particularly skilled in the international policy game in which both governments are engaged, which leads to the election of a government with different preferences from the median voter.

When capital mobility increases, tax competition also increases: in a symmetric equilibrium this pushes down taxes in both countries. Increased tax competition also has an offsetting `political' effect, however, since voters will be more inclined to appoint a policy-maker further `to the left'. If the two countries' initial conditions differ, both economic and political convergence will follow.

Persson and Tabellini also investigate the consequences of increased mobility of final goods and services in a two-sector model of a small open economy. The only tax base labour is employed in both export and import sectors; and workers within each sector differ in their productivities and average wages. Individuals vote to appoint a policy-maker who imposes distorting taxes and distributes the proceeds. The government has the same preferences as the median voter, but the identity of this voter is now endogenous and depends on the structure of the economy. Removing trade barriers alters the relative wages between sectors and therefore changes the incentives for redistribution. Again there are both `economic' and `political' effects (the latter is the change in the winning political coalition), which now operate in opposite directions. In this model, the `political' effect may dominate, the equilibrium tax rate and the size of government may rise or fall, and the two countries may display economic and political convergence or divergence.

The Politics of 1992: Fiscal Policy and European Integration
Torsten Persson and Guido Tabellini