Formation of nations in a welfare-state minded world

Nir Dagan and Oscar Volij

[Summary] [Get the full paper] [Introduction] [Cited by]


We model the endogenous formation of nations in a world economy where nations apply redistributive policies. We show that stronger distributive policies may lead to greater inequality in the world's distribution of income as a result of rich individuals tending to form their own nations. By the same token, stable economic integration occurs only when redistributive policies are not too strong.

The model is an application of the "theory of clubs" namely the core with endogenous coalition structure, applied to an economy with a continuum of players. By using an established model and equilibrium concept, rather than an ad hoc solution concept, the results are more convincing.

Journal of Public Economic Theory 2:157-181 (2000)

Get the full paper


One of the main purposes of taxation is the redistribution of income, and one of its rationales is that it brings about a better society in terms of income equality. Other things being equal (namely, disregarding other purposes and effects of taxation, such as providing public goods and incentives), a non-regressive income tax improves the distribution of income in society. On the other hand, it is not clear how far a society is willing to go in accepting a strong redistributive policy.

Most treatments of taxation consider a given society with a benevolent government that tries to maximize a social welfare function; a few papers apply game-theoretic models in which the government is responsive to pressures exerted by the voters. An alternative game-theoretic approach, whereby the formation of jurisdictions within society is endogenously determined, was introduced by Wooders (1978), Guesnerie and Oddou (1981) and Greenberg and Weber (1986). There, however, the issue is the provision of a public good. In the present paper we adopt a similar approach, but apply it to the analysis of income redistribution. Our primary purpose is to investigate the effects of redistributive policies on the distribution of income worldwide. A close predecessor is Bennett and Wooders (1979) where a similar approach is applied to the analysis of the effects of redistributive policies to efficiency. Our solution concept incorporates the possibility of any group of individuals forming a separate nation and applying a tax policy in it. Consequently, our approach takes into consideration the fact that if the tax burden is too heavy, some individuals will be willing to secede and form their own nation.

In order to focus on the redistributive role of taxation we adopt a general equilibrium framework in which taxes are non-distortionary. While individuals differ only in their initial endowments, they have the same preferences, which are defined over their consumption bundles of private goods and on a measure of income redistribution. We assume no cultural links or historical background to unite people, and no form of atavism separates individuals. Summarizing, we model a world in which all individuals are identical except for their initial wealth.

The individuals' concern about income redistribution is what we call "welfare-state mindedness." In the model, individuals do not want to live in a society where the government does not provide a minimum level of income. Once this minimum level is guaranteed by the government for all individuals in society, agents care only for their own consumption. Therefore, provided the required minimum level is guaranteed, the only reason for an agent to join another nation or to emigrate from his own, is an improvement of his own material well-being. This kind of welfare-state mindedness may seem too extreme but was neatly captured by a front-page New-York Times article on December 13, 1996. A representative Norwegian is quoted to say "We are a very social democratic society... It may be costly, but there is social peace. There are no poor people in Norway and I don't want to see any."

We look for an international equilibrium, which is a stable partition of the set of individuals into nations. By stable we mean that no group of individuals would be better off by forming a new nation. In the equilibrium, not only the partition of the world into nations is endogenously determined, but also each nation's redistributive policy. It can be argued that our equilibrium concept abstracts from political institutions that may be relevant for the determination of the nation's redistributive policy. Our results indicate, however, that the precise modeling of these political institutions is irrelevant, provided people have the ability to form their own nations with their own institutions, without the consent of others. Alternatively one can say that the only institutions that will be observed in equilibrium are those consistent with our endogenously determined redistributive policy.

Unlike in models where the main role of taxation is to finance a public good (see, for instance, Westhoff (1977) and Greenberg and Weber (1986), our equilibria are typically constituted by nations of very different people. It is not generally true that individuals with similar incomes cluster together. Unlike most treatments of migration (see, for instance, Myers (1990), Wildasin (1991), Hercowitz and Pines (1991) and Cukierman, Hercowitz and Pines (1994)), where there is free mobility between jurisdictions, in our model it may well be the case that an individual prefers, in equilibrium, a nation other than his own. This desire to emigrate does not upset the equilibrium because, in order to immigrate, an individuals needs the consent of the absorbing country, without which no movement is possible. While the assumption of free mobility is certainly appropriate when one deals with jurisdictions within a nation, it is extremely unrealistic when the mobility is across countries, as anyone who tried to migrate from one country to another can testify.

Another result relates to the issue of economic integration. In order to achieve economic integration, individuals should not be excessively welfare-state minded. It is shown that there is a level of welfare-state mindedness whose corresponding redistributive policy guarantees economic integration, that results not only in efficient production but also yields a world distribution of income that Lorenz dominates any other equilibrium income distribution achieved under a stronger policy. Further, once beyond that critical level, the stronger the distributive policy, the less equal the worldwide distribution of income. The intuition behind this result is that too strong a redistributive policy may lead to a world with many relatively egalitarian societies that nonetheless differ in their per capita incomes, while a weaker policy would yield a world with less egalitarian nations but with similar average income levels. Matters become aggravated when the incomes policy pursued is too vigorous, because the division of the world into very different nations (in terms of their capital-labor ratio) carries an efficiency loss with it.

The paper is organized as follows: After presenting the basic definitions related to national economies in Section 2, we discuss the central solution concept of an international equilibrium in Section 3. Section 4 gives a characterization of international equilibria, showing also their existence and essential uniqueness. The relation between government intervention, income distribution and integration of the world economy is analyzed in Section 5. Section 6 discusses the related literature.

Cited by

  1. Fritz Grafe and Ana Mauleon, Externalities and free trade ageements, Annales d'Économie et de Statistique 59:37-62 (2000)
  2. T. Kämpke, R. Pestel and F.J. Radermacher, A Computational Concept for Normative Equity, European Journal of Law and Economics 15:129-163 (2003)
  3. Sanjeev Goyal and Klaas Staal, The political economy of regionalism, European Economic Review 48:563-593 (2004)
  4. Ori Haimanko, Michel Le Breton, and Shlomo Weber, The Economics of Political Integration and Disintegration Transfers in a polarized country: bridging the gap between efficiency and stability, Journal of Public Economics 89:1277-1303 (2005)