SFB 303 Discussion Paper No. A - 499

Author: Janeba, Eckhard, and Horst Raff
Title: Should Income Redistribution be (De-) Centralized? The Role of Risk Aversion and Income Inequality
Abstract: Consider a system of regions populated by heterogeneous individuals. Suppose that these individuals are mobile across regions and that they must decide, by majority rule, on what kind of redistributive tax policy, if any, to implement. Should such a policy be voted on and imposed on a system-wide (i.e., centralized) basis or on a region-by-region (i.e., decentralized) basis? Using the concept of a veil of ignorance, we construct a benchmark case in which a decentralized political system dominates a centralized one in expected value terms. In this benchmark scenario, individuals are riskneutral or nearly so, and tax competition among regions in a decentralized system reduces the inefficiencies inherent in the redistribution process. In numerical examples, we show that for a certain income distributions in society a large enough degree of risk aversion may lead to centralization becoming the preferred solution; however, there does not exist a monotone relationship between risk aversion and the advantage of decentralized and centralized systems. Risk aversion interacts with the distribution of gross incomes in a non-trivial way.
Keywords: income redistribution, mobility, majority voting, fiscal federalism
JEL-Classification-Number: D7, H1, H7
Creation-Date: October 1995
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