DP501 | The Politics of 1992: Fiscal Policy and European Integration

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The internal market in Europe will greatly increase the international mobility of resources. How will this affect fiscal policy in different countries? We first consider taxation of capital in a two-country model, where a democratically-chosen government in each country chooses tax policy. Higher capital mobility changes the politico-economic equilibrium in two ways. On one hand, it leads to more tax competition between the countries: this `economic effect' tends to lower tax rates in both countries. On the other hand, it alters voters' preferences and makes them elect a different government: this `political effect' offsets the increased tax competition, although not completely. We then consider taxation of labour, in a model where labour is internationally immobile. Eliminating the remaining barriers to trade in goods changes the distribution of labour earnings in the model, which again has a political as well as an economic effect. Again the economic and political effects push the tax rates in different directions, but here the political effect can prevail. The tendency for an adapting political equilibrium to preserve the status quo emerges as a general result of the paper.