The Dynamics of Inequality and Social Security in General Equilibrium

Zheng Song < review of economic dynamics> OCT 2011

Abstract:This paper analyzes the dynamic politico-economic equilibrium of a model where repeated voting on social security and the evolution of household characteristics in general equilibrium are mutually affected over time. In particular, we incorporate withincohort heterogeneity in a two-period Overlapping-Generation model to capture the intragenerational redistributive effect of social security transfers. Political decision-making is represented by a probabilistic voting à la Lindbeck and Weibull (1987). We analytically characterize the Markov perfect equilibrium, in which social security tax rates are shown to be increasing in wealth inequality. A dynamic interaction between inequality and social security leads to larger social security programs. In a model calibrated to the U.S. economy, the dynamic interaction is shown to be quantitatively important: It accounts for more than half of the social security growth in the dynamics. We also perform some normative analysis, showing that the politico-economic equilibrium outcomes can be fundamentally different from the Ramsey allocation.

Keywords:Inequality, Intra-generational redistribution, Markov perfect equilibrium, Probabilistic voting, Social security