nep-pbe New Economics Papers
on Public Economics
Issue of 2007‒05‒19
23 papers chosen by
Peren Arin
Massey University

  1. Productivity and Taxes as Drivers of FDI By Assaf Razin; Efraim Sadka
  2. The stabilizing role of government size By Javier Andrés; Rafael Doménech; Antonio Fatás
  3. Hidden Economies and the Socially Optimal Fiscal-Tax to Liquidity-Tax Ratio By Ercolani, Marco G.
  4. Do fiscal rules cause budgetary outcomes? By Signe Krogstrup; Sébastien Wälti
  5. Shadow economies and corruption all over the world : what do we really know? By Schneider, Friedrich
  6. Fiscal Implications of Personal Tax Adjustments in the Czech Republic By Alena Bicakova; Jiri Slacalek; Michal Slavik
  7. The complexity of economic policy : restricted local optima in tax policy design By Saint-Paul, Gilles
  8. Why Do Most Countries Set Higher Tax Rates on Capital? By Nicolas Marceau; Steeve Mongrain; John D. Wilson
  9. A Tax Reform Analysis of the Laffer Argument By Alan Krause
  10. Regional Unemployment Disparities: An Evaluation of Policy Measures By Nicolaas Groenewold; Alfred Hagger
  11. A Simple Coase-Like Mechanism that Transfers Control of Government Spending Levels from Politicians to Voters By Graves, Philip E.
  12. Decentralization and Environmental Quality: An International Analysis of Water Pollution By Hilary Sigman
  13. Altruistic Versus Spiteful Behavior in a Public Good Game By Alexander Matros
  14. The Welfare Optimal Distribution of Olympic Success Considered as a Public Good By Loek Groot
  15. Moral hazard and bail-out in fiscal federations: evidence for the German Länder By Heppke-Falk, Kirsten H.; Wolff, Guntram B.
  16. Fiscal Situation and Stabilization Fund of Buenos Aires City: evolution and forecast By Uña, Gerardo; Bertello, Nicolas
  18. Minority Voting and Public Project Provision By Gersbach, Hans
  19. The EU Budget Dispute - A Blessing in Disguise? By Ondrej Schneider
  20. How Much Do Perceptions of Corruption Really Tell Us? By Weber Abramo, Claudio
  21. Mechanisms for Abating Global Emissions Under Uncertainty By John C. V. Pezzey; Frank Jotzo
  22. Does Welfare Policy Affect Residential Choices? Evidence from a Natural Experiment By Jon H. Fiva
  23. Occupational Choice and the Quality of Entrepreneurs By Eren Inci

  1. By: Assaf Razin; Efraim Sadka
    Abstract: We develop a framework in which the host country productivity has a positive effect on the intensive margin (the size of FDI flows), but only an ambiguous effect on the extensive margin (the likelihood of FDI flows to occur). The source-country productivity has a negative effect on the extensive margin. An increase in the host-country corporate tax rate reduces the actual FDI flows the likelihood of such flows to occur. An increase in the source-country corporate tax rate reduces the likelihood of FDI flows. These predictions are confronted with Data on FDI flows, drawn from the International Direct Investment dataset (Source OECD), covering the bilateral FDI flows among 18 OECD countries over the period 1987 to 2003. We find some support for the main predictions of the model.
    JEL: F2 F21 F23 F3
    Date: 2007–05
  2. By: Javier Andrés (Universidad de Valencia); Rafael Doménech (Economic Bureau of the Prime Minister, Spain); Antonio Fatás (INSEAD)
    Abstract: This paper presents an analysis of how alternative models of the business cycle can replicate the stylized fact that large governments are associated with less volatile economies. Our analysis shows that adding nominal rigidities and costs of capital adjustment to an otherwise standard RBC model can generate a negative correlation between government size and the volatility of output. However, in the model, we find that the stabilizing effect is only due to a composition effect and it is not present when we look at the volatility of private output. Given that empirically we also observe a negative correlation between government size and the volatility of consumption, we modify the model by introducing rule-of-thumb consumers. In this modified version of our initial model we observe that consumption volatility is also reduced when government size increases in similar way to the observed pattern in OECD economies over the last 45 years.
    Keywords: government size, output volatility, automatic stabilizers
    JEL: E32 E52 E63
    Date: 2007–05
  3. By: Ercolani, Marco G.
    Abstract: Differential tax analysis is used to show how the socially optimal fiscal-tax to liquidity-tax ratio changes with the relative size of the tax-evading hidden economy. The smaller the relative size of the hidden economy, the larger the optimal fiscal-tax to liquidity-tax ratio. The empirical cross-section and panel evidence supports this theoretical result.
    Keywords: inflation tax, hidden/shadow/underground economy, seigniorage
    JEL: E31 E52 H21 O17
    Date: 2007
  4. By: Signe Krogstrup (IUHEI, The Graduate Institute of International Studies, Geneva); Sébastien Wälti
    Abstract: This paper focuses on the observed empirical relationship between fiscal rules and budget deficits, and examines whether this correlation is driven by an omitted variable, namely voter preferences. We make use of two different estimation methods to capture voter preferences in a panel of Swiss sub-federal jurisdictions. First, we include a recently constructed measure of fiscal preferences. Second, we capture preferences through fixed effects with a structural break as women are enfranchised. We find that fiscal rules continue to have a significant impact on real budget balances.
    Keywords: Fiscal policy; fiscal rules; fiscal institutions; budget deficits; fiscal preferences; endogeneity
    JEL: C2 D7 E6 H6
    Date: 2007–05
  5. By: Schneider, Friedrich
    Abstract: Estimations of the shadow economies for 145 countries, including developing, transition and highly developed OECD economies over 1999 to 2003 are presented. The average size of the shadow economy (as a percent of "official" GDP) in 2002/03 in 96 developing countries is 38.7%, in 28 transition countries 40.1% and in 21 OECD countries 16.3%. An increased burden of taxation and social security contributions, combined with a labour market regulation are the driving forces of the shadow economy. Furthermore, the results show that the shadow economy reduces corruption in high income countries, but increases corruption in low income countries. Finally, the various estimation methods are discussed and critically evaluated.
    Keywords: shadow economy of 145 countries, tax burden, tax moral, quality of state institutions, regulation, DYMIMIC and other estimation methods
    JEL: D78 H11 H2 H26 O17 O5
    Date: 2007
  6. By: Alena Bicakova; Jiri Slacalek; Michal Slavik
    Abstract: We investigate the fiscal implications of the changes in personal income tax implemented in the Czech Republic in January 2006. In addition to evaluating the direct effect of this tax reform, our analysis takes into account its employment effect on the government budget due to individuals entering or leaving employment. We first estimate the probability of working (labor supply) as a function of the effective net wage and then simulate the impact of the changes in paid taxes and received benefits on employment. We find that a 10 percent rise in the net wage increases the probability of working by 0.55 and 0.18 percentage points for women and men respectively. These estimates suggest that the employment effect is unlikely to substantially alleviate the fall in net budget revenues. We predict that, for the sub-population of prime age employees, net government revenues decline by roughly 8 billion Czech korunas (CZK) as a consequence of the implemented income tax cuts. The employment effect counteracts the decline by only CZK 0.4 billion. The stimulating effect of the tax reform on employment is reduced by the current benefit system: the incentive to work due to the higher after-tax wage is partially offset by the fall in social benefits once people start working.
    Keywords: Fiscal effects, labor supply, personal income tax, tax reforms.
    JEL: E62 J31
    Date: 2006–12
  7. By: Saint-Paul, Gilles
    Abstract: Economists traditionally tackle normative problems by computing optimal policy, i.e., the one that maximizes a social welfare function. In practice, however, a succession of marginal changes to a limited number of policy instruments are implemented, until no further improvement is feasible. I call such an outcome a “restricted local optimum”. I consider the outcome of such a tatonment process for a government which wants to optimally set taxes given a tax code with a fixed number of brackets. I show that there is history dependence, in that several local optima may be reached, and which one is reached depends on initial conditions. History dependence is stronger (i.e. there are more local optima), the more complex the design of economic policy, i.e. the greater the number of tax brackets. It is also typically stronger, the greater the interaction of policy instruments with one another — which in my model is equivalent to agents having a more elastic labor supply behavior. Finally, for a given economy and a given tax code, I define the latter’s average performance as the average value of the social welfare function across all the local optima. One finds that it eventually sharply falls with the number of brackets, so that the best performing tax code typically involves no more than three brackets.
    Keywords: Complexity, Optimal taxation, bouded rationality, learning, multiple equilibria, path dependence
    JEL: H2 H21 J22
    Date: 2007
  8. By: Nicolas Marceau (Universite du Quebec a Montreal); Steeve Mongrain (Simon Fraser University); John D. Wilson (Michigan State University)
    Abstract: We consider tax competition in a world with tax bases exhibiting different degrees of mobility, modeled as mobile and immobile capital. An agreement among countries not to give preferential treatment to mobile capital results in an equilibrium where mobile capital is nevertheless taxed relatively lightly. In particular, one or two of the smallest countries, measured by their stocks of immobile capital, choose relatively low tax rates, thereby attracting mobile capital away from the other countries, which are then left to set revenue maximizing taxes on their immobile capital. This conclusion holds regardless of whether countries choose their tax policies sequentially or simultaneously. In contrast, unrestricted competition for mobile capital results in the preferential treatment of mobile capital by all countries, without cross-country differences in the taxation of mobile capital. Nevertheless our main result is that the non-preferential regime generates larger global tax revenue, despite the sizable revenue loss from the emergence of low-tax countries. By extending the analysis to include cross country differences in productivities, we are able to resurrect a case for preferential regimes, but only if the productivity differences are sufficiently large.
    Keywords: Tax Competition, Capital Mobility
    JEL: F21 H87
    Date: 2007–05
  9. By: Alan Krause
    Abstract: This paper shows that tax reform techniques are well-suited to an examination of the Laffer argument, i.e., the possibility that an increase in a tax rate may reduce tax revenues (and vice versa). Our methodology allows us to examine the Laffer argument directly, without deriving the Laffer curve, which in turn allows us to conduct the analysis in a very general setting. Despite the high level of generality, we are able to reach some clear conclusions that provide formal support for the established intuitions that the Laffer effect requires: (i) a 'high' labour-income tax rate, and (ii) a 'large' labour supply response to wage changes. The notions of 'high' and 'large' are made precise in our framework. The analysis also provides indirect support for the intuition that it is never optimal for a government to operate on the downward-sloping segment of the Laffer curve. Finally, we show that our methods provide a theoretical framework for an empirical investigation.
    Keywords: Laffer argument, tax reform
    JEL: H2 H6
    Date: 2007–05
  10. By: Nicolaas Groenewold (UWA Business School, The University of Western Australia); Alfred Hagger (School of Economics, The University of Tasmania)
    Abstract: This paper analyses the efficacy of regional and federal government policies in reducing inter-regional unemployment disparities. We use as our framework a two-region general equilibrium model with a given freely-mobile supply of labour. We assume interregional migration to occur in response to inter-regional utility differentials. Each region has households, firms and a regional government. In addition to regional governments, there is a federal government. The firms in a region use a single factor, labour, to produce a single good which we assume to be different to that produced in the other region. It is supplied to households and to the regional government in the form of payroll taxes. Households consume some, trade some with households in the other region and give some up to the federal government as income tax. Firms and households bargain over wages and firms then choose employment to maximise profits. The resulting equilibrium will generally not be a full-employment one. We simulate a linearised numerical version of the model. We examine seven alternative policies, six carried out by a regional government and one by the federal government. In the first group there are traditional tax/expenditure polices as well as policies which might be seen as attacking the natural rate of unemployment: changes in unemployment benefits, changes in union power, changes in the labour force and changes in labour productivity. The federal government policy is a regionally- differentiated fiscal policy. Contrary to expectations, many policies which have traditionally been recommended to alleviate unemployment, are found, in fact, to exacerbate the unemployment problem.
    Date: 2007
  11. By: Graves, Philip E.
    Abstract: Elected representatives have little incentive to pursue the interests of those electing them once they are elected. This well-known principle-agent problem leads, in a variety of theories of government, to nonoptimally large levels of government expenditure. An implication is that budgetary rules are seen as necessary to constrain politicians’ tax and spending behavior. Popular among such constraints are various Balanced Budget Amendment proposals. These approaches, however, are shown here to have serious limitations, including failure to address the central concern of spending level. An alternative approach is advanced here that relies on a Coase-like mechanism that transfers control of government spending to the voter. Prisoner's dilemma incentives and political competition are seen to be critical to the superiority of the present mechanism to approaches requiring budget balance.
    Keywords: political incentives, government spending, mechanism design, balanced budget amendments
    JEL: H11 H61 H62 H72
    Date: 2007
  12. By: Hilary Sigman
    Abstract: Many arguments about decentralization in public goods provision have testable implications for the relationship between decentralization and the level and spatial variability of public goods. This paper explores the empirical relationship between decentralization and environmental public good, water quality in rivers at monitoring stations around the world. It examines pollution levels and spatial variability of pollution within a country for both a local and a regional pollutant. The results suggest higher pollution levels with greater decentralization when fixed effects are included; the evidence is strongest for the regional pollutant, where it might result from interjurisdictional free riding. Federalism is associated with greater spatial variability in pollution within a country, consistent with the traditional view that decentralization allows policies more tailored to local conditions.
    JEL: H77 Q5
    Date: 2007–05
  13. By: Alexander Matros
    Abstract: This paper analyses an evolutionary version of the Public Good game of Eshel, Samuelson, and Shaked (1998) in which agents can choose between imitation and best-reply decision rules. We describe conditions under which altruistic and spiteful (maximizing) behavior arise: these conditions are established for any number of neighbors and any total number of agents in the population. Given mistake-free play, (short-run) outcomes are identical whether agents are constrained to employ an imitation rule only; or they can choose between imitation and best-reply rules. Given the possibility of mistakes, (long-run) outcomes vary across these two scenarios. The paper suggests how to provide public goods and gives an explanation of why we observe seemingly irrational cooperation - altruistic behavior - in the rational world.
    JEL: C70 C72 C73
    Date: 2006–12
  14. By: Loek Groot
    Abstract: This study considers the performance of countries at the Olympic Games as a public good and investigates different welfare optimal distributions of Olympic success. First, it is argued that at the national level Olympic success, measured as the number of gold medals won, meets the two key conditions of a public good, nonrivalry and non-excludability. Second, it is demonstrated that standard income inequality measures as the Lorenz curve and Atkinson’s measure can successfully be applied to the distribution of Olympic success. Four different distributions are considered: the actual distribution, the distribution according to population shares, the distribution under constant and declining marginal utility of medals and the one also taking production costs and declining marginal utility of per capita income into account. For the latter two, the rules for the welfare optimal distributions are stated, viz. equality of the marginal contributions to welfare and the Samuelson condition. At the end, a device is proposed to make the distribution of Olympic success more equitable.
    Keywords: Olympic Games, Public Goods, Externalities, Social Welfare
    JEL: D63 H41 H50
    Date: 2007–03
  15. By: Heppke-Falk, Kirsten H.; Wolff, Guntram B.
    Abstract: We identify investor moral hazard in the German fiscal federation. Our identification strategy is based on a variable, which was used by the German Federal Constitutional Court as an indicator to determine eligibility of two German states (Länder) to a bail-out, the interest payments-to-revenue ratio. While risk premia measured in the German sub-national bond market react significantly to the relative debt level of a state (Land), we also find that a larger interest payments-to-revenue ratio counter-intuitively lowers risk premia significantly. Furthermore, with increasing values the risk premia decrease more strongly. This is evidence of investor moral hazard, because a larger indicator value increases the likelihood of receiving a bail-out payment. Quantitatively, the effects are, however, quite small. Our findings are robust to a variety of sample changes. In addition, we provide a case study of the recent Federal Constitutional Court ruling on the Land Berlin, which had filed for additional federal funds. The negative response of the court did not lead to a change in financial markets’ bail-out expectations. In sum, our results indicate significant investor moral hazard in the sub-national German bond market.
    Keywords: moral hazard, bail-out, sovereign bond spreads, fiscal federalism, Germany
    JEL: E62 F34 G14 G15 H6 H7
    Date: 2007
  16. By: Uña, Gerardo; Bertello, Nicolas
    Abstract: After a period of positive fiscal results during years 2003 to 2005, the City of Buenos Aires faces challenges in its fiscal situation as of year 2006, which surely will be reflected in exercise 2007. During the period the 2003- 2005 City accumulated positive financial results near $1,800 million, starts off of which, $418 million, they were destined to the Stabilization Fund created in 2003 by Decree of the Executive authority. The estimations made by the Executive authority on the closing of exercise 2006 at the time of presenting the Project of Budget 2007 show a negative result of -$1,096 million, the contained negative result in Budget 2007 bases similar originally elevated by the Executive to the Legislature, and later modified in the parliamentary approval. As opposed to an electoral year, where the pressures on the public expenditure usually increase, it is precise to strengthening the institutionalization and transparency of the Buenos Aires City Stabilization Fund.
    Keywords: Fiscal Policy-Stabilization Fund-Budget Process-Legislature
    JEL: E62 H72
    Date: 2007–03
  17. By: Bernard Walters (Economics Discipline Area, School of Social Sciences, University of Manchester)
    Abstract: The HIV/AIDS pandemic has motivated large increases in aid commitments and disbursements, with promises of further large increases in the near future. This aid is urgently required to address the emerging humanitarian crisis and implies immediate, large-scale increases in public expenditure. The central question that this paper examines is whether such increases can effectively address the epidemic without inducing macroeconomic disturbances, especially for those countries, particularly in sub-Saharan Africa, where there is already high aid dependence and parallel commitments to the other MDGs. For the aid to lead to a real resource transfer, the monetary authorities in the recipient countries must accommodate such inflows. However, the twin dangers of ‘Dutch disease’ effects and inflation provide motivation for resisting accommodation. This paper argues that although such dangers are real, they are overemphasized: aid directed at HIV/AIDS is likely to have positive short- and long-term effects on production possibilities in the recipient countries and to be complementary to efforts to achieve the other MDGs. Furthermore, the increased fiscal deficit is a necessary condition for the appropriate resource transfer and is not likely, in itself, to have an inflationary impact. The danger of inflation lies in an effort by the monetary authorities to resist absorption. Recipient governments are understandably fearful of fiscal sustainability and debt sustainability because of the historical record of very high aid volatility and low predictability. However, spending that reduces the debilitating effects of HIV/AIDS is most likely to counteract such effects by raising government revenues in both the short and medium term. Nevertheless, donors have a responsibility to match disbursements to commitments on a more systematic and long-term basis, and reduce the dangers of volatility and unpredictability by shifting aid towards debt relief and grants. The possibility that aid-induced spending will quickly induce decreasing returns is an overly static and pessimistic view: aid targeted at HIV/AIDS can respond very elastically in the medium term and release the supply constraints that limit its effectiveness. Finally, many of the major impediments to aid effectiveness lie in donors’ behaviour, particularly their lack of co-ordination with one another and with the recipient country. In summary, although there are potential dangers in scaling up aid-supported spending to address the HIV/AIDS pandemic, they are manageable and provide no reason for delaying the immediate application of resources on a large scale.
    JEL: B41
    Date: 2007–05
  18. By: Gersbach, Hans
    Abstract: We propose a two-stage process called minority voting to allocate public projects in a polity. In the first period, a society decides by a simple majority decision whether to provide the public project. If the proposal in the first period is rejected, the process ends. Otherwise the process continues, but only the members of the minority keep agenda and voting rights for the second stage, in which the financing scheme is determined. In the second stage, the unanimity rule or the simple majority rule is applied. We provide a first round of relative welfare comparisons between minority voting and simple majority voting and outline our research program.
    Keywords: democratic constitutions, minority voting, public projects
    JEL: D60 D72 H40
    Date: 2007
  19. By: Ondrej Schneider
    Abstract: This paper analyses the European budget and the net position of the ten new member states. We argue that the EU budget should be reconsidered, as the Union has expanded to 25 member states and has become more heterogeneous. We demonstrate how the ten new members fared with respect to the budgetary plans outlined in the budget proposal approved at the 2002 summit at Copenhagen. We show that, in 2004, the new member states failed to qualify for the whole planned budget within the agricultural policy and the structural funds. On the other hand, they qualified for more than planned from a set of internal policy programmes and also from compensation transfers. We discuss the financial outlook for 2007–2013 and its recent developments. We argue that for the EU budget to support economic growth, the priorities must be re-oriented towards potentially productive spending programmes, and spending on oldfashioned programmes, such as the Common Agricultural Policy, should be scaled down or possibly re-nationalised. We show, however, that it is exactly these programmes that remained unchanged in the final negotiations for the 2007–2013 perspective. A simple economic growth model illustrates that the current EU budget setting is, at best, neutral with respect to the EUwide long-term growth potential and may actually hamper growth in the majority of the EU countries if the distortionary nature of taxation is taken into account.
    Keywords: Budget, European Union, growth.
    JEL: E6 H77
    Date: 2006–12
  20. By: Weber Abramo, Claudio
    Abstract: Regressions and tests performed on data from Transparency International Global Corruption Barometer 2004 survey show that personal or household experience of bribery is not a good predictor of perceptions held about corruption among the general population. In contrast, perceptions about the effects of corruption correlate consistently among themselves. However, no consistent relationship between opinions about general effects and the assessments of the extent with which corruption affects the institutions where presumably corruption is materialized is found. Countries are sharply divided between those above and below the US$ 10,000 GDP per capita line in the relationships between variables concerning corruption. Among richer countries, opinions about institutions explain very well opinions concerning certain effects of corruption, while among poorer countries the explanatory power of institutions for the effects of corruption falls. Furthermore, tests for dependence applied between the variables in the sets of respondents for each of 60 countries also show that, for most of them, it is likely that experience does not explain perceptions. On the other hand, opinions tend to closely follow the trend of other opinions. Additionally, it is found that in the GCB opinions about general effects of corruption are strongly correlated with opinions about other issues, as much as to justify the hypothesis that it would suffice to measure the average opinion of the general public about human rights, violence etc. to accurately infer what would be the average opinion about least petty and grand corruption. The findings reported here challenge the value of perceptions of corruption as indications of the actual incidence of the phenomenon.
    Keywords: corruption, perceptions, corruption indicators
    JEL: D73 H11 K42
    Date: 2007
  21. By: John C. V. Pezzey (Australian National University,Centre for Resource and Environmental Studies); Frank Jotzo (Australian National University, Research School of Pacific and Asian Studies)
    Abstract: We give theoretical, partial equilibrium comparisons of a tax with thresholds, tradable targets ('emissions trading' or ET), and non-tradable targets, as mechanisms to abate well-mixed ('global') emissions from many parties, under independent uncertainties in both future business-as-usual emissions and marginal abatement costs. All three mechanisms are revenue-neutral, and use flexible thresholds or targets indexed continuously to parties' activity levels. We analyse both risk-neutral or risk-averse behaviour. Key theoretical results are that because of emissions uncertainty, there is no simple Weitzman (1974) rule for choosing between 'prices' (a tax) to 'quantities' (ET); under ET, marginal abatement cost uncertainty is a benefit, compared to certainty; and under risk aversion, any mechanism with more expected welfare also gives more expected abatement. We apply our theory to global greenhouse gas abatement in 2020, using an 18-region numerical simulation model with new uncertainty estimates. Key global, empirical results are that under either risk behaviour, a tax dominates ET, which hugely dominates non-tradable targets; and under risk aversion, an optimally indexed tax gives about 60% more welfare and 30% more abatement than unindexed ET, while optimally indexed ET achieves about two-fifths of these improvements.
    Keywords: emissions trading, global abatement, greenhouse gases, risk aversion, tax, uncertainty
    JEL: D81 H23 Q54 Q58
    Date: 2006–08
  22. By: Jon H. Fiva (Statistics Norway)
    Abstract: This paper studies how changes in welfare benefit levels affect welfare recipients’ residential choices. Although several empirical studies have stressed that welfare policy may affect residential choices of welfare recipients, few studies have simultaneously taken into account that residential choices of welfare recipients also affect welfare policy. The main contribution of this paper is to address this policy endogeneity by utilizing a policy reform as a natural experiment. The results show that welfare policy exerts a nontrivial effect on residential choices of welfare recipients. Moreover, I show that ignoring the policy endogeneity may give rise to a downward bias in the estimated migration responses.
    Keywords: Welfare Benefits; Migration; Policy Endogeneity
    JEL: I38 H73 H77 R23
    Date: 2007–05
  23. By: Eren Inci (Boston College)
    Abstract: This paper focuses on the quality of entrepreneurs when individuals, who differ in terms of entrepreneurial ability and wealth, choose between entrepreneurship and wage-earning. A loan is required to become an entrepreneur. Four wealth classes form endogenously. Banks' inability to identify the ability of individuals leads them to offer pooling contracts to the poor and the lower-middle classes. Regardless of ability, all poor class individuals become workers and all lower-middle class individuals become entrepreneurs. Banks are able to offer separating contracts to the upper-middle and the rich classes. High-ability individuals in these wealth classes become entrepreneurs and their low-ability counterparts become workers. Equilibrium contracts may entail cross-subsidies within or between occupations. In some economies, a small success tax on entrepreneurs used to subsidize workers can increase the average quality of entrepreneurs and welfare by changing the thresholds of the wealth classes. In some others a reverse policy is required. Since the aggregate level of investment is fixed, the reason for these policies is not under- or overinvestment by entrepreneurs, as it often is in previous literature.
    Keywords: adverse selection; entrepreneurship; general equilibrium contract theory; moral hazard; occupational choice; success tax; wage subsidy
    JEL: D43 D82 H25 L26
    Date: 2007–05–02

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