Fiscal Policy Reforms in a Global Economy

The paper considers two countries each populated by workers and capitalists and equipped with a government that collects taxes to nance productive expenditure and income redistribution. The share of income redistributed de nes the size of the welfare state. Both groups in each country bene t from an abolition of the welfare state in the long run. Nevertheless, the optimal scal policy in autarky can be characterised by maintaining a large welfare state since transfer cuts induce transitional losses. Starting in a such position of policy inertia free trade and capital mobility is introduced. Fiscal policy competition leads to a reduction of tax rates and a relative increase of productive expenditure. The welfare state is largely reduced although not completely abolished. If both countries coordinate their scal policy the reduction of taxes and income transfers is less pronounced. The model explains why increasing globalisation may bene t the country with the formally larger welfare state and deteriorate welfare in the other country. In a calibrated version this result is shown for an average Europe G{4 country and the United States