Income Redistribution in an Economic Union: The Trade Off Between Inter- and Intra-National Redistribution

This paper studies the design of redistributive policiesbetween and within the member countries of an economic union.There are two types of countries, which differ in their proportionof high income individuals. Both the supra-national and the nationalgovernments attempt to redistribute income within their respectiveboundaries. However, the central government cannot observe anindividual country‘s ability to pay; it only observes the aggregate(internal) redistributive effort of each country. We derive theoptimal incentive compatible tax-transfer policy of the centralgovernment and show that there is a tradeoff between inter- andintra-national redistribution. Specifically, to reduce informationalrents of the rich countries, the optimal policy induces a distortionin the poor countries‘ (internal) redistributive policies. Interestingly,both insufficient as well as excessive redistribution can arise. Copyright Kluwer Academic Publishers 1997