Income redistribution in an economic union : the trade off between inter- and intranational redistribution

This paper studies the design of redistributive policies between and within the member countries of an economic union. There are two types of countries, which differ in their proportion of high income individuals. Both the supra-national and the national governments attempt to redistribute income within their respective boundaries. However, the central government cannot observe an individual country's ability to pay; it only observes the aggregate (internal) redistributive effort of each country. We derive the optimal incentive compatible tax-transfer policy of the central government and show that there is a tradeoff between inter- and intranational redistribution. Specifically, to reduce informational rents of the rich countries, the optimal policy induces a distortion in the poor countries'(internal) redistributive policies. Interestingly, both insufficient as well as excessive redistribution can arise.