Abstract
We study the interaction between competitive markets and income redistribution that reallocates unequal pre-tax market incomes away from the rich to the poor majority. In one setup, participants earn their income by trading in a double auction (DA) with exogenous zero or full redistribution. In another setup, after trading, they vote on redistributive tax policies in a majoritarian election with two competing candidates. This results in virtually full redistribution, even when participants have the opportunity to influence taxes by transferring money to the candidates. We find that the high redistribution reduces trading efficiency, but not as much as predicted if market participants trade randomly. This is because, rather than capitulating to the much lower trading incentives, many participants respond to redistribution by asking and bidding more conservatively in the DA, and in this way help to prevent further efficiency losses.
The final version may be found at http://dx.doi.org/10.1016/j.jpubeco.2013.02.002.