Tax Contracts and Government Formation

Abstract

We examine how tax contracts affect government formation and welfare of voters in a parliamentary democracy. A tax contract specifies a range of tax rates a party is committed to if in government. We develop a new model of party competition and show that the introduction of tax contracts has two effects: a perks-reduction effect and a policy-shift effect. The former is dominant in soci- eties with a low degree of political polarization. If a society is highly polarized, tax contracts can yield more moderate political outcomes. However, there are also circumstances for which tax contracts induce more extreme policies.