The large variation in the amount of government redistribution in democracies is a much discussed subject in modern economics, and the effect of income inequality on redistribution lies at the core of the debate. Meltzer and Richard (1981) present a model that hypothesizes that there is more redistribution in countries where the income inequality is high, due to the preferences of the median voter. This hypothesis has been tested many times, both on cross-sectional and time-series data, with varying results. This thesis tests the effect of income inequality on redistribution utilizing panel data on Norwegian municipalities, using a fixed effects model, due to the potential problem of omitted variables affecting the results when using cross-sectional data.
The skewness of the income distribution is used to measure the income inequality, and the monthly welfare norm for single-person households, set by the local government in each municipality, is used as the main measure of redistribution. The main finding is that inequality has a small, statistically significant, negative effect on the welfare norm, with the effect being so small that it is not economically significant. A standard deviation decrease in the income inequality measure would not decrease the norm by more than 30 NOK.
Two sample cuts are made to test robustness. The effect of equality reverses after 2001, when a national guideline for welfare payments was introduced. Post-2001, inequality has a positive effect on redistribution, due to the fact that most local governments adapted to the new guideline. This caused governments above the new guideline to reduce their welfare norms, and vice versa. The municipalities are also divided into two groups to see if there are signs of welfare competition affecting the results. This is done by sorting the Norwegian counties by average municipality size, and dividing at the median. The municipalities in the counties where the average municipality size is the lowest make up the “high-pressure” group, where welfare competition is expected to be the strongest. The remaining municipalities make up the “low-pressure” group. The effect of inequality is slightly stronger in the “low-pressure” group, in line with the theory that welfare competition influences the results.
Another measure of redistribution is also used, the average welfare payment per welfare client, made out by local welfare offices. Here the effect of inequality is highly statistically significant and positive, indicating that ceteris paribus, there is more redistribution in more unequal municipalities. There are strong concerns about endogeneity with this variable, and taking the previous results found into account, I conclude that the average welfare payment per client does not seem like a suitable measure of redistribution.