Compensating reform losers requires distorting taxes fixed before outcomes are known.

Evidence

In general, those who are net losers from a policy reform can be compensated by transfers, even though the latter will generally induce welfare costs, such as the costs of distortionary taxation. Suppose that after M is chosen, a fixed amount of resources ω can be raised from all individuals through taxes, and assume for simplicity that taxes are raised before the idiosyncratic and aggregate shocks on preferences are realized. Note that this implicitly assumes that any increase in income obtained through the reform cannot be used to compensate, since the amount available for compensation is fixed ex ante. — Philippe Aghion, Alberto Alesina, and Francesco Trebbi, Endogenous Political Institutions, 107

Categorization

• DEFINE: Sets out the compensation mechanism and the ex-ante tax constraint that drives the model.