Distributional conflict in small open economies

•A simple general equilibrium model is employed to investigate distributional conflict inefficiencies in small open economies.•The overall inefficiency is decomposed into three components.•These are associated with: (i) time inconsistency; (ii) strategic political interaction; (iii) heterogeneity among individuals.•A numerical exercise indicates that the overall distributional-conflict inefficiency may cause a substantial output loss.

We aim at a better understanding of the inefficiencies resulting from distributional conflict in small open economies. To this end, a general equilibrium model with the following characteristics is set up: two groups of agents (capitalists and workers), an endogenous income tax, productive government expenditures, social transfers, and an outside option for capital. The overall distributional-conflict inefficiency is decomposed into three components: (i) a fundamental time inconsistency problem; (ii) strategic interaction in the political process; (iii) heterogeneity among individuals and the resulting unavoidable conflict of interest. A numerical exercise (based on OECD data) indicates that the distributional-conflict inefficiency may cause a substantial output loss.