The evolution of the welfare state over the last few decades has differed strikingly across countries in the world. For example, spending on social benefits as a fraction of GDP has substantially increased in the US since 1980, remained stable in Canada, and declined in Sweden. To explain these different trends, I propose a model with agents that are heterogeneous in occupation and wealth, and who vote on social benefits over the course of their lifetime. The model highlights the key role of “aspirational voters”—members of the middle class who support pro-business policies and sacrifice social benefits hoping to become future entrepreneurs. The importance of aspirational voters, in turn, depends on wealth inequality. The model predicts that social spending should increase in rich countries with high wealth inequality, while it should decline if inequality is low. A calibrated version of the model successfully predicts the observed trends of social spending in 18 out of 24 countries from all continents.

This article explores the political origins of size-contingent Employment Protection Legislation (EPL), which typically imposes stricter requirements on larger firms. The theory is based on the political conflict between workers and entrepreneurs that is shaped by endogenous occupational decisions. The equilibrium policy protects workers in larger but not in smaller firms. This is true regardless of the weights the government puts on the welfare of workers and entrepreneurs. Firms strategically adjust their labor demand in response to the size-contingent EPL policy, resulting in welfare distortions. These welfare distortions can be eliminated by balancing the bargaining power of workers and entrepreneurs.

Employment protection laws (EPLs) are aimed to protect workers. However, if firms cannot easily adjust to EPLs, then their workers may not benefit from higher protection at all. I address this concern from both a theoretical and empirical perspective. In the model, EPLs crowd out external finance, discouraging firms’ investment and employment. These distortions are larger in more financially constrained firms that have less room to accommodate EPLs. As a result, EPLs harm financially constrained firms and their workers, while they may only benefit unconstrained firms and their workers. I test the predictions of the model by exploiting the adoption of state-level US wrongful discharge laws. I find strong evidence that EPLs reduce labor earnings, firms’ profits, investment, and employment in more financially constrained firms. This negative effect is decreasing in the level of financial constraints. Overall, EPLs have regressive effects as they only benefit the most unconstrained firms and their workers.

This paper models policy-making as an intricate process in which governments balance political and economic considerations. I incorporate this view into a macro model with heterogeneous agents who face idiosyncratic shocks and express their political sentiments. I provide analytical results when political sentiments are uniformly distributed and independent over time. The model endogenously sorts people into three categories depending on their policy demands; the “indifferent”, “the sensible”, and “the senseless” citizens. Policy-making responds mainly to the dynamics of sensible agents, but the survival of the government can be threatened by senseless agents. I expand the model to consider a general distribution of sentiments that depends on past sentiments so that the government takes into account the future threats of its current policy decisions. The model allows for a structural empirical approach to disentangle how economic versus political grounds have influenced policy decisions and the process of development across countries.