Institutions, Factor Prices, and Taxation: Virtues of Strong States?

Abstract

While in a few societies economic institutions are designed to provide property rights protection, a level playing field, and basic public goods necessary for economic growth, in many they are structured to maximize the rents captured by the “elite,” the individuals or social groups monopolizing political power (e.g., Douglass C. North 1981; Acemoglu, Simon Johnson, and James A. Robinson 2005. The elite often choose entry barriers, regulations and inefficient contracting institutions that retard economic growth and create resource misallocations in order to protect their economic rents and redistribute resources to themselves (e.g., Mancur Olson 1982; Per Krusell and Jose-Victor Rios- Rull 1996).1 However, if resources could be redistributed to the elite with fewer distortions, a more efficient allocation of resources, with (part of) the proceeds accruing to the elite, could be chosen. For example, when the necessary fiscal instruments and the associated state capacity are absent, the elite may choose economic institutions and policies so as to redistribute income to themselves by reducing the productivity of competing groups and thus manipulating factor prices (Acemoglu 2007). Direct taxation, if feasible, would be both more efficient and more profitable for the elite. This reasoning suggests that when the state becomes more “developed,” achieves greater “capacity,” and has access to a larger set of fiscal instruments, there will be less need for such 1 A second, perhaps more important reason is that the elite may be afraid that a more efficient allocation of resources will reduce their political power and their future ability to obtain rents (e.g., Acemoglu and Robinson 2000, 2006). Institutions and Development † Institutions, Factor Prices, and Taxation: Virtues of Strong States? By Daron Acemoglu* inefficient, indirect methods of redistribution and the allocation of resources will improve (e.g., Acemoglu 2007; Timothy J. Besley and Torsten Persson 2010). The example of the development of the English state and economy in the eighteenth century is often used to support this presumption. This paper points out that, in contrast to this argument, the availability of more efficient means of taxation is a double-edged sword because of its impact on the political equilibrium; because more efficient means of taxation increase the potential benefits of controlling the state, they may also intensify political conflict aimed at capturing this control. This indirect effect counteracts the benefits from more efficient taxation and may dominate the direct effect, so that the allocation of resources may deteriorate when the society and the state have access to additional fiscal instruments. More generally, although greater state capacity and stronger states may bring a variety of economic benefits, they will also increase the value of controlling the state and thus induce increased political conflict and infighting. Therefore, the virtues of strong states emerge when the increase in the economic strength of the state is a consequence of, or coincident with, an increase in the political accountability of rulers and politicians— not necessarily when there is an autonomous increase in the fiscal capacity of the state.