Ufi!2 1 DEWEY ^^nur\5 111 11 II I II 1 ^ 3 9080 03316 3400 ! Massachusetts Institute ot Technology Department of Economics Working Paper Series Institutions, Factor Prices and Taxation: Virtues of Strong States Daron Acemoglu Working Paper 10-2 January 2010 15, Room E52-251 50 Memorial Drive MA Cambridge, 021 42 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://ssrn.com/abstract=1540249 Institutions, Factor Prices and Taxation: Virtues of Strong States?* Daron Acemoglu MIT and CIFAR January 15, 2010 Abstract , Many of the most pernicious economic institutions and policies create entry barriers or manipulate factor prices to transfer resources fromentrepreneurs and workers to groupsthat hold political power. These inefhciencies partly result from the fact that direct and efficient fiscal instruments that can be used for taxation and redistribution of resources are absent. One might then conclude that increasing state capacity and expanding the set of available fiscal instrumeirts should improve the allocation of resources by preventing the use of these inefficient, indirect methods of redistribution. This reasoning ignores the effect of greater state capacity and the change in the set of available fiscal instruments on the political equilibrium, however. Because the availability ofmore efficient means of taxation increases the potential benefits of controlling state power, it also intensifies costly political confiict aimed at capturing the control of the state. This indirect effect counteracts the benefits 'Massachusetts Institute of Technology and Canadian Institute for Advanced Research. I thank Melissa Dell and Christopher Udry for useful comments and suggestions. Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/institutionsfactOOacem from more efficient taxation and may dominate the direct benefits. The paper establishes the possibihty that the aUocation of resources may deteriorate substantially in response to an autonomous increase in state capacity and the set of fiscal instruments. It also argues that in the British case, which is a key historical example that points to the central role of increased state capacity in economic development, this change was not autonomous; instead, it was an equilibrium response to changes in political institutions that placed better checks on the exercise of power by the executive. This reasoning suggests that the study of the effect of fiscal capacity and the evaluation of policies aimed at increasing state capacity in less-developed economies should be done in the context of dynamic models of political economy, in which fiscal capacity and political constraints are jointly determined. Keywords: contests, institutions, factor price manipulation, political equilibrium, po- litical institutions, state capacity, taxation. JEL Classification: D74, 012, P14, P16. 1 Introduction While in a few societies economic institutions are designed to provide property rights protection, alevel playing field, and basic public goods necessary for economic growth, in many they are structured to maximize the rents captured by the "elite," the indi- viduals or social groups monopolizing political power (e.g., Douglass C. North, 1981, Acemoglu, Simon Johnson and James A. Robinson, 2005, North, John J. Wallis and Barry R. Weingast, 2009, Acemoglu and Robinson, 2010). The elite often choose en- try 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-RuU, 1996, Stephen Parente and Edward J. Prescott, 1999).^ 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 pieces (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 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 ofthe development ofthe English state and economy in the 18th century is often used to support this presumption. ^A second, perhaps more important reason is that the ehte may be afraid that a more efficient allocation ofresources will reduce their political power and their future ability to obtain rents (e.g., Acemoglu and Robinson, 2000, 2006). 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 po- litical 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 effi- cient 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 in- struments. 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 accountabil- — ity of rulers and politicians not necessarily when there is an autonomous increase in the fiscal capacity of the state. This view is in fact more consistent with promi- nent historical examples (from England and elsewhere), which show that increases in the fiscal capacity of the state have typically been concomitant with increases in its accountability (e.g., Brewer, 1988). I use a simple model to exposit these ideas. I start with a simplified version of Acemoglu (2007), with two additional features. First, instead of a single group of elites (in addition to the middle class and workers), there are now two groups of competing elites. Second, these two groups can engage in a costly contest in order to capture state power. I provide an example in which without efficient taxation mechanisms, the group in power uses inefficient entry barriers to manipulate factor prices. The availability of tax instruments avoids this source of inefficiency in the allocation of resources. However, I also show that these tax instruments increase the costs expended in order to capture the control of the state and this may more than — offset the benefits. ' Naturally, these results do not imply that the increased power ofthe state and the availability of a richer set offiscal instruments lead to a worse allocation ofresources, since these changes often occur endogenously in response to better political controls so that the elite are unable to use these instruments to extract greater resources from the rest ofthe society. This paper therefore suggests that it is important to study the development of the power of the state as part of a process in which better political institutions are built in order to control the exercise of power. The main idea proposed in this paper is closely related to Wilson (1990) and Becker and Mulligan (1998), who suggest that politicians might want to commit to use inefficient methods in order to reduce total redistribution. The main difference is that in the current paper the potential costs of efficient methods ofredistribution are not simply greater redistribution, but the waste created in a power struggle in order to capture the now more valuable control of the state. Economic Model 2 Consider a static and simplified version of the model presented in Acemoglu (2007). The economy is populated by a continuum L-\-29e+6m ofrisk neutral agents. Agents are in four groups. The first comprises a total mass L of workers, who supply labor inelastically. The second is a total population 6''" of "middle class" agents, denoted by m, and finally, there are two sets of potentially competing elites, denoted by 1 and 2. For simplicity, let us assume that each of these two groups has size 6^, normalized to 6'^ — I. Middle-class and elite agents (of either group) can become entrepreneurs. Each entrepreneur can hire at most A workers. The productivity of each middle class agent is A^, while the productivity of elite agents of groups 1 and 2 are both given by A^^^ Throughout, let us focus on the more relevant case where the middle class are moi-e productive than the elite, i.e., (Al) 0<^" <^"'. .' I assume that theelitegroup 1 initiallycontrols thestate. One policy tool available to the state is an entry barrier B'^'^ affecting middle-class agents wishing to become entrepreneurs (hire labor). These entry barriers are purely wasteful and generate no revenues (whether there are also additional entry barriers applying to the other elite group has no effect on the results). In addition, they may also have access to a non-distortionary income tax, t. Since there is no marginal decision, such as labor supply or capital investment, this income tax is equivalent to a lump-sum tax. Tax revenues, if any, are redistributed lump-sum and in a group-specific manner, so that all the proceeds could be redistributed to the group in power. The key economic margin in this model is the allocation of labor to different entrepreneurs. In particular, denoting the set of entrepreneurs by S, labor market clearing requires j-^^Pdj < L, where P denotes the labor hired by entrepreneur j, and with a slight abuse of notation, I also use /"' and l'^ for the emplojanent levels of middle-class and elite entrepreneurs. Let us also assume ^2<- (A2) 29" < A which, combined with (Al) and the fact that each entrepreneur can employ A workers, implies that there is a sufficient number of middle-class entrepreneurs to employ all workers, but there will not be "excess demand" for labor coming only from the two ^Allowing these productivities to be different, Al and ylo- would have no effect on the results.