Under-Investment in State Capacity: The Role of Inequality and Political Instability

Introduction

The most commonly known and the earliest denition of state capacity is the state’s power to raise tax revenues. As documented in Acemoglu (2005) and Acemoglu, Ticchi and Vindigni (2010), tax revenues constitute only a small portion of the GDP in the developing countries, such as those in Latin America, Asia and sub-Saharan Africa. The important consequence of the state’s inability to collect taxes is the limited provision of public goods and services, which are crucial for the well-being and the living standards of its citizens, especially those of the poor. If the level of economic development and the welfare of a country are closely related to state capacity, it is critical to understand why certain countries have a low state capacity problem. What are the main determinants of the level of state capacity? When do governments under-invest in state capacity? These are the main questions we aim to answer in this paper.

We present a two-period, two-group political economy model based on the theoretical framework developed in Besley and Persson (2009). We name the two groups as elites and citizens, assuming the elites to be the minority group. In each period, the group holding the political power chooses its policy vector of taxes, spending in public goods and the level of investment in state capacity. The maximum tax rate is determined by the level of state capacity, which can be increased with costly investments by the government. We associate political inequality to autocratic political systems. Specifically, in a fully democratic political system, the utility weights are equal to the population shares. We assume that the system is politically unequal when the utility of a particular group is weighted disproportionately. We also allow for political instability, and assume that the political system is unstable if the ruling group is likely to lose the political power to the opponent group, which can occur as a result of a civil war.

We first investigate how the incidence and the risk of external wars, as well as political inequality and stability, shape the government’s decision to invest in state capacity. Then, we include income inequality to analyze its effect on the investment decision.

Our main theoretical results indicate that the effects of external and civil wars go in the opposite directions. While the future risk of fighting external wars calls for building stronger state capacity, fighting civil wars (which is a measure of political instability) causes the government to invest less in state capacity. In the case of an external war, it is the government’s best interest to invest in state capacity, to be able to tax both groups at the maximum possible rate, and use these resources to increase spending in public goods (e.g., defense). However, if the country is fighting a civil war, the political system is highly unstable. In this case, the government’s actions are myopic, so the future benefit of having higher state capacity stock is low. Therefore, political instability (proxied with the incidence of civil wars, or with the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means) leads to lower investment in state capacity. In the case of political inequality, our model predicts that more democratic political systems (lower political inequality) invest more in state capacity. Furthermore, all these results are independent of which group holds the political power.

When we allow for income inequality, the investment decision becomes group-specific. More precisely, when the elites are in power, in the presence of political instability, both income and political inequality lead to lower investment in state capacity. Conversely, if the citizens are the rulers, our theory predicts that the combination of high political and income inequality results in higher state capacity. However, this is not always the case. Under some circumstances, inequality can result in low investment in state capacity, rationalizing the failed social revolutions.

We empirically test the model’s main predictions by applying econometric methods on cross-sectional data. We use several different measures to proxy for state capacity, which cover different and complementary aspects, ranging from fiscal to bureaucratic dimensions. Our empirical results support the theoretical predictions. We find that higher incidence of external wars and political stability (lower incidence of civil wars or lower likelihood that the government will be destabilized) are associated with higher state capacity. On the contrary, inequality (political and/or income) is negatively correlated with state capacity. We also consider the interactions of income inequality with political stability and democracy. The estimation results indicate that, when there is income inequality, the magnitudes of the positive correlations of democracy and political stability with state capacity are significantly reduced.

The organization of this paper is as follows: Section 2 reviews the related literature. Section 3 introduces the model and discusses the theoretical results. In Section 4, we explain in detail the data we use, present the empirical evidence and discuss the regression results. Finally, Section 5 concludes.