Chapter 2: Fiscal Capacity

The fiscal history of a people is above all an essential part of its general history. An enormous influence on the fate of nations emanates from the economic bleeding which the needs of the state necessitates, and from the use to which the results are put.

- Joseph Schumpeter, 1918

Joseph Schumpeter. Volkswirtschaftliches Institut via Wikimedia Commons

Following on from the general overview in Chapter 1, we now begin our presentation of an intellectual framework for understanding state capacity and the forces that shape its creation and maintenance.

In this chapter, we introduce some of the main ideas of the book in a formal model, but with an exclusive focus on building fiscal capacity. The crucial component of the approach is the idea that fiscal capacity constitutes a capital investment, which makes it feasible to raise more taxes in the future.

A government can choose levels of redistributive transfers and the provision of public goods. The necessary revenue comes from an income tax. But the level of taxation is constrained by fiscal capacity. In our core model, which has only two time periods, the incumbent government in period 1 makes a decision on whether to increase fiscal capacity for period 2.

Politics plays an important role in the theory through two channels. Political institutions are a key element, by affecting the use of tax revenue, in particular how much of available revenues an incumbent government can allocate to its own group of supporters. Politics also enters via the process of political turnover. The model delivers a prediction about investments in fiscal capacity, as a function of political institutions and the likelihood that the government will be replaced. Economic structure also enters the model and helps to determine fiscal-capacity investments, via the level of income and the governments access to non-tax revenue, such as resource rents or foreign aid.

Our core model is very streamlined to make a number of points as clearly and concisely as possible. The role of fiscal capacity is specified as a reduced form, but later on in the chapter we show how our simple formulation can be given microeconomic foundations. In a sequence of extensions, we relax a number of the simplifying assumptions in the core model and show the consequences for the main results.