Notes - 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

The core model used here is based on Besley and Persson (2009b, 2010b). Many of the underlying ideas are developed verbally by Hintze (1906) and Tilly (1985, 1990). Cukierman, Edwards, and Tabellini (1992) develop an early model in which investment in income taxes (fiscal capacity) reduces reliance on seigniorage. They also spell out the implications of polarization and political instability.

There is a vast literature on taxation and development, which relates to the general issues in this chapter. Burgess and Stern (1993) and Kaldor (1963) provide overviews of taxation in low-income countries and the ways that tax collection can be restructured and improved. Collections of articles on taxation and development issues include Bird and Oldman (1980), Gordon (2010), and Newbery and Stern (1987). Keen (2010) gives an up-to-date review of the policy experience and more recent literature.

Many influential contributions have studied the forces that have shaped the tax system in history. These often emphasize the importance of political institutions in shaping this process. Bonney (1999) is a collection of essays that look at a variety of historical experiences with the different paths taken all over Europe. Dincecco (2011, Chapter 1) provides a comprehensive overview of the historical literature. Hoffman and Rosenthal (1997) offer an overview of the issues relating public finance to warfare. For a specific discussion of U.K. public finances with a central role for war see Brewer (1989) and O’Brien (2001, 2005). Mathias and O’Brien (1976) contrast the historical experiences of France and the United Kingdom, bringing out the differences in economic and political structure. Karaman and Pamuk (2011) discuss the evidence from early modern Europe.

Schumpeter (1918) is a classic reference in fiscal sociology and our opening quote is from his work. A large modern literature links taxation to culture, politics, and governance, including Braütigam, Fjeldstad, and Moore (2008), Levi (1988), and Moore (2004). Increasingly this taxation is seen as part of a broader state-building agenda. Levi (1988) discusses the idea that a tax system can be viewed as a contract between citizens and government, linking trust in government and taxation together. This idea is developed formally in Perroni and Scharf (2007), who use a repeated game framework with collective punishments.

At the heart of building fiscal capacity is the idea of expanding tax enforcement and compliance. The earliest formal paper in the tax-enforcement literature is Allingham and Sandmo (1972), which models the gamble that people take when deciding to pay their taxes, facing a probabilistic fine if they do not comply. Cowell (1990) and Slemrod and Yitzhaki (2002) survey the key models and the evidence, which mainly takes off from the Allingham-Sandmo approach. Kleven, Thustrup Kreiner, and Saez (2009) consider the role of firms in transmitting taxation as a means of reducing compliance costs and argue that this was an important factor in shaping the large increases in tax revenue raised by government in the twentieth century.

There is growing interest in the idea that tax morale is central to understanding tax compliance and Torgler (2007) surveys the theoretical and empirical contributions, which draw on psychology and economics in explaining why people pay their taxes. This literature tends to move away from the rational-gambler model toward a wider interpretation of motivation by tax payers. Zolt and Bird (2005) is a useful overview of the issues involved in extending the domain of personal-income taxation in developing countries, where compliance is a more serious problem.

Tanzi (1987) remains a useful quantitative overview of patterns of taxation and development. For a comprehensive overview of the evidence on the choice of tax levels and tax bases see Kenny and Winer (2006). A number of studies have looked at the adoption of specific taxes. Aidt and Jensen (2009a) develop an event study of factors influencing the introduction of an income tax. Berry and Berry (1992) study the factors leading to adoption of income taxes in the context of U.S. states. Scheve and Stasavage (2010) look at inheritance taxation in historical perspective, highlighting the importance of both economic and political developments. Keen and Lockwood (2010) study the factors that have influenced the adoption of a VAT. Aizenman and Jinjarak (2008) argue that political instability makes tax collection from a VAT less effective. Gordon and Li (2009) stress the fact that developing countries rely heavily on trade taxes and suggest a theoretical explanation. Baunsgaard and Keen (2005) consider the impact of trade liberalization on taxes, and Jensen (2010) studies the relationship between tax revenues from oil wealth and other forms of taxation. Dincecco (2011) is a broad historical study of how taxation interacted with political reform, especially fiscal centralization and limited government, in several West European countries.

Cárdenas (2010) and Cárdenas and Tuzemen (2010) extend the model in Besley and Persson (2009b) to study the impact of income inequality on fiscal-capacity investments, theoretically and empirically. Gradstein (2008) and Chong and Gradstein (2007) also consider the link between inequality and state capacity. The impact of polarization on public finance was studied by Alesina, Baqir, and Easterly (1999), who argue that greater polarization is associated with lower public-goods provision. Esteban, Ray, and Duclos (2004) study a variety of polarization measures theoretically and empirically.

Overviews of the political economy of taxation and public-goods provision include Hettich and Winer (1999) and Persson and Tabellini (2002). There is a large emerging literature on dynamic public finance and political economy related to the models developed in this chapter. Golosov, Tsyvinski, and Werning (2006) survey the normative literature. Acemoglu, Golosov, and Tsyvinski (2008, 2009), Azzimonti (2009), Bai and Lagunoff (2011), and Battaglini and Coate (2007, 2008), among others, have studied dynamic political equilibria with government turnover. The dynamic public-goods model in Battaglini and Coate (2007) has many formal similarities with the infinite-horizon model studied in Section 2.2.8. These papers are related to the literature on strategic public debt by Aghion and Bolton (1990), Alesina and Tabellini (1990), and Persson and Svensson (1989), who all study strategic issue of debt in the presence of political turnover.