The Origins of State Capacity

There is now broad agreement that growth requires a functioning state with the capacity to raise revenues for key public goods. But in many developing countries the state is weak, and in particular the ability to enforce tax law is often inadequate. This raises the question of how rich countries first expanded their tax enforcement capacities, and what lessons can be drawn for developing countries today?

An intriguing argument by political historians holds that state capacity evolved historically over centuries in response to the exigencies of war. War placed a premium on sources of taxation and created incentives for governments to invest in revenue-raising institutions. For example, Britain first introduced an income tax in the budget of 1798 given the pressure on its public finances due to the Napoleonic war. The U.S. first introduced a form of income taxation in 1861 during the civil war, and the Internal Revenue Service (IRS) was founded on the back of this with the Revenue Act of 1862. Both countries significantly extended their income tax systems during the first and second world wars; in Britain, for example, the pay-as-you-earn method of tax collection was introduced in 1944. In Sweden, a system of relatively uniform permanent taxation of land and temporary taxation of wealth goes back as far as the 13th century.

In contrast to these historical lessons, traditional economic theory presumes sufficient institutions not only to tax citizens, but also to sustain markets. The Arrow-Debreu model implicitly assumes a government that flawlessly enforces contracts. Studies of optimal taxation explicitly acknowledge informational constraints, but implicitly assume a bureaucracy able and willing to enforce any tax policy respecting those constraints. Positive analyses in political economics of how the power to tax or regulate is chosen in a political equilibrium with collective choice make the same implicit assumption. This starting point cannot safely be taken for granted in many states, neither historically nor in the developing world of today.

One motivation for our paper is to fill that lacuna in the theoretical literature. Another motivation is to provide answers to some empirical questions in development. Why are rich countries also high-tax countries with good enforcement of contracts and property rights? Why do parliamentary democracies have better property rights protection and higher taxes than presidential democracies? Why is it so hard to find evidence in aggregate data that high taxation is negatively related to growth, while there seems to be good evidence that poor property rights protection is?