Lectures 7-8_090520.pdf

Political Economics IIISpring 2009

IV. State Capacity, Conflict and DevelopmentLectures 7-8

Torsten Persson, IIES

1

Discuss roles of state building and conflict in development

develop basic framework and extend ina couple of directions

new theory and clear hints at how to approach the data

A. The origins of state capacity

B. State capacity and the genius of taxation

C. State capacity and the strategy of conflict

2

A. The origins of state capacityMotivations — Figure 1

State capacity in political and economic history

power to raise revenues important for militarysuccess and state development, more generally

Ignored by economists, yet implicit in economic theory

state capacity to raise (any) taxes basically assumedin public finance, political economics, development...

as is capacity to enforce contracts (support markets)

Empirical observations of development

over wide range of countries (financial) market developmentand tax capacity positively correlated with each other and GDP

3

010

2030

40S

hare

of I

ncom

e T

axes

in G

DP

0 50 100 150 200private credit to GDP

Above median income Below median incomeFitted values

Figure 1

Purpose of analysis

Study investment in two forms of state capacity

fiscal capacity: constrains tax policy, which raisesrevenue for common-interest spending or redistribution

legal capacity; constrains regulatory policy, which protectsproperty rights (in potentially discriminating way)

What are the main determinants of state capacity?

model which economic, political and institutional featurespromote investments, under uncertainty, in state capacity

4

Central result

Complementarity between fiscal and legal capacity

investments in the two types of state capacityare mutually reinforcing

we should indeed see market development andtaxation go hand in hand

complementarity has a number of — analytical,substantial and empirical — implications

5

Related work

Economic and political history

body of work on fiscal capacity and its relation to militarycapacity and the fighting of wars

but no links to legal capacity (support of markets)

Law, politics, and financial development

recent work on legal, or political, origins of financial developmentbut no links to taxation and fiscal development: "why dopowerful groups maldesign financial system to protect rentsrather than support markets and redistribute to themselves?"

6

Road map

1. A basic model

2. Equilibrium policy

3. Equilibrium investments in state capacity

4. A preliminary look at the data

5. Final remarks

7

1. A basic model

Main building blocks

Private sector

earns income in private markets and consumes

Government

regulates (legally protects capital markets)taxes and spends on transfers or public goodsinvests in legal and fiscal capacity

8

Private groups and types

Two time periods, s ∈ {1, 2}

Two groups of individuals, J ∈ {A,B}each has share 12 of populationgroups defined by some observable featureevery member has income wJ

s , no savingsutility is linear in consumption (risk neutrality)

Incomes

depend on regulation pJs

wJs = w(pJs)

think about "legal protection of property rights"microfoundations: credit market model with partialenforcement of collateralized debt contracts

9

Regulation

Government has discretion over current regulation

policy pJs can be group-specificconstrained by existing legal capacity, i.e., pJs ≤ πs .

Investment in legal capacity

courts, judges, credit and property registries.initial stock π1 is given, but can be augmented in s = 1by (positive) investment π2 − π1, at (convex) cost L(π2 − π1),where Lπ(0) = 0

10

Taxation

Government has discretion over current taxation

government taxes output at rates tJs

these can be negative, i.e., redistributive transferspolicy can be group-specificconstrained by existing fiscal capacity, i.e., tJs ≤ τsmicrofoundations: an individual can earn a share(1− τs) of her income in the informal sector)

Investment in fiscal capacity

tax authority, infrastructure to enforce income taxor impose a value added tax

initial stock is given τ1 but can be augmented in s = 1by (positive) investment τ2 − τ1, at (convex) cost F (τ2 − τ1),where Fτ (0) = 0

11

Public goods

Common-interest (non-redistributive) motive for taxation

public goods have same linear payoff αsGs to everybodythink about as “threat of external conflict” and “defense”

αs has two-point distribution αs ∈ {αL, αH ]}, where αH > 2αL < 1, and Prob[αs = αH] = φ

shocks to α iid over timerealization of αs known when {tJs} set

12

Private utility and government budget

Utility of each group

linear payoffs allow us to write

vJ = αsGs + (1− tJs)w(pJs)

Government budgetsXJs

tJsw(pJs)

2+R1 = G1 + [L(π2 − π1) + F (τ2 − τ1)]

in period 1, and XJs

tJsw(pJs)

2+R2 = G2

in period 2

Rs is additional revenue source, Rs ∈ {RL,RH}, whereProb[Rs = RH] = ρ — interpret as natural resource rents.

13

Government decision weights and turnover

Representative governments

at policy stage in each s one group Is holdsthe government, the other is the opposition Os

Decision weights in policy

the incumbent Is gives weights 1− θ to itselfand θ to Os, where θ ≤ 1

2

Government turnover

γ ∈ [0, 1] is probability of transition of powerin s = 2 from I1 to O1

Interpret crudely as political institutions

θ inclusiveness, minority protectionγ political instability

14

Timing in period s

1. Start out with state capacity {πs, τs}and incumbent group Is−1

2. Nature determines αs, and Rs

3. Group Is−1 remains in power withprobability 1− γ

4. New incumbent Is chooses policy {tIs, tOs, pIs, pOs,Gs}and invests in legal and fiscal capacity (only at s = 1)s t government budget constraint and state capacity

5. Payoffs are realized and agents consume

15

2. Equilibrium policy

Can study policy and investments separately

incumbent government maximizes

V Is = (1− θ)w³pIs´(1− tIs) + θw

³pOs´(1− tOs) +

αs

⎡⎢⎣tIsw³pIs´+ tOsw

³pOs´

2+ zs

⎤⎥⎦ ,

where we have eliminated Gs and defined

zs = Rs −½L(π2 − π1)− F (τ2 − τ1) if s = 1

0 if s = 2 .

s t constraints Gs ≥ 0, tJs ≤ τs and pJs ≤ πs

16

Regulation (legal protection) — Proposition 1(a)

For s ∈ {1, 2} any government Js, and any αs and Rs,optimal regulation fully utilizes all legal capacity, pIs = pOs = πs

“obvious” result, cf. Diamond-Mirrlees production efficiencyresult breaks down if there are rents — explain in B

does not imply property rights well protected everywhere

17

Taxation and public goods — Proposition 1 (b)

Common-interest state, αs = αH ≥ 2(1− θ)

where tIs = tOs = τs, and Gs = τsw(πs) + zsvalue of public goods worth more than transfers to incumbentall available revenue used or public goods

Redistributive state, αs = αL < 2(1− θ)

where tOs = τs,Gs = 0,−tIs = τsw(πs)+2zsw(πs)

all available revenue transferred to incumbent group

In more general model: undersupply of public goods

if α continuous, public goods provided in too few states ofworld, compared to Utilitarian optimum with θ = 1

2where condition is αs ≥ 1

18

3. Equilibrium investments in state capacity

Objective

Incumbent I1 maximizes expected utility

expected weighted payoff at s = 2,under uncertainty about α2, R2 and I2,less investments costs at s = 1

first-order conditions are

wp(π2){1 + τ2[(E(λ2)− 1]} 0 λ1Lπ (π2 − π1) (1)c.s. π2 − π1 > 0

w(π2)[(E(λ2)− 1] 0 λ1Fτ (τ2 − τ1) (2)c.s. τ2 − τ1 > 0

19

Key public finance parameters

E(λ2) = φαH + (1− φ)2[(1− θ − γ(1− 2θ)] .expected value of future public funds, and

λ1 = Max [α1, 2(1− θ)]

realized period-1 value of public funds

20

Central condition

E(λ2)− 1 ≥ 0holds if common-interest state probable enough,or political instability is low enough

Sufficient condition for positive investmentsof both types — assume this holds throughout A

Sufficient condition for complementarity

higher π raises incentives to invest in τ and v.v.moreover, payoff function is supermodular: we canexploit results on monotone comparative statics

simple to derive effects of most parameter shifts

21

Economic development/real wages — Proposition 2 (a)

Countries with higher real wages choosegreater investment in fiscal and legal capacity.

upward multiplicative shift of w(·) raises w(π2) and wp(π2)for given π2, for given E(R2) this implies higher GDP w(π2)+R2

consistent with empirical observation (Figure 1)

22

Share of resource rents in GDP — Proposition 2 (b)

Countries with higher share of non-resource income choosegreater investment in fiscal and legal capacity.

for given GDP, higher w(·) raises the non-resource share inGDP w(π2)/(w(π2) +R2)

prospective explanation for weak African states

23

Value of public goods — Proposition 2 (c)

Higher expected demand for public goods raisesinvestment in state capacity.

∂E(λ2)∂φ = αH − 2 [1− θ − γ (1− 2θ)] > 0

common interests make fiscal capacity more valuableprediction: external conflict does promote fiscal capacityas argued in economic and political history literature

by complementarity, auxiliary prediction for legal capacity

24

Political instability and inclusiveness — Proposition 2 (d)

Investment in fiscal and legal capacity are promoted by lowerpolitical instability, and by more inclusive political institutionsif political instability is high enough

∂E(λ2)∂γ = − (1− φ) 2(1− 2θ) < 0 and ∂E(λ2)

∂θ = (1− φ) 2(2γ − 1)

the ruling group sees that fiscal capacity will be usedto redistribute away from its own group less often

additional prediction: interaction term — political stabilitymore important, the more non-inclusive are political institutions

minority protection good for investment, when this lowers theprospective losses from redistribution by the opponent group

prediction: more consensual political institutions, e.g.,parliamentary democracy, may raise investments in state capacity

25

Costs of investments — Proposition 2 (e)

Lower costs of either legal or fiscal capacity raisesinvestments in legal and fiscal capacity

downward multiplicative shift of L(·) or F (·) cutsRHS of (1) or (2) for given π2 and τ2

theoretical rationale for "legal origins" hypothesis,but with auxiliary prediction for fiscal capacity

26

4. ImplicationsGrowth and development

"Endogenous" growth

due to investments in economic institutionsY2 − Y1

Y1=w(π2)− w(π1) +R2 −R1

w(π1) +R1

growth due to institutional improvement leading tomore efficient private markets

due to complementarity, government size is growing tooempirical results: hard find negative corr. taxation — growth,easy find positive corr. financial development — growth

Can add private accumulation of capital

additional positive effect on growth of legal capacity,but standard negative effect on growth of fiscal capacity

27

A first look at the data

General prediction about determinants

determinants of legal and fiscal capacity should be common

Specific predictions about determinants

positive effect of demand for common-interest public goodsincidence of external wars in past (COW),1816/independence—1975

positive effect of more consensual political institutionsincidence of democracy, parl. democracy in the past (Polity IVand Persson-Tabellini), 1800/independence—1975

different effects of legal origins (Shleifer et al) — may expectBritish vs. French legal origin to affect both legal and fiscalcapacity in the same directions

28

Legal capacity — Table 1

Alternative outcome measures

private credit to GDP (as in King-Levine), avg 1975—contract enforcement (Doing business project), circa 2005government anti-diversion policy (ICRG), avg 1982-97

Consider correlations with suggested determinants

29

Table 1 Economic and Political Determinants of State Capacity across Countries

Legal capacity

(1) (2) (3) Private credit

to GDP (1975-2000)

Contract enforcement (circa 2005)

GADP (1982-1997)

Incidence External Conflict up to 1975

0.509*** (0.143)

1.010*** (0.277)

0.576*** (0.170)

Incidence Democracy up to 1975

0.095 (0.059)

0.044 (0.078)

0.125** (0.050)

Incidence parliamentary Democracy up to 1975

0.000 (0.062)

0.040 (0.087)

0.111* (0.061)

English Legal Origin – 0.008

(0.033) 0.126** (0.059)

– 0.007 (0.040)

Socialist Legal Origin — 0.185**

(0.079) 0.096*** (0.034)

German Legal Origin 0.406***

(0.120) 0.466*** (0.062)

0.248*** (0.053)

Scandinavian Legal Origin

0.112*** (0.041)

0.551*** (0.081)

0.254*** (0.055)

Observations 93 122 115 Adjusted R-squared 0.524 0.235 0.596

Robust standard errors in parentheses: * significant at 10%; ** significant at 5%; *** significant at 1%. Socialist legal origin dropped in Col 1, since data on private credit not available in that category.

Fiscal capacity — Table 1 continued

Alternative outcome measures

[1 — informal sector GDP share] (World Bank), circa 2005income taxes as share of total taxes (IMF), avg 1975—total taxes as share of GDP (ditto)

Consider correlations with suggested determinants

30

Table 1 Economic and Political Determinants of State Capacity across Countries

Legal capacity Fiscal capacity

(1) (2) (3) (4) (5) (6) Private credit

to GDP (1975-2000)

Contract enforcement (circa 2005)

GADP (1982-1997)

1 – share of informal sector (circa 2005)

Income taxes in total taxes (1975-2000)

Total taxes in GDP

(1975-2000)

Incidence External Conflict up to 1975

0.509*** (0.143)

1.010*** (0.277)

0.576*** (0.170)

0.478*** (0.137)

0.405* (0.221)

0.555*** (0.162)

Incidence Democracy up to 1975

0.095 (0.059)

0.044 (0.078)

0.125** (0.050)

0.128* (0.072)

0.072 (0.083)

0.088 (0.059)

Incidence parliamentary Democracy up to 1975

0.000 (0.062)

0.040 (0.087)

0.111* (0.061)

0.051 (0.075)

0.157* (0.089)

0.160** (0.067)

English Legal Origin – 0.008

(0.033) 0.126** (0.059)

– 0.007 (0.040)

– 0.011 (0.053)

0.002 (0.047)

– 0.015 (0.042)

Socialist Legal Origin — 0.185**

(0.079) 0.096*** (0.034)

0.159*** (0.054)

– 0.130*** (0.032)

– 0.119** (0.031)

German Legal Origin 0.406***

(0.120) 0.466*** (0.062)

0.248*** (0.053)

0.234*** (0.046

0.206** (0.092)

0.010 (0.083)

Scandinavian Legal Origin

0.112*** (0.041)

0.551*** (0.081)

0.254*** (0.055)

0.127*** (0.052)

0.098 (0.098)

0.292*** (0.087)

Observations 93 122 115 87 103 104 Adjusted R-squared 0.524 0.235 0.596 0.383 0.371 0.639

Robust standard errors in parentheses: * significant at 10%; ** significant at 5%; *** significant at 1%. Socialist legal origin dropped in Col 1, since data on private credit not available in that category.

4. Final remarks

Theoretical framework

useful point of departure to think about development ofstate capacity

central insight: legal and fiscal capacity complements

Can extend theory in several directions

e.g., introduce income inequality — drives legal and fiscalcapacity in different directions

look at interaction with private accumulation — way tounderstand persistent effects of institutions on development?

Serious empirical work remains

31

B. State capacity and the genius of taxation

Growth of government

Expansion of government activity and taxation

one of most salient facts of 20th centurysubject and puzzle in several literaturesincluding modern work on political economics

state capacity approach provides new angle

32

Debate on large government

Is large government costly?

benevolent government (left-wing) view; growth ofgovernment reflects that government does things well

malevolent government (right-wing) view: growth reflectsabuse of power, rent seeking and so on

Both views, politically naive

left-wing: fails to acknowledge important role of(vested) interests in policymaking

right-wing: fails to acknowledge that suppressing suchinterests is not feasible in political context

33

Main idea

Evidence of effects of big government mixed

hard to find evidence for large effects on incomeboth in macro and micro data

Illustrate why this may be the case

the positive economics of Diamond and Mirrleesdevelop simple example where large governmentmay not be so costly as simple extension of state capacityframework from part A

34

Road map

1. A simple two factor economy

2. Equilibrium policy and state capacity

3. Implications

35

1. A simple two-factor economyAlternative production structure

Two factors of production

w(pJs) now group-specific “capital”,productivity depends on legal protection

raw labor, traded at economy-wide market

Ownership of factors

a share, σ, of each group holds 1 unit of capital,remaining share, 1− σ, holds 1 unit of labor

Technology

well-behaved Cobb-Duoglas technology on intensive form lJs(kJs)η,

where kJs = w(pJs)lJs

is the capital-labor ratio

36

Equilibrium wages

Economy-wide capital-labor ratio

k(pIs, pOs) =σ[w(pIs) + w(pOs)]

(1− σ)2

Factor market equilibrium

derive equilibrium wage ω(pIs, pOs) = (1− η)k(pIs, pOs)η

with

∂ω

∂pJs= (1− η) η(k(pIs, pOs))η−1

σwp

³pJs´

2(1− σ)> 0

legal protection of any group raises common wageas more productive capital raises labor demand

37

2. Equilibrium policy and state capacity

Analyze policy in modified model

yJs(pIs, pOs) = (1− σ)ω(pIs, pOs) + σlJs[(kJs)η − ω(pIs, pOs)]

income of each group depends on legal protectionof both groups, through equilibrium wage

replace w(pJs) by yJs(pIs, pOs)

Main consequences

if σ large, Is may prefer low ω(pIs, pOs) to raise rentscan keep down wage by cutting pOs, blockinglegal protection for other group’s capital owners

Go through similar steps as in A

same tax policy, but potentially different legal protection38

Efficiency or not — Proposition 3

If θ = 12 or τs = 1, legal capacity is always fully utilized for

both groups: pOs = pIs = πs.There exists bτ (θ, α), such that legalprotection of opposition minimal, pOs = 0, for all τ < bτ (θ, α),and where bτθ(θ, α) < 0, and bτα(θ, α) < 0 if α = αH.

always efficient legal protection in utilitarian case,or when fiscal capacity is high enough

but with low fiscal capacity, politically motivated Ismay prefer to redistribute by distorting marketsrather than by taxes and transfers at maximum income

critical bound bτ(θ, α) depends on institutions andcircumstances, decreasing in θ and αH

39

Endogenize state capacity

Low fiscal capacity may trigger inefficient redistribution

argument known e.g., from Acemoglu (2006)

However, argument is incomplete

it takes τs and πs as given — why τs so low?key to low investments already in Proposition 2

Is there a possibility of a non-investment trap?

i.e., can inefficient policies persist over time if statecapacity is chosen in same way as in A. above

40

Non-investment trap — Proposition 4

Suppose that τ1 < τ̂ (θ, αL) .Then, for φ close to 0, there is a rangeof γ > 1/2, where τ2 = τ1 and investment in legal capacity π2 islower than it would be if τ1 > τ̂ (θ, αL)

if τ2 = τ1 < bτ opposition gets minimal legal protection,pOs = 0, in each period, whichever group holds power

incumbent in period 1 fears redistribution via taxes and doesnot invest in fiscal capacity to bring economy out of this trap

investment in legal capacity also lower (by complementarity)

41

3. ImplicationsLarge vs. small states

Two economies, S and L, where Proposition 4 applies

τS1 < bτ < τL1 and πS1 = πL1 = π1

non-resource GDP Y (pIs, pOs) = [yIs(pIs, pOs) + yOs(pIs, pOs)]/2

Compare income levels

Y L1 − Y S

1 = Y (π1, π1)− Y (π1, 0) > 0

Y L2 − Y S

2 = Y (πL2 , πL2 )− Y (πS2 , 0) > Y L

1 − Y S1

large state has higher GDP in both periods, andincome gap to small state grows over time (as πL2 > πS2 )

in A, low fiscal capacity (and taxation) related to low income(co-determined by other factors, or low income causes small state)here, small state may actually cause low income

42

Political incentives to distort markets

E.g., literature on the politics of financial development

important to not only consider incentives forcreating or preserving rents

some results on the politics of underdevelopedmarkets implicitly assume limited fiscal capacity

have to pose “political Coase-theorem question” explicitlyanalysis here shows how that can be done

43

Argument more general than simple example

Might similar mechanism explain other production distortions?

take e.g., tariff protection or red-tape regulationsalient instances of policy-induced production distortions

casual evidence suggest such distortions are common in developingcountries with weak states

similar joint determination due to political instability and otherfactors hampering investments in state capacity

44

C. State capacity and the strategy of conflictBasic facts about civil war — Figure 2

Internal conflict widespread phenomenon

civil war has plagued many nations in postwar periodprevalence over all countries and years since 1950 is 7%,cumulated death toll exceeds 15 million

Big fact # 1

prevalence varies greatly over years,peaks in early 1900s above 12%

Big fact # 2

prevalence varies greatly over countries,civil war and poverty (low GDP/capita) strongly correlated

45

Figure 2 Incidence of Civil War

Repression — violation of human rights

Government repression also widespread phenomenon

many governments use violent means to raise their probabilityof staying in power without civil war breaking out

such one-sided repression shows up in violations of humanrights: executions, political murders, imprisonments, brutality, ...

Prevalence

by strict measure (purges) 6% of country-years, 1962-2005by wider measure (human-rights infringements) 32%, 1976-2006

46

Main ideas — Table 2

Domestic violence and development jointly determined

same economic and political factors may explainprevalence of civil war and low income:

e.g., two parallel literatures on the "resource curse"

How does civil war interact with state capacity?

by analysis in A, external conflict risk may promote state capacity,by enhancing common, rather than redistributive, interests

domestic violence: manifestation of stark redistributive conflictrisk of domestic conflict may have opposite effects on incentivesto invest in state capacity, compared to risk of external conflict

simple correlations consistent with that idea

47

Table 2: Fiscal capacity and different types of war

(1)

(2)

(3)

(4)

(5)

(6)

Taxes as a percentage of

GDP

Taxes as a percentage of

GDP

Income taxes as a percentage of total taxes

Income taxes as a percentage of total taxes

Average percentage inflation rate

Average percentage inflation rate

Any internal war – 6.993*** – 2.723** – 7.953** – 3.094 14.346*** 12.551** during 1945-1997 (1.843) (1.310) (3.960) (3.574) (4.790) (5.567) Any external war 6.911*** 1.604 16.157*** 6.653** 3.586 6.676 during 1945-1997 (2.267) (1.569) (3.713) (3.317) (5.863) (6.628) Share of years in 5.028** 1.902 – 3.979 democracy during 1945-1997 (2.368) (7.020) (11.157) Share of years in parliamentary 6.529*** 7.553 – 5.403 democracy during 1945-1997 (1.939) (6.401) (4.395) Mean (log of) income during 3.302*** 7.936*** 0.974 1945-1997 (1.067) (2.231) (3.934) Observations 125 105 125 105 116 100 R-squared

0.489

0.739 0.390 0.598 0.307 0.370

Robust standard errors in parentheses (* significant at 10%; ** significant at 5%; *** significant at 1%) In addition to the variables shown, all specifications include a set of dummies for (eight) regions and (five) legal origins.

How approach these issues?

Step-wise approach

set up model allowing for conflict and peacestudy the risk of conflict (domestic violence) as function ofeconomic, political. institutional determinants, for givenlevels of state capacity — this will be a bit of a detour

revisit state capacity decisions, for different risks of (endogenous)domestic conflict

Benefits of explicit theory

guidance on how to approach the data

48

Road map

1. Conflict and violent takeover

2. From theory to evidence

3. Investments in state capacity revisited

4. Summing up: A-C

49

1. Conflict and violent takeover

Existing literature — theory of conflict

Many classical models of conflict and contests

what happens when parties commit resources to fighting?Grossman, Skaperdas, etc.

Not closely integrated with institutions and data

little concern for forces of economic developmentlack of tangible institutionsnot well integrated with observations and evidence

50

Existing literature — evidence on civil war

Substantial literature in political science and economics

determinants of onset and duration of civil war

Suggested explanations for concentration to poor countries

Collier-Hoeffler — low opportunity cost of fightingFearon-Laitin — low state capacity to counter insurgencyboth arguments take income as given

Ongoing debate about other proposed determinants

natural resources, ethnic tensions, institutions...

Methodology

not closely integrated with theorywith a few exceptions, based on cross-sectional inference

51

Existing literature — violation of human rights

Little explicit theory

Some empirical work

more violations of human rights in poor and undemocratic countriesfew attempts to connect incidence of repression and civil war

52

Desirable features of theory

Use simple “canonical model” of internal conflict

illuminate interplay between economic, politicaland institutional factors — connect theory and evidence

To what use?

interpret known factsstay simple enough to allow further extensionsin particular, endogenize state capacity

generate testable predictions over observables

Which testable predictions?

make precise in which way resource rents, wages and politicalinstitutions may drive conflict

uncover a set of common determinants for civil war and repression53

Alternative model for transfer of power

Both incumbent and opposition group can mount armies

δIs−1 ∈ {0, AI

s} where 0 < AIs < 1 is fixed number,

subject to political decision, financed out of public purse

δOs−1 ∈ {0, AO

s }, 0 < AOs < 1 decided and paid within opposition

continuous, rather than discrete, army choices easy to introduce

No conscription

soldiers just paid period s, wage ws — first take as given

Probability that group Os−1 becomes Is

γ(δOs−1, δIs−1), which is increasing in 1st argumentand decreasing in 2nd argument

54

Two changes of the model in A.

New form of government budget constraint

0 ≤X

Js∈{Is,Os}

tJsws

2−Gs + zs − wsδ

Is−1 .

Stage 3 in the timing described in A. is replaced by

3 a. Group Os−1 chooses δOs−1 whether to mount insurgency AO

s .

3 b. Incumbent Is−1 chooses whether to use violence δIs−1

= AIs.

3 c. Group Is−1 remains in office with probability 1− γ³δOs−1, δIs−1

´.

55

Policy outcomes and objectives in common-interest states

Policy decisions at stage 4

for incumbent Is, policy decisions arethe same as in A. (given available budget)

Suppose αs = αH > 2

objectives of Is−1 and Os−1 at stage 3,given optimal policy at stage 5

E[V Is−1(πs, τs) | αs = αH ] =

αH [τsw (πs) + zs − w (πs) δIs−1] + w (πs) (1− τs)

and

E[V Os−1 | αs = αH ] = αH [τsw (πs) + zs − w (πs) δIs−1]

+w (πs) (1− τs − δOs−1) .

56

Peace in common-interest state - Proposition 5

Common-interest states, αs = αH, are always peacefulwith δOs−1 = δIs−1 = 0

objectives are strictly decreasing in δOs−1 and δIs−1

because all residual spending is on public goods,there is nothing to fight over

this will not be the case in redistributive states

57

Objectives in redistributive states

When αs = αL < 1 < 2 (1− θ)

objectives of Is−1 and Os−1 at stage 3, given optimalpolicy at stage 5, now involve clear trade-offs betweenresources and probability of controlling policy

E[V Is−1(πs, τs) | αs = αL] = w (πs) (1− τs) +h(1− θ)− γ

³δOs−1, δIs−1

´(1− 2θ)

i·

2[τsw (πs) + zs − w (πs) δIs−1]

E[V Os−1 | αs = αL] = w (πs) (1− τs − δOs−1) +

γ³δOs−1, δIs−1

´2[τsw (πs) + zs − w (πs) δ

Is−1]

58

Preliminaries

Assumptions(a) The technology for conflict is: γ

³δO, δI

´= μ

hδO − δI

i+ γO

(b) μAIs ≤ γO ≤ 1− μAO

s — probability always between 0 and 1(c) 12 + γO − μAI

s ≥ 1−θ1−2θ — see below

Define government revenue relative to non-resource GDP

Zs =τsw (πs) + zs

w (πs)

and two bounds for this variable

Zs =(1− θ)− γO (1− 2θ)

(1− 2θ)μ +AIs and Zs =

1

2μ+AI

s

with (c) Zs > Zs

59

Potential conflict in redistributive states — Proposition 6

Redistributive states, αs = αL, have three possible outcomes

1. If Zs < Zs, outcome is peaceful, bδOs−1= bδIs−1 = 0.

2. If Zs ∈£Zs, Zs

¤, no insurgency bδOs−1

= 0, but incumbent

uses repression against opposition with bδIs−1 = AIs:

3. If Zs > Zs, civil war where opposition and incumbentmount armies AO

s and AIs

proof uses the reaction functions of two parties

60

Anatomy of three regimes

Peace: Zs < Zs

when w(πs) high, Rs low, or θ near 12too expensive to fight (opportunity cost argument),or not enough to fight over because pie, or sharef it, small

Repression: Zs ∈£Zs, Zs

¤resource rents higher or wages lower, so more at stakeAssumption (c) means government has lower threshold

Civil war: Zs > Zs

even more at stake, so both parties choose to fight

61

2. From theory to evidenceConditions for observing violent outcomes

Consider country c at year s

treat wages wc,s as time-varying but given, andtreat investment in state capacity, Lc as constant and given

condition for civil war at year s is

Zc,s = τc,s +Rc,s − Lc

wc,s> Zc,s =

1

2μc+AI

c,s

while condition for repression is

Zc,s > Zc,s > Zc,s =(1− θc)

(1− 2θc)− γOc

μc+AI

c,s

62

What is observable in the data?

Observable determinants of violence

can measure (or find decent proxies for) Rc,t, wc,t and θc

Unobservable determinants

or very hard to measure μc, γOc , Lc, A

Ic,s − τc,s, and αc,s

Unobserved randomness in Zc,s − Zc,s and Zc,s − Zc,s

i.e., random realizations of conditions for violencedefine

εc,s = AIc,s − τc,s

with c.d.f. Xc(ε)

Incidence of violence

do observe if there is civil war, or repression, in c at t

63

Lesson #1 for an econometrician

Conditional probability of observing civil war

in country c at date s is

(1− φc) ·XcµRc,s − Lc

wc,s− 1

2μc

¶where 1st term is the probability of observing αc,s = αLand 2nd is the probability of observing Zc,s − Zc,s > 0

Basic prediction

higher Rc,s or lower wc,s raises probability of observing civil warin richer model, Xc increasing in Rc,t and decreasing in wc,t

only as long as θc below some, unobserved upper bound θc < 12

can test this with time-varying measures of Rc,s and wc,s (and θc)

64

Lesson #2 for an econometrician

Conditional probability of observing repression

but not civil war, in country c at date t

(1−φc)·"Xc

ÃRc,s − Lc

wc,s− (1− θc)

(1− 2θc)+γOcμc

!−Xc

µRc,s − Lc

wc,s− 1

2μc

¶

Basic prediction

higher Rc,t, lower wc,t, and lower θc raise probabilityof observing repression as well as civil war

these two states are ordered in the three determinantsby Proposition 6

can test this by estimating an ordered logit (or probit)

65

#1. Incidence of Civil War?Preliminaries

Clean inference from unobserved determinants

estimate panel regressions with fixed country effectsis equivalent to estimating

(1− φc) ·hXc³Rc,s−Lcwc,s

− 12μc

´−E{Xc

³Rc,s−Lcwc,s

− 12μc

´}i

Heterogeneity in incidence of civil war over time

mainly driven by time variation in Rc,t and wc,t

rid of influence by unobserved factors (like μc, γOc , and Lc)

if add fixed year effects, we allow for world-wide,non-parametric trend in civil war (recall Figure 2), andexploit only country-specific time variation in Rc,t and wc,t

66

Use variation in commodity prices

Source of exogenous variation

world market prices not likely to be influenced bycivil war in a single country

Can build simple open-economy model

increased export prices raise resource rents Rc,tand hence gain from winning a civil conflict

increased import prices decrease wages wc,t(and thereby indirectly raise resource rents), whichcuts the cost (and boosts the gain) of civil conflict

thus both increased export prices and increasedimport prices raise the critical difference Zc,s − Zc,s

67

Econometric specification

First, estimate linear panel regression

civc,t = ac + at + byc,t + κc,t

where ac and at are country and year fixed effectsand yc,t a vector of time-varying regressors, includingexport and import prices for primary commodities

Test for heterogeneity with regard to θc

estimate in different samples defined by politicalinstitutions in place

Linearity vs. non-linearity

fraction of countries in civil war is relatively low,which may bias linear probability estimates

also estimate by conditional (fixed effect) logit

68

Data

Civil war

binary indicator(s), Corrrelates of War (alt. Uppsala/PRIO)

Independent variables

country-specific commodity export-price indexes, world pricesof about 45 commodities — shocks toRc,t — UNCTAD, NBER/UN

commodity import price indexes — shocks to wc,t — same sourcesdisaster count (floods & heat-waves) — shocks to wc,t — EM-DAT5-year lag GDP/capita, although some risk of simultaneityin model, what matters is share of resource rents in GDP

Split sample by indicators

parliamentary democracy, or high executive constraints — thecondition for θc R θc — Polity IV and Persson-Tabellini

69

Basic results — Table 3

Effects of export and import prices?

both raise the probability of civil war,except oil export prices

Quantitatively significant?

yes! one standard deviation increase in price indexesraise the probability of civil war by 7-15%

Evidence for heterogeneity?

yes! no (or opposite) effects in parliamentary democracy

Other regressors?

more disasters do raise probability of observing civil war

70

Table 3: Within-country determinants of civil war – Basic results

(1) (2) (3) (5) Civil war in year Civil war in year Civil war in year Civil war in year

Export price index 0.035*** 0.039*** -0.046** 0.094*** (0.013) (0.014) (0.022) (0.031) Import price index 0.293*** 0.193*** -1.675*** 0.586*** (0.083) (0.070) (0.373) (0.205) Oil Export Prices -0.001 -0.001 0.015 -0.001 (0.002) (0.002) (0.050) (0.002) Oil Import Prices -0.025*** -0.020*** -0.101 0.056*** (0.006) (0.005) (0.105) (0.022) 5-year lag, log(GDP per cap) -0.046*** -0.106*** -0.076** -0.037* (0.014) (0.015) (0.032) (0.020) Weathershock 0.013** (0.006) Sample All Non-parliamentary

democracies Parliamentary democracies

All

Observations 4648 3531 1117 3814 Number of Countries 124 102 49 117 R-squared 0.045 0.036 0.105 0.055

Notes: Robust standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%. All specifications include fixed country and year effects

Robust to functional form — Table 4

Conditional logit results

qualitative results hold upwhen re-estimate OLS specification on restricted sampleearlier quantitative results hold up, as well

71

Table 4: Within-country determinants of civil war – Robustness to specification and sample

(1) Civil war in year

(2) Civil war in year

(3) Civil war in year

(4) Civil war in year

Export price index 1.802*** 0.382*** 2.103*** 0.408*** (0.626) (0.099) (0.671) (0.107) Import price index 9.685*** 1.709*** 7.569** 1.376*** (3.546) (0.357) (3.746) (0.537) Oil Export Prices -0.019 -0.002 -0.015 -0.002 (0.013) (0.002) (0.013) (0.003) Oil Import Prices 3.092 0.382 1.843 0.051 (2.064) (0.257) (2.823) (0.344) 5-year lag, log(GDP per cap) 0.953** 0.018 0.505 -0.005 (0.423) (0.060) (0.469) (0.070) Weathershock 0.060 0.008 0.032 0.001 (0.094) (0.014) (0.117) (0.015) Estimation method Conditional logit OLS Conditional logit OLS Sample Civil war countries

Civil war countries Civil war non-parl.

democracies Civil war non-parl.

democracies Observations 1282 1282 1067 1067 Number of countries 38 38 34 34 R-squared 0.124 0.092

Notes: Standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%. All specifications include fixed country and year effects

Robust to measurement — Table 5

Alternative data sources

replace COWmeasure with UCDP/PRIO measure ofcivil war incidence or # battle deaths (intensity of conflict)— point estimates maintain their sign, though much less precise

split sample by high constraints on executive, rather thanparliamentary democracy — results hold up

replace incidence of civil war by onset of civil war— results do not hold up

72

Table 5: Within-country determinants of civil war – Alternative measurement

(1) (2) (3) (4) (5) Civil War

Incidence (UCDP/PRIO)

Civil War Onset

(UCDP/PRIO)

Battle Deaths in thousands

(UCDP/PRIO)

Civil War Incidence (COW)

Civil War Incidence (COW)

Export price index 0.024 -0.014 0.576** 0.101*** -0.049* (0.033) (0.010) (0.311) (0.034) (0.029) Import price index 0.112 0.035 7.594 0.760*** -1.541*** (0.190) (0.053) (5.022) (0.221) (0.331) Oil Export Prices -0.001 -0.000 0.010 -0.001 -0.049 (0.001) (0.001) (0.022) (0.002) (0.045) Oil Import Prices 0.018* -0.002 -0.682 0.044** 0.010 (0.010) (0.004) (2.659) (0.021) (0.089) 5-year lag, log (GDP/cap) -0.001 -0.002 1.095*** - 0.060*** -0.003 (0.016) (0.007) (0.334) (0.023) (0.040) Weathershock 0.021*** -0.001 - 0.131 0.004 0.013 (0.005) (0.002) (0.967) (0.007) (0.010) Sample All All All Low Exec.

constraints High Exec. constraints

Observations Countries

4559 118

4559 118

2599 83

2797 98

1017 56

R-squared 0.047 0.011 0.043 0.046 0.088

Notes: Robust standard errors in brackets; * significant at 10%; ** significant at 5%; *** significant at 1%. All columns include fixed country and year effects

#2 Repression or Civil War?

Preliminaries

Recall Lesson # 2 for an econometrician

higher Rc,t, lower wc,t, and lower θc raise the probabilityof observing civil war or repression, rather than peace

repression and civil war are ordered statesgauge by estimating ordered logit

A few specifications

cross-sectional specifications, including fixed year effectshard to include fixed country effects

73

Two repression measures

Gibney et al (2007) — annual data, 1976-2006

from US State department and Amnesty Internationalpolitical terror scale 1− 5: set binary indicator 1 if 3 or above

Banks (2005) — annual data, 1962-2005

more restrictive measure on number of purges:set binary indicator 1 whenever purges positive

Construct ordered dependent variable

combine each repression measure with Correlates of War datapeace = 0, repression/but not civil war = 1, civil war = 2

Basic correlations

GDP/capita: peace — $6,500, repression — $3,200, civil war — $2,000in parliam. dem: peace — 35%, repression — 16%, civil war — 9%

74

Basic results — Table 6

Effect of key determinants

indicators of resource rents, income and parliamentary democracytend to raise probability of repression and civil war

especially so for commodity prices and the Banks measure

Note on reporting of results

coefficients reported as odds ratios: number above (below) unitycorresponds to a positive (negative) coefficient

significance levels refers to “H0: not different from unity”

75

Table 6: Economic and Political Determinants of Repression and Civil War

(1) (2) (3) (4) (5) (6)

Log GDP 0.668*** 0.652*** 0.660*** 0.631*** 0.630*** 0.626*** (7.85) (7.56) (6.81) (8.37) (8.24) (7.97) Parliamentary Democracy 0.401*** 0.345*** 0.316*** 0.578*** 0.554*** 0.580*** (6.98) (7.84) (7.88) (3.36) (3.72) (3.39) Large Oil Exporter 1.102 1.269 1.081 1.200 1.314* 1.205 (0.63) (1.43) (0.41) (1.13) (1.67) (1.06) Large Primary Exporter 0.644*** 0.572*** 0.377*** 0.284*** 0.284*** 0.195*** (3.97) (4.66) (6.80) (7.30) (7.30) (7.26) Weathershock 1.186*** 1.420*** 1.399*** 1.124*** 1.250*** 1.275*** (3.88) (8.32) (7.66) (2.78) (4.69) (4.93) Commodity Export Price Index 1.106*** 1.172*** (3.24) (3.83) Commodity Import Price Index 0.206** 1.413 (2.52) (0.82) Oil Export Prices 1.008 1.030*** (0.46) (3.33) Oil Import Prices 1.394*** 1.198*** (7.68) (2.59) Year Dummy Variables No Yes Yes No Yes Yes Observations 1993 1993 1878 3549 3549 3394

Notes: In columns 1-3, the dependent variable is constructed from the COW and the repression data in Gibney et al (2007). In columns 4-6, the dependent variable is instead constructed using the purges data in Banks (2005). All columns are estimated using an ordered logit. The reported coefficients are odds ratios with robust z-statistics in parentheses: the significance levels refer to differences from unity (* significant at 10%; ** significant at 5%; *** significant at 1%).

3. Investments in state capacity revisited

Preliminaries

How does civil-war risk affect investment incentives?

when civil-war risk absent, A.3 applies with γO = γ

for simplicity, consider the situation when 1st periodincumbent knows for sure that α2 = αL

Remaining uncertainties

future resource rents and R2 and political control I2consider increased risk of conflict triggered by changesin ρ, making high resource rents more likely

76

Two new effects on state capacity investments

a. Effects via discount factor for 1st-period incumbent

by Prop. 6, probability of turnover in period 2 is

Γ (Z (R2;π2, τ2)) =

⎧⎪⎨⎪⎩γO + μ

hAO −AI

iif Z (R2;π2, τ2) > Z

γO − μAO if Z (R2;π2, τ2) ∈£Z,Z

¤γO if Z (R2;π2, τ2) < Z

depends exogenously on R2, and endogenously on π2 and τ2instability smallest with repression, larger or smallerwith conflict than with peace depending on AO R AI

b. Effects via the costs of conflict

incumbent has to pay the real market wage to future armiesmay be reluctant to raise incomes by investing in legal capacity

77

Case 1 — cycles between peace and civil war

Effect of high and low resource rents

Z (RH ;π2, τ2) > Z > Z > Z (RL;π2, τ2) i.e., both opposition andincumbent arm if R2 = RH, while nobody arms if R2 = RL

investments in τ2 or π2 never large enough to change the regime

Payoff to period-1 incumbent

E[V Is(π2, τ2) | αs = αL] = w (π2) (1− τ2)

+E (λ2) [τ2w (π2) + E (z2)]

−ρh1− θ − (

³μ³AO −AI

´+ γO)

´(1− 2θ)

i2w (π2)A

I,

where E (λ2) =h1− θ +

³μρ³AO −AI

´+ γO

´(1− 2θ)

i2

and term on third line is expected cost of incumbent’s armyas in A., assume E (λ2) > 1 so investments are complements

78

Case 1 — optimality conditions for state capacity choices

First order conditions

wp(π2)h{1 + τ2[E(λ2)− 1]}− ρ

h1− θ +

³μ³AI −AO

´− γO

´(1− 2θ

≤ λ1Lπ(π2 − π1)

w(π2)[E(λ2)− 1] ≤ λ1Fτ (τ2 − τ1) .

Assume that AI ≈ AO

conflict has no 1st-order effect on political turnover, soa higher ρ does not alter discount factor and hence not E (λ2)

Only one impact effect of higher conflict risk

marginal benefit of legal capacity falls, larger expected military costcf. second term on LHS of first condition

by complementarity, both types of investment fall

79

Wasteful military spending and state capacity —Proposition 7

Suppose we have α2 = αL, conflict or peace depending on R2,and AI ≈ AO. Then, a higher ρ raises the probability of conflictand reduces the incentive to invest in both fiscal and legal capacity

if AI ≈ AO conflict is Pareto inferior: resources spent withoutmaterial change in who holds power

by the proposition, this static inefficiency is compounded by adynamic inefficiency: a lower incentive to invest in state capacity

80

Case 2 — cycles between repression and civil war

Effect of high and low resource rents

Z (RH ;π2, τ2) > Z > Z (RL;π2, τ2) > Z i.e., both opposition andincumbent arm if R2 = RH, only incumbent arms if R2 = RL

Payoff to period-1 incumbent

E[V Is(π2, τ2) | αs = αL] = w (π2) (1− τ2)

+E (λ2)hτ2w (π2) +E (z2)− w (π2)A

Ii,.

where E (λ2) =h1− θ −

³μ³ρAO −AI

´+ γO

´(1− 2θ)

i2

again assume E (λ2) > 1

81

Case 2 — optimality conditions for state capacity choices

First order conditions

wp(π2)h{1 + τ2[E(λ2)− 1]}−

h1− θ −

³μ³ρAO −AI

´+ γO

´(1− 2θ)

≤ λ1Lπ(π2 − π1)

w(π2)[E(λ2)− 1] ≤ λ1Fτ (τ2 − τ1) .

Conflict does have 1st-order effect on political turnover

even if AI ≈ AO, so higher ρ lowers discount factor and E (λ2)

Effects on marginal benefit of both types of state capacity

higher ρ decreases the LHS of both conditions, for legalcapacity because ∂LHS

∂ρ = −2 (1− 2θ)μAO(1−AI) < 0

by complementarity, both types of investment fall

82

Conflict-induced instability and state capacity —Proposition 8

Suppose we have α2 = αL, and conflict or repression depending on R2.Then, a higher ρ raises the probability of conflict and reducesthe incentive to invest in both fiscal and legal capacity

the effect on the discount factor always outweighs effect onexpected cost of fighting

analogous to Prop 2 (d), but higher instability now equilibriumoutcome, where conflict makes incumbent survival less likely

83

Implications

Caution for empirical studies of civil war

hazardous to consider a correlation between poverty and civilwar as causal effect from poverty to conflict.

two leading explanations: low opportunity cost of fightingdue to low wages, and low state capacity in poor countries

low state capacity, as well as low wages, may be simultaneouslydetermined with a high probability of civil war

Risk of different types of conflict

risk of internal and external conflict indeed appear to entail verydifferent incentives for state building

More generally

risk of conflict, low state capacity and low incomesmay be closely intertwined

84

4. Summing up: A-C

Common themes

Political institutions and levels of development

may shape static policies at a point in time,but also dynamic state development

Public revenue and public goods preferences

realized and expected shocks shape current policies,as well as incentives to build the state

85

What have we learned?

State capacity

major concept in other fieldshave shown a way to bring it into mainstream economics

low state capacity viewed as major problem in thedevelopment community

A low investment in legal capacity slows growthB low fiscal capacity may cause low income, via distortionsC low legal capacity may cause civil war, via low incomes

highlighted basic complementarity between the twoa way to think about the clustering of institutions

86

What next?

Conflict

have contrasted common-interest and redistributive statessuggests that risks of external and internal conflicts shapevery different incentives to build the state

Development

theory helps approach the data, but models very simple

try to better understand long-run development:add in private accumulation and full-fledged dynamics

try to endogenize political institutions: may revealadditional complementarity in the development process

87