The Role of Fiscal Dependency in Political Development

To the best of our knowledge, the empirical corpus of work on the origins and persistence of democracy has not evaluated the impact of governments' fiscal independence from peoples' taxes on the quality of democracy. Our proxy for fiscal independence is the component 1C titled "government enterprises and investments" taken from the Economic Freedom of the World index. Component 1C measures in a given country the fraction of total investment that is supplied by the government and state-owned enterprises. A higher fraction corresponds to greater fiscal independence. The econometric analysis employing a variety of IV estimators, which includes Lewbel (2012) generated instruments, reveals a conditional negative, robust, and statistically significant effect of fiscal independence on the degree of democracy. The study also unveils a statistically and economically significant impact of fiscal independence on variables inherent to democracy, such as judicial independence and freedom of the press, as well as on human capital, a proximate determinant of democracy. These findings account for the observed heterogeneity in the potentially confounding effects of democratic rule determinants commonly used in the democratization literature. In particular, the study allows for years of education, ethno-linguistic fractionalization, the individualism-collectivism cultural trait, legal origin, risk of expropriation protection, income inequality, geographical characteristics such as latitude and availability of oil reserves, and fixed effects to control for unobserved heterogeneity bias induced by time-invariant variables at the continent level. The evidence uncovered suggests a novel mechanism under-girding the onset, and more crucially, the persistence of democratic rule. The unveiled finding on fiscal dependency is congruous with landmark historical events such as the English Glorious Revolution as well as the tardier emergence of democracy in continental Europe. Similarly, our findings cast light on the modern heterogeneity of democratic outcomes. Specifically, results inform the flourishing Western democracies experience, and the absence or low levels of democracy among countries where governments are owners of revenue-generating companies or recipients of substantial tax revenues paid by private or state-owned corporations. Conspicuous examples of nations, with governments mostly fiscally independent, are Saudi Arabia and Venezuela.