A reflection on inefficient policies

(This is a preliminary draft. Comments are welcome.)

Why do governments in poor countries implement growth-retarding policies? Acemoglu (2005) discuss the following two mechanisms leading to inefficient policies: revenue extraction and factor price manipulation. (He suggests yet another mechanism, namely, political consolidation. But I personally don't buy this idea. So I put it aside here.)

Revenue extraction is a mechanism in which the government expropriates portions of profits earned by entrepreneurs. By taxing production, entrepreneurs' incentive to produce is discouraged, which also limits the scope of expropriation. Therefore, this mechanism does not completely discourage private production.

Factor price manipulation, on the other hand, is more deleterious. In this mechanism, the government distorts the allocation of factors of production by applying different de facto tax rates across production sectors. This creates rent earned by owners of production factors, which is extracted by the government. This is more harmful to the economy than revenue extraction for two reasons. First, if the government is not constrained at all, it prefers shutting down some industries completely in this case. In the case of revenue extraction, that would reduce tax revenues to zero, which the government does not want. Second, factor price manipulation hinders not only investment - as in the case of revenue extraction - but also the economy's overall productivity as well. A typical example of factor price manipulation is the regulation of entry of start-up firms.

Notice that while revenue extraction requires the government's capability of tax collection (including demanding bribe payments - if you don't pay me money, I'll shut down your business - and asset confiscation), factor price manipulation does not because the government can simply put up entry barriers to a certain sector. (This may not be true as the government still needs some means of enforcement in the case of factor price manipulation...)

Revenue extraction can be prevented if either of the following two conditions is satisfied.

1. The government is unable to collect taxes.

2. Separation of power along with checks and balances is set up. See Persson et al. (1997).

In terms of political development, it's the middle stage of development that is most susceptible to rent extraction.

Factor price manipulation can be prevented if either of the following two conditions is satisfied.

3. Factor price is inelastic. For example, Acemoglu (2005) shows that if the labour market is loose (supply of labor exceeds demand) in the absence of government policies, factor price manipulation is impossible as wages cannot be lowered further.

4. Political competition is stiff enough for the government's survival probability to be less than one and the electorate prefers no factor price manipulation. See Besley et al. (2005). Djankov et al. (2002)'s finding that limited and representative governments tend to have fewer entry regulations (after controlling for income) may or may not support this claim as they do not use a measure of political competition, which can be proxied by measures of limited and representative governments.

Condition 4 may not be sufficient to eradicate factor price manipulation. Krusell and Rios-Rull (1996) show that even a pure majority voting by citizens ends up preventing the adoption of new technology if managers with old technology outnumbers the rest of society. In reality, however, this is unlikely. The distribution of managers and workers in their model should be interpreted as de facto power (voting plus lobbying etc.) distribution.

For growth to be maximised, at least one of conditions 1 and 2 and at least one of conditions 3 and 4 have to be satisfied. Rich countries can be said to satisfy conditions 2 and 4. A very poor economy may be growing fast because condition 1 is met due to a poor government capability and because condition 3 is satisfied due to abundant labour.

It may be the case that East Asia follows a path from one situation in which conditions 1 and 3 are satisfied to another in which the government becomes capable of collecting taxes but labour market is still loose. As revenue extraction is less harmful than factor price manipulation, the failure of condition 1 only can sustain a reasonably high growth.

Africa, on the other hand, may follow a different path in which condition 3 fails before condition 1 does. This may be true given that African countries are generally not so densely populated. As a result, factor price manipulation completely retards growth, which sounds similar to what Bates (1981) describes (Robin Burgess's lecture note succinctly summarises this book).

Evidence seems to suggest that factor price manipulation matters more than revenue extraction to understand economic growth. Jones and Olken (2005) find that when economic growth accelerates, it is not because factor accumulation accelerates but because technological progress accelerates. As revenue extraction per se does not affect technological progress (it just discourages private investment, hence factor accumulation), it is when the government stops manipulating factor prices that economic growth takes off.