How Do Political Institutions Affect Fiscal Capacity? Explaining Taxation in Developing Economies
Abstract: A central aspect of institutional development in less developed economies is building tax systems capable of raising revenues from broad tax bases, i.e., fiscal capacity. While it is recognized in the literature that fiscal capacity is pivotal for state building and economic development, it is less clear what its origins are and what explains its cross-country differences. We focus on political institutions, seen as stronger systems of checks and balances on the executive. Exploiting a recent database on public sector performance in developing economies, we provide a systematic empirical analysis, identifying their long-run impact, and we ‘unpack’ the concept of fiscal capacity, distinguishing between the accountability and transparency of a tax system (impartiality) and its effectiveness in extracting revenues. We find that stronger constraints on the executive foster the impartiality of tax systems. However, there is no robust evidence that they also improve its effectiveness. The impact of political institutions on the impartiality dimension works through the rule of law and the performance of the bureaucracy.