Weak Institutions and Relational Taxation in the Oil and Gas Industry

Abstract: International contracts are difficult to enforce, especially in countries with weak institutions. Hence, oil rich countries can hold up international oil firms by renegotiating taxation once the investment is sunk. If future gains from trade exist, countries can devise a self-enforcing agreement that is "back-loaded" (Thomas and Worrall (1994)). When the country's credibility is low, delaying investment and tax collection enhances the country's credibility. On the other hand, a high credibility country's do not need to back-load the contract. The latter provides a natural empirical counterfactual. Moreover, for the agreement to be enforceable, countries with weaker institutions should receive a higher share of the available rents, especially, in periods of higher uncertainty. Using a novel data set of oil and gas contracts in many heterogeneous countries - more and less credible, we find evidence in line with the theory.