Freedom Through Taxation: The Effect of Fiscal Capacity on the Rule of Law

Abstract

This paper explores the effects of fiscal capacity on the rule of law. Following the Besley and Persson (2009) model exploring complementarities between fiscal capacity and legal capacity, we test the relationship using fiscal capacity and rule of law data from the Varieties of Democracy dataset. We leverage the lengthy time-series found in the dataset by employing the common correlated effects (CCE) estimator and the dynamic common correlated effects (DCCE) estimator to supplement standard panel methods. Unlike the widely used fixed effects method, the CCE and DCCE methods adjust for the presence of econometric issues, including cross-sectional dependence, heterogeneous slopes, and unobservable common factors that plague the error-structure in panel data. Consistent with Olson’s model of the stationary bandit and Besley and Persson (2009), we conclude that innovations in fiscal capacity have positive, non-trivial effects on the rule of law.

Keywords: Fiscal Capacity, Legal Capacity, Rule of Law, Institutional Development, State Capacity, Stationary Bandit

JEL Classification: O43, K00, P10, H20