In answering why some countries are much better off than others, the popular answer has become “institutional differences.” More specifically, some governments are better than others at promoting growth. This is so, not out of ignorance, but because the incentives and rules which guide political action differ between governments. Where the institutions of governments are poor, politicians find it within their interests to plunder, or extract, wealth from their citizenry, usually indirectly — seigniorage, exploitation of natural resources, et cetera —, because income taxes and the like don’t produce much income when those you are taxing are near the poverty line. The question that persists is, why do political institutions remain inefficient? Daron Acemoglu offers a preliminary answer in a 2003 paper, “Why Not a Political Coase Theorem: Social Conflict, Commitment, and Politics” (gated, ungated).

In theory, with certain assumptions, we can posit a world where political agents and non-political agents can agree to a stream of side payments to allow for policy changes. To quickly illustrate the idea, suppose there is a single-person government, which extracts $100 over some period of time t, and one non-political agent, who earns $20/t. A policy change can lead to the latter increasing her income to $200/t, but reducing the politician’s revenue stream to $50/t. Assuming, for simplicity’s sake, that these are the only figures we need to worry about, it behooves the non-politician to pay the politician anywhere between $50.00…01 and $179.999…9 to enact the policy change, because both of them are now better off. We can call this the Political Coase Theorem (PCT). Why don’t we typically observe this behavior in the real world?1 The Coasean answer: transaction costs. Acemoglu’s answer, which is a subset of transaction costs: commitment problems.

If governments and their citizenry were to engage in side payments, we stumble upon the problem of enforceability. A Coasean solution, in this case, requires one party to promise a future sum or stream of income to another — the payment is made after the policy change. Suppose you establish a contract with a plumber to fix your kitchen sink, with the agreement to pay him a certain amount of money when the job is finished. If, at that time, you renege on your obligation, the plumber can count on government to enforce the contract for him. But, between governments and citizenry there is no “higher power” that can enforce the promise of side payments. Thus, any contract must be self-enforcing; there have to be built-in incentives for both parties to fulfill their obligations. The trouble is, in these hypothetical government–citizen agreements, there are strong incentives to break the contract.

The idea of the policy change is that if a government lifts constraints — by reducing extraction, respecting property rights, et cetera — on the private sector’s ability to invest and innovate, the latter will achieve some increase in income. That is, the private sector will produce more. But, the private sector is only interested in producing more if it reaps the rewards of its effort; more technically, they must be better off than they were under the old set of rules. If a government is expected to renege on its promise to allow its citizens to keep whatever fraction of income necessary to incentivize the investment, clearly the private sector will prefer to not invest at all.

Likewise, a government is only interested in enacting the policy change if it is better off as a result. If it retains its power to extract at will, it can simply tax the agreed side payment at will, but we run into the commitment problem described in the previous paragraph. What if the government agrees to relinquish power? To induce a ruler to give up power, the private sector has to pay her. But, once power is surrendered, that ruler has no way of guaranteeing the agreed upon income.

We can think of ways of making the contract self-enforceable. For example, if the ruler does not carry through with her promise, the group of citizens may decide to replace her. But, this incentive is weakened if a ruler expects replacement — say, if the citizens can replace the ruler with another one, at a cheaper cost than fulfilling the agreement. Another possible solution is an expectation of repetition, where if both parties are promised a stream of future income over multiple periods of time, the incentive to renege falls. For example, at time t the ruler can either keep her promise or, instead, extract all wealth. If she does the latter, though, she lets go of potential future payments at times t+1, t+2,….,t+n. However, the probability of replacement can increase as investment, and therefore output, rises, because it threatens the distribution of power.

Ultimately, the argument is not that there will be no political change without a perfect contract, but that, in the real world, institutional change will be imperfect, or inefficient. More importantly, Acemoglu seeks to show that the distribution of power matters. How power is distributed between the various agents is a determinant of the outcome, because it affects the incentives to commit to a contract, and therefore bears some relationship to the rate of economic growth. This being said, it should be clarified that Acemoglu is not claiming that the distribution of power is the only, or even the main, determinant — a more complete picture is left to future research. Nevertheless, the framing of the problem is an interesting angle from which to approach the question of why some political institutions are more extractive than others, and why they remain so.

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1. The side payment language may seem to constrict the way that citizens can recompense their rulers for making a policy change. But, we can think of a more realistic method: an agreement to a future level of taxation.