The Legacy of War on Fiscal Capacity∗
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The Legacy of War on Fiscal Capacity∗ Didac Queralty January 18, 2018 Abstract This manuscript revisits the relationship between war and state-making in mod- ern times by focusing on types of war finance. Tax-financed war exerts lasting effects on state capacity because new taxes require enhancements of the state apparatus and complementary fiscal innovations. Loan-financed war may not contribute to long-term state capacity because countries might default once the war ends, preempting any persistent fiscal effect. I advance two mechanisms of transmission of war effects: one being political—tax-financed war transforms taxation into a nonzero-sum game|, the other bureaucratic. To address concerns of endogeneity in access to war participation and war finance, I exploit unanticipated, historical crashes in international financial markets, which temporarily dried up capital flows around the globe and precluded war- ring states from borrowing irrespective of their (un)observed characteristics. Results suggest that the advent of a genuinely global capital market in the early nineteenth century undermined the association between war and state making. ∗First Draft: June 2015. I am grateful to Ben Ansell, Laia Balcells, Thomas Brambor, Carles Boix, Allan Dafoe, Alexandre Debs, Mark Dincecco, Hector Galindo, Aina Gallego, Francisco Garfias, Scott Gates, Maria Jose Hierro, Margaret Levi, Pilar Nogues-Marco, Shanker Satyanath, Peter Schram, Ken Scheve, David Stasavage, Hans-Joachim Voth, Tianyang Xi, and seminar participants at Columbia University, Carlos III, Universitat de Barcelona, EUI, Lund, Peking, Sciences Po, Stanford, Vanderbilt, and Yale for comments and suggestions. yYale University, Political Science; [email protected] 1 1 Introduction War, although devastating, offers a matchless opportunity to transform the state. The magnitude of resources a country must amass to finance the means of war offers rulers the incentives to invest in state making while reducing domestic resistance to taxation. War clears the path to fiscal centralization (Dincecco, 2011), the professionalization of the tax administration (Ardant, 1975), and the adoption of new taxes|from excises (Brewer, 1988) to progressive income taxes (Scheve and Stasavage, 2010). Fiscal innovations are often ac- companied by complementary organizations, including treasuries and central banks (O'Brien, 2001), and improved budgeting technologies (Dincecco, 2011). Far from disappearing, the financial innovations that make war possible are expected to exert lasting effects on the extractive capacity of the state (Ardant, 1975; Besley and Persson, 2011; Brewer, 1988; Dincecco and Prado, 2012); that is, states make war as much as war makes states (Tilly, 1990). The bellicist theory of state formation draws heavily from the history of state building in Europe, from the fifteenth to the eighteenth century (Dincecco, 2011; Ertman, 1997; Hintze, 1975). But the evidence is mixed outside the European continent. Why did war make states in Europe but did not in the so-called periphery (i.e. Asia, Africa, and Latin America)? Modern-states outside Europe were created only in the nineteenth century, coinciding with or following the first globalization of international finance. Readily available external finance, I argue, weakened the incentives to expand taxation and develop domestic credit institutions. Ultimately, the advent of a genuinely global capital market undermined the relationship between war and state making. Others have revisited the bellicist hypothesis by focusing on initial conditions: urban- ization and regime type (Karaman and Pamuk, 2013), and initial state capacity and social composition (Kurtz, 2013; Soifer, 2015). Yet none of these studies takes into account the liquidity of international financial markets, which is the focus of my study. Others have opined that access to financial markets have limited state capacity in Latin America (Cen- 2 teno, 2002; Thies, 2005). Yet the theoretical mechanism by which rulers prefer not to tax elites in those accounts is unspecified, and the empirics suffer from the limitations of ob- servational studies. I articulate the political-economy of war financing (i.e. what are the political cost of taxing elites, and under what conditions are rulers more likely to assume those costs?), test its implications causally, and advance two mechanisms of transmission of war financing on long-term fiscal capacity: The first being political: namely, tax-financed war facilitates the adoption of power-sharing institutions, which transform taxation into a nonzero-sum game. The second mechanism being bureaucratic: i.e. the newly created tax administrations opposed disinvestment in fiscal capacity, carrying on the effect of war on long-run fiscal capacity. Drawing on a sample of 100+ countries as early as 1815, I show evidence that access to external finance is detrimental for short- and long-term state-building. I address endogeneity in access to external finance by exploiting unanticipated global credit crunches, or sudden stops (Calvo, 1988). These crises created time windows in which, for exogenous reasons, warring states could not rely on external loans to finance the means of war. Accordingly, during these periods incentives to finance war with taxes are strongest. Endogeneity in war participation is addressed threefold: First, I concentrate on a subsample of wars that were initiated while credit still flowed but suddenly dried up, thus disconnecting the decision to go to war or the type of war to fight from availability of external finance. Second, I focus on countries that did not choose to go to war but were dragged into it|the non-initiators. Third, following Gennaioli and Voth(2015), I run a reduced-form model in which war by country i is instrumented by war by its adjacent neighbors. Keeping a host of initial economic and political characteristics constant, results show that war systematically makes states in the short- and long-run if it is waged in the absence of external finance, that is, when incentives to tax are strong. On the contrary, making war while having access to international capital markets is at best inconsequential in terms of state building. Consistent with the original work of Tilly(1990), often over-simplified, results 3 confirm that state building is not merely a function of war making but also access to domestic capital. The empirical section also offers evidence of the two transmission mechanisms: Tax- financed war in the long-nineteenth century strengthens executive constraints in the short- and long-run, and is also makes more staffed tax administrations. The statistical evidence is supported with a brief case study: Chile at War. That vignette illustrates how lack of access to international capital tilts war finance in favor of taxes and how that impacts long-term fiscal capacity. The conclusion section resumes the comparison between state-building in the periphery with that of European countries in early-modern times. 2 The Political Economy of War Finance In modern times war is generally funded by a combination of loans and taxes (Poast, 2015; Sprague, 1917).1 Resorting to one or the other is as much a matter of possibility (has the state enough capacity to tax its citizens and/or access to lending markets?) as of political opportunity (who wins and who loses upon borrowing and taxing?) Taxation is politically delicate because it involves some form of extraction from elites, the masses, or both. Rulers can rarely impose new taxes on elites without their consent, consultation, and negotiation (Levi, 1988; Tilly, 1990). In return for newer taxes, elites may demand veto powers over spending decisions. Consistently, tax increases to finance the means of war yielded major advances in parliamentary representation in early-modern Europe (Bates and Lien, 1985; Ferejohn and Rosenbluth, 2016; Stasavage, 2016). Taxing the masses may not be easier, especially when the tax increase is accompanied by a military draft. In such circumstances political concessions may be required to prevent tax revolts from below (Hintze, 1975). One way or another, \power-sharing institutions were the price and outcome of bargaining with different members of subject population in overcoming resistance 1Expanding the money supply is considered in AppendixK. Importantly, this and other forms of war finance (e.g., financial repression) work against the research hypothesis. Having additional sources of nontax revenue relaxes the ruler's incentives to conduct tax reform, lessening the effect of war on long-term fiscal capacity. 4 to financing with taxation the means of war" (Tilly, 1990, p.64, italics added). Financing war with domestic loans should come with similar political costs: namely power-sharing institutions (North and Weingast, 1989). Nonetheless, domestic borrowing requires levels of capital accumulation that cannot be taken for granted, especially not in the developing world (della Paolera and Taylor, 2013). When domestic credit markets are small, rulers may finance externally, a practice that accelerated after the Napoleonic Wars (Reinhart and Rogoff, 2009). Crucially, external finance does not suffer from the same political costs and administrative challenges attached to taxation (Bueno de Mesquita and Smith, 2013; Centeno, 2002; Shea, 2013); that is, rulers do not have to concede political rights or representation to international lenders. A good margin suffices. Nor does external borrowing come with the uncertainties of tax yields, thus facilitating the planning of military campaigns (Slantchev,