When will a dictator be good? by Ling Shen Handout prepared by team Dixit: Denzel Diego Pawel Table of Contents 1 Introduction .......................................................................................................................................... 3 Background .......................................................................................................................................... 3 2 The Model............................................................................................................................................. 3 3 The Exogenous Growth Model ............................................................................................................. 6 3.1 Dictatorship ................................................................................................................................... 6 3.2 Democracy ..................................................................................................................................... 9 4 Democratization ................................................................................................................................. 13 4.1 The incentive of political transition in the bad dictatorship ....................................................... 13 4.2 The incentive of political transition in the good dictatorship ..................................................... 15 5 External effect and endogenous growth ............................................................................................ 17 Conclusion ............................................................................................................................................. 20 Criticisms and extensions ...................................................................................................................... 21 1 Introduction Background Economists have realized the importance of political institutions in shaping economic performance. Most academic studies of political economy (e.g., Shepsleand Weingast 1995; Cox 1997; Persson and Tabellini 2000, 2003) focus on the democratic political system, where formal political institutions, such as the constitution, the rule of law, and the election system, are already well advanced. However, few studies shed light on dictatorship, although most people on earth live in such regimes. A puzzling phenomenon in dictatorial economies is that they can achieve dramatically different economic growth rates. Good and Bad Dictators Good dictators will: o Invest in public education, infrastructure o Establish rule of law to encourage private investment, subsidizes R&D, etc Bad dictators will: o Transfers large fraction of social wealth to herself Both are willing to tax citizens Purpose of the Paper: To provide a theoretical model that illustrates underlying determinants of a dictator’s behavior 2 The Model The model is based on three different components: o Economic growth is generated by decentralized investment . The higher the private investment, the higher the aggregate technology level . Private investment positive external effect on aggregate technology level This represents endogenous growth . **We will also consider exogenous growth in a later section o Political power affects economic performance through the redistribution policy . 2D vector- tax rate and social transfer . Social transfer policy = measurement of “goodness” “Bad” and “good” are statements about the amount of the social transfer o Democracy is growth-enhancing in the current model, because it protects decentralized investment from expropriative taxation Sequential Process of the Model is as follows: 1. Beginning of period t, technology level 퐴푡is determined by exogenous factors (section 3), or by endogenous variables in t-1 (section 5) 2. Citizens decide whether or not to begin a revolution 3. If there is no revolution, or if the revolution fails, the ruler can keep political power. She decides her social transfer scheme (to be good or bad) 4. If revolution is successful, the ruler is killed and citizens establish democracy 5. Citizens decide whether to invest after watching dictator’s political state and behavior (i.e. 푎 is determined) 6. Citizens produce output 7. Tax rate τ determined either by dictator or democratic system. Tax revenue collected and citizens receive remaining output Additional assumptions are included for the sake of simplicity in the model: o Tax rate is determined after production to reflects the idea that taxation is key property of dictatorship o Social transfer is paid to citizens before production o We assume there is a perfect capital market with 0% interest rate. o The more that income is taxed in dictatorship compared to democracy, the more incentive there is to democratize. o All debts cleared at the end of each period o Agents are risk neutral . Citizen’s net income (without weapon spending): 푌푎푡 = 푦푎푡 1 − 휏푡 + 푠푎푡 − 퐼푎푡 푒퐴푡 . Ruler’s net income: 푌푟푢푙푒푟 , 푡 = 휏푡 푦푎푡 − 푠푎푡 푑a To fully understand the mechanisms of the model, the economic and political characteristics must be defined. They are as follows: Economic environment o The economy is an infinite horizon economy o There are two agents: the dictator and continuum Λ of citizens o Citizens and rulers live forever (if ruler isn’t killed during revolution) o Citizens born with different abilities (invariant over time) . Each citizen is distinguished by independently determined value: a휖Λ= [0,1] 퐼푎푡 o Production Function (citizen a , time t): 푦푎푡 = 퐴푡 푁푎휆 , 휆> 1 . 푦푎푡 = output of individual a in period t . 퐴푡 = aggregate technology level . N =natural resources per capita . 휆 = gross return on investment (for mathematical purposes) . 퐼푎푡 = indicator function of investment in period t =1 if citizen a invests in time t; =0 if citizen a does not invest . a = value 휖 [0,1] that uniquely represents an individual citizen and their productive abilities These values are ordered within the continuum Λ 휖 [0,1] o 0 = no ability o 1 = perfect ability 푎 represents a certain threshold ability level, above which citizens will choose to invest; citizens with a value a <푎 will not choose to invest o The return rate for each citizen a is (N(휆-1)a)/ e . e = the cost percentage of investing in technology e퐴푡 represents the investment cost in technology . >1: citizen a invests Political Environment o Assume the initial political state is dictatorship . The ruler is unproductive and can tax citizens at any rate she chooses . The ruler can redistribute tax revenue as she pleases . Dictatorship impedes growth of productivity due to taxation o Political institutions are represented by the vector (τ, s) where: . τ = tax rate; between [0, 휏 ], 휏< 1 휏< 1 reflects the sustenance (threshold tax) level of the citizens. If the tax rate exceeds this level, they will not be able to live properly and will be willing to start a revolution. s = social transfer financed via taxation . 푠푎 = social transfer obtained by individual a o Bad dictator: Consumes all tax revenue; 푠푎 = 0 ∀ 푎. o Good dictator: Shares benefits with some citizens; 푠푎 > 0 for some a . The author refers to the dictator’s partial sharing as group-specific social transfer. Only a certain portion of the citizenry will gain from the dictator’s chosen social transfer policy. • Dictator knows distribution of private ability, citizens’ investment decisions • She cannot distinguish individuals by ability; hence group specific transfer is based on investment. In other words, the rich will benefit from the dictator’s social transfer policy because they have invested the most In the model, a democracy is formed if a revolution is successful. The following are key qualities of a democratic system: • There is no ruler. The tax rate is determined by all citizens via “1 person, 1 vote” majority voting system 푑푒푚 • Every citizen gets the same transfer: 푠푎 = 푠 , ∀ 푎 • Social transfer is not group specific. This means no certain class of citizens will receive more benefits than the rest of society. • Allowing group specific transfer does not qualitatively change result about dictator behavior. 3 The Exogenous Growth Model 3.1 Dictatorship Assumptions: 1. Repeated game with finite periods. 2. Initial political framework is dictatorship. 3. Technology level 퐴푡 grows exogenously. 4. Tax rate is set by the dictator after production at휏푑푖푐 = 휏 regardless of whether she is good or bad. 5. Tax policy cannot be used as a tool to encourage citizens to invest (i.e. a promise to reduce the tax rate is not credible). 6. The dictator (if she is a good one) chooses the group of citizens that will receive the amount 푠푡as a social transfer. In fact only citizens who invest will receive a social transfer푠푡 = 퐴푡 푆, where푆 is the steady state of social transfer to technology level. 7. A citizen will invest if: (푒 − 푆) 푎 ≥ 푎 (푆) = 푁 1 − 휏푡 [휆 − 1] 푦푎푡 1 − 휏푡 + 푠푎푡 − 퐼푎푡 푒퐴푡 ≥ 푦푎푡 1 − 휏푡 퐴푡 푁휆푎 1 − 휏푡 + 퐴푡 푆 − 푒퐴푡 ≥ 퐴푡 푁푎 1 − 휏푡 푎[퐴푡 푁휆 1 − 휏푡 − 퐴푡 푁 1 − 휏푡 ] ≥ 푒퐴푡 − 퐴푡 푆 퐴 (푒 − 푆) 푎 ≥ 푡 퐴푡 푁 1 − 휏푡 [휆 − 1] The investment threshold can be lowered by increasing transfer 푆. Some citizens will still invest if 푆 = 0, an assumption made to avoid corner solutions so that 푎 푆 < 1, ∀ 푆 ≥ 0. This means that when 푆 = 0, 푒 − 0 푎 0 = 푁 1 − 휏푡 휆 − 1 푒 1 > 푁 1 − 휏푡 휆 − 1 풆 ퟏ − 흉 > (퐴1) 풕 푵 흀 − ퟏ And the net benefit of investment for the individual with 푎 = 푁 휆 − 1 1 − 휏푡 is greater than the cost of investment. Or, what is the same, the net return rate of investment is 푵[흀 − ퟏ](ퟏ − 흉 ) 풕 > 1 풆 Dictator’s Income Maximization The dictator