Rates of inflation differ markedly across countries, and consequently so does the importance of seigniorage relative to other sources of government revenue. Traditional explanations of why governments resort to seigniorage revenue focus on high costs of administering and collecting regular taxes. In the existing literature, however, the reasons for tax inefficiencies are unspecified, or assumed to depend exogenously on economic structure or the degree of economic development. In Discussion Paper No. 381, Alex Cukierman, Sebastian Edwards and Research Fellow Guido Tabellini propose an alternative, political explanation. An inefficient tax system, that facilitates tax evasion and imposes high collection costs, constrains the government. If the policy objectives of the main political parties differ markedly, the authors argue, such constraints may be welcomed by those who disagree with the government in office. One government may thus have an incentive deliberately to maintain (or to create) an inefficient tax system in order to constrain a future government with different policy priorities.
In their theoretical model, Cukierman et al. distinguish between fiscal policy (the routine choice of tax rates and the level and composition of government spending) and tax reforms (changes in the structure of the tax system affecting the tax base and methods of collection). While fiscal policy changes can be implemented swiftly, tax reforms take time and resources to administer. The model features two policy-makers, who differ only in the desired allocation of spending between two public goods; the magnitude of this difference represents the degree of polarization of the political system. The probability of a change in government at the end of each period varies directly with the degree of political instability.
The current government chooses values for a tax, seigniorage and the two public goods, but the degree of inefficiency of the tax system (the proportion of tax revenue due that is uncollected) is chosen by the government of the previous period. Cukierman, Edwards and Tabellini demonstrate how the equilibrium tax structure can involve a positive degree of inefficiency, which rises with both the instability and the polarization of the political system. The more inefficient the equilibrium tax structure, the higher the reliance on seigniorage.
Using cross-country data on 79 developing and industrialized countries during 1971-82, the authors regress the fraction of total revenue collected in the form of seigniorage onto explanatory variables representing the structure of the economy, the stage of development, and political instability and polarization. The empirical results reveal a statistically significant relationship between political instability and reliance on seigniorage. This is extremely robust to alternative specifications, to the sample of countries and to alternative definitions of seigniorage. There is also a positive relationship between seigniorage and political polarization, but this result is weaker because polarization is difficult to measure.
Other political or economic factors may provide better explanations for finite periods of greatly increased reliance on seigniorage revenue. But the degree of political instability appears to be an important determinant of persistent cross-country differences in inflation and seigniorage, Cukierman, Edwards and Tabellini conclude.

Seigniorage and Political Instability
Alex Cukierman, Sebastian Edwards and Guido Tabellini

Discussion Paper No. 381, February 1990 (IM)