Political instability and distributional conflict generally harm economic growth. For example, Latin American countries have often adopted populist programmes that have created disincentives to growth through capital flight and reductions to domestic investment but at other times adopted sounder policies without changing their political institutions. In Discussion Paper No. 633, Research Fellows Gilles Saint-Paul and Thierry Verdier develop a politico-economic model of endogenous growth to investigate its unevenness across time and countries. People decide their savings levels when young, vote on a flat rate of capital taxation when old, and also differ in their access to foreign capital markets. Those who rationally anticipate a high tax rate on capital accumulate little capital and then find it optimal to vote for such a high tax rate. A similar low-tax equilibrium will apply elsewhere, and countries can jump from high-tax to low-tax equilibria and vice versa over time. A productive externality, which may be interpreted as `learning-by-doing', generates unbounded returns to capital and allows the economy to grow indefinitely through increased capital accumulation.

Saint-Paul and Verdier find that multiple equilibria will arise if the `group in power' or the decisive individual in determining the political outcome has above-average access to foreign capital markets. If people rationally anticipate high capital taxation when they are old, they will tend to put their savings abroad; the decisive individual will put an above-average share abroad, compensate for a lower share of the tax base and therefore favour a higher tax rate when it is time to vote. The decisive person's above-average elasticity of domestic saving behaviour permits `free riding' on others' savings; this generates a positive feedback from expected to actual tax rates and gives rise to multiple equilibria. If the decisive person's elasticity of domestic savings behaviour were below average, in contrast, an increase in the expected future tax rate would correspondingly reduce the actual tax rate, leading to a negative feed-back and hence a unique equilibrium.

Saint-Paul and Verdier demonstrate that the high-tax equilibrium can then imply a lower growth rate than the low-tax equilibrium, which everyone in current and future generations nevertheless prefers. This result strikingly implies that a democratic, rational society can vote for an inefficient outcome: there exists an alternative allocation that everyone strictly prefers and which is feasible without altering the institutions, political structure or key features of the tax system. This inefficiency arises because people can neither commit to the low tax rate nor coordinate this savings decision to ensure the achievement of the good equilibrium.

Distributional Conflicts, Power and Multiple Growth Paths
Gilles Saint-Paul and Thierry Verdier

Discussion Paper No. 633, February 1992 (IM)