Fiscal Policy Under Weak Political Institutions

The purpose of this paper is to determine the normative and positive implications for fiscal policy in a weakly institutionalized economy which is not managed by a benevolent government, but is managed by a selfish dictator. We examine an economy with no capital, with fully state contingent financial instruments, and with exogenous stochastic government purchases. The dictator can use taxes and debt to extract rents, but dissatisfied households can threaten to replace him after his tenure with an equally selfish dictator. In contrast to the optimal tax rate under a benevolent government which is flat along the equilibrium path, we find that the optimal tax rate is history dependent and increasing along the equilibrium path. The reason is that the tax rate reflects the history of incentive compatibility constraints on the dictator. Providing the dictator with incentives to not steal imposes a limit on the size of government assets under his control and puts upward pressure on future tax rates, and in the long run, the tax rate reaches a maximum. Moreover, if we allow households to replace the dictator with a benevolent government at a cost, the tax rate can increase or decrease along the equilibrium path and can experience history dependence even in the long run. The reason is that providing incentives for the households to support the dictator imposes a limit on the size of government debt and puts downward pressure on future tax rates