Democracy and Growth Volatility: exploring the links

Our empirical investigation reveals that less democratic countries have higher volatility of GDP growth rates. Disparity in polity across countries robustly dominates differences in initial income, inequality or instability of regimes, the commonly cited reasons in the literature, as the main determinant of volatility. To explain this observation we use a stochastic dynamic model in which democracy is parameterized by the fraction of people who benefit from fiscal transfers. The government in this model maximizes the group’s utility by taxing the whole population and transfering revenue to this group. The optimal fiscal policy in such economy ensures the favored group at the expense of the rest. It is procyclical and amplifies the exogeneous shocks. More so in less democratic countries. Thus, our model is successful in explaining why tax policies are pro-cyclical in some countries, in addition to providing reasons for differences in volatility of growth rates across countries.