Taxation, Federalism, and the Dilemma of Regional Development

Taxation lies at the boundary where politics meets economics. In the classical political economy of Adam Smith and David Ricardo, the structure of the tax system (including tariffs restricting trade) determined the development prospects of a country. Fiscal institutions are shaped by the struggle between political organizations and private interests, the former seeking revenue and the latter protecting their assets. In order to collect revenue, rulers must overcome complex issues of measurement, compliance, and monitoring (North, 1981; Levi, 1988). Once tax authorities establish mechanisms to measure the tax base as well as detect and punish tax evasion, such institutions are difficult to change. Adding to the stability of the fiscal system, powerful economic interest groups will lobby to prevent the loss of tax exemptions. Even when not efficient, tax institutions are often stable, changing only when they experience shocks, such as a war, or unexpected windfall revenues (Steinmo, 1993).

Studying the institutional arrangements of tax systems provides a particularly clear view of politics (Schumpeter, 1991[1918]; Steinmo, 1993). Powerful economic and political actors are usually shielded from expropriation or excessive taxation, as reflected in tax institutions, under both democratic and nondemocratic systems. In democracies, representative organizations, court systems, or specific arrangements that divide power – such as the division of federal power into state jurisdictions – provide for effective vetoes to avoid radically redistributive decisions (see North and Weingast, 1989; Acemoglu and Robinson, 2001).