Chapter 21 - Democracy, Redistribution, and Inequality

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Abstract

In this paper we revisit the relationship between democracy, redistribution, and inequality. We first explain the theoretical reasons why democracy is expected to increase redistribution and reduce inequality, and why this expectation may fail to be realized when democracy is captured by the richer segments of the population; when it caters to the preferences of the middle class; or when it opens up disequalizing opportunities to segments of the population previously excluded from such activities, thus exacerbating inequality among a large part of the population. We then survey the existing empirical literature, which is both voluminous and full of contradictory results. We provide new and systematic reduced-form evidence on the dynamic impact of democracy on various outcomes. Our findings indicate that there is a significant and robust effect of democracy on tax revenues as a fraction of GDP, but no robust impact on inequality. We also find that democracy is associated with an increase in secondary schooling and a more rapid structural transformation. Finally, we provide some evidence suggesting that inequality tends to increase after democratization when the economy has already undergone significant structural transformation, when land inequality is high, and when the gap between the middle class and the poor is small. All of these are broadly consistent with a view that is different from the traditional median voter model of democratic redistribution: democracy does not lead to a uniform decline in post-tax inequality, but can result in changes in fiscal redistribution and economic structure that have ambiguous effects on inequality.

Introduction

Many factors influence the distribution of assets and income that a market economy generates. These include the distribution of innate abilities and property rights, the nature of technology, and the market structures that determine investment opportunities and the distribution of human and physical capital.

But any market system is embedded in a larger political system. The impact of the political system on distribution depends on the laws, institutions, and policies enacted by that system. What institutions or policies a political system generates depends on the distribution of power in society and how political institutions and mobilized interests aggregate preferences. For example, we expect institutions that concentrate political power within a narrow segment of the population—typical of nondemocratic regimes—to generate greater inequality.1

As the literature has shown, there are several theoretical mechanisms through which such an impact might operate. One would be the enactment of policies benefiting the politically powerful at the expense of the rest of society, including policies pushing down wages by repression and other means. In Apartheid South Africa prior to 1994, for example, the political system dominated by the minority white population introduced government regulations on the occupation and residential choices of black Africans in order to reduce their wages (e.g., by reducing competition for white labor and by forcing blacks into unskilled occupations, see Lundahl, 1982, Wilse-Samson, 2013). Another mechanism is the one highlighted by Meltzer and Richard's (1981) seminal paper. Building on earlier research by Romer (1975) and Roberts (1977), they developed a model where extensions of the voting franchise, by shifting the median voter toward poorer segments of society, increase redistribution, and reduce inequality.2

Despite these strong priors, the empirical literature is very far from a consensus on the relationship between democracy, redistribution, and inequality. Several works have reported a negative relationship between democracy and inequality using specific historical episodes or cross-national studies. Acemoglu and Robinson (2000) argued this was the case based on the economic history of nineteenth-century Europe and some twentieth-century Latin American examples. An important study by Rodrik (1999) presented evidence from a panel of countries that democracy is associated with higher real wages and higher labor share in national income. Lindert, 1994, Lindert, 2004 provided evidence from OECD countries indicating a linkage between democratization and public spending, particularly on education; Persson and Tabellini (2003) presented similar cross-national evidence; and Lapp (2004) pointed to a statistical association between democratization and land reform in Latin America. Other papers point in the opposite direction, however. Sirowy and Inkeles (1990) and Gradstein and Milanovic (2004) have argued that the cross-national empirical evidence on democracy and inequality is ambiguous and not robust. Scheve and Stasavage, 2009, Scheve and Stasavage, 2010, Scheve and Stasavage, 2012 have claimed that there is little impact of democracy on inequality and policy among OECD countries, and Gil et al. (2004) have forcefully argued that there is no relationship between democracy and any policy outcome in a cross section of countries (Perotti, 1996, was an earlier important paper with similar negative findings).

In this chapter we revisit these issues in a unified theoretical and empirical framework. Theoretically, we review the standard Meltzer-Richard model and point out why the relationship between democracy, redistribution, and inequality may be more complex than the standard model might suggest. First, democracy may be “captured” or “constrained.” In particular, even though democracy clearly changes the distribution of de jure power in society (e.g., Acemoglu and Robinson, 2006), policy outcomes and inequality depend not just on the de jure but also the de facto distribution of power. For example, Acemoglu and Robinson (2008) argue that, under certain circumstances, those who see their de jure power eroded by democratization may sufficiently increase their investments in de facto power (e.g., via control of local law enforcement, mobilization of nonstate armed actors, lobbying, and other means of capturing the party system) in order to continue to control the political process. If so, we would not see an impact of democratization on redistribution and inequality.3 Similarly, democracy may be constrained by either other de jure institutions such as constitutions, conservative political parties, and judiciaries, or by de facto threats of coups, capital flight, or widespread tax evasion by the elite.

Second, we suggest that democratization can result in “inequality-increasing market opportunities.” Nondemocracy may exclude a large fraction of the population from productive occupations (e.g., skilled occupations) and entrepreneurship (including lucrative contracts) as in apartheid South Africa or the former Soviet bloc countries. To the extent that there is significant heterogeneity within this population, the freedom to take part in economic activities on a more level playing field with the previous elite may actually increase inequality within the excluded or repressed group and consequently the entire society.4

Finally, consistent with Stigler's (1970) “Director's law”, democracy may transfer political power to the middle class rather than to the poor. If so, redistribution may increase and inequality may be curtailed only when the middle class is in favor of such redistribution.

After reviewing the fairly large and heterogeneous prior literature on this topic, the rest of this chapter examines the empirical impact of democracy on tax revenues as a percentage of GDP (as an imperfect measure of redistribution) and on inequality as well as a number of additional macro variables. We evaluate previous empirical claims about the effect of democracy in a consistent empirical framework that controls for a number of confounding variables. Our objective is not to estimate some structural parameters or the “causal” effect of democracy on redistribution, but to uncover whether there is a robust correlation between democracy and redistribution or inequality, and to undertake a preliminary investigation of how this empirical relationship changes depending on the stage of development and various other factors potentially influencing how democracy operates.

The previous literature has used several different approaches (e.g., cross-sectional regressions, time-series and panel data investigations) and several different measures of democracy. We believe that cross-sectional (cross-national) regressions and regressions that do not control for country fixed effects will be heavily confounded with other factors likely to be simultaneously correlated with democracy and inequality. We therefore focus on a consistent panel of countries, and investigate whether countries that become democratic redistributed more and reduced inequality relative to others. We also focus on a consistent definition of democracy based on Freedom House and Polity indices, building on the work by Papaioannou and Siourounis (2008). One of the problems of these indices is the significant measurement error, which creates spurious movements in democracy. To minimize the influence of such measurement error, we create a dichotomous measure of democracy using information from both the Freedom House and Polity datasets as well as other codings of democracy to resolve ambiguous cases. This leads to a measure of democracy covering 184 countries annually from 1960 (or post-1960 year of independence) to 2010. We also pay special attention to modeling the dynamics of our outcomes of interest, taxes as a percentage of GDP, and various measures of structural change and inequality.

Our empirical investigation uncovers a number of interesting patterns (why many of these results differ from some of the existing papers in the literature is discussed after they are presented). First, we find a robust and quantitatively large positive effect of democracy on tax revenue as a percentage of GDP (and also on total government revenues as a percentage of GDP). The long-run effect of democracy in our preferred specification is about a 16% increase in tax revenues as a fraction of GDP. This pattern is robust to various different econometric techniques and to the inclusion of other potential determinants of taxes, such as unrest, war, and education.

Second, we find a positive effect of democracy on secondary school enrollment and the extent of structural transformation (e.g., an impact on the nonagricultural share of employment and the nonagricultural share of output).

Third, however, we find a much more limited effect of democracy on inequality. In particular, even though some measures and some specifications indicate that inequality declines after democratization, there is no robust pattern in the data (certainly nothing comparable to the results on taxes and government revenue). This may reflect the poorer quality of inequality data. But we also suspect it may be related to the more complex, nuanced theoretical relationships between democracy and inequality pointed out above.

Fourth, we investigate whether there are heterogeneous effects of democracy on taxes and inequality consistent with these more nuanced theoretical relationships. The evidence here points to an inequality-increasing impact of democracy in societies with a high degree of land inequality, which we interpret as evidence of (partial) capture of democratic decision making by landed elites. We also find that inequality increases following a democratization in relatively nonagricultural societies, and also when the extent of disequalizing economic activities is greater in the global economy as measured by U.S. top income shares (though this effect is less robust). These correlations are consistent with the inequality-inducing effects of access to market opportunities created by democracy. We further find that democracy tends to increase inequality and taxation when the middle class is less prosperous relative to the poor. These correlations are consistent with Director's law, which suggests that democracy often empowers the middle class to redistribute from the rest of society to itself. Our results suggest the need for a more systematic investigation of the conditions under which democracy does indeed reduce inequality and increase redistribution.

The chapter proceeds as follows. In the next section we discuss the theoretical connections between democracy, redistribution, and inequality. In Section 21.3 we provide a survey of the existing empirical literature on the impact of democracy on taxes, redistribution, inequality, and some other reduced-form dependent variables potentially associated with inequality (e.g., average calories per person, life expectancy, and infant mortality). Section 21.4 then describes our econometric methodology and data. Section 21.5 presents our new findings, and Section 21.6 concludes.

Section snippets

Theoretical Considerations

In this section, we illustrate some of the linkages between democracy and inequality that have been proposed in the literature. We begin with the seminal Meltzer and Richard (1981) model, but then alter the set of instruments available to the government to show how the logic of the standard model can be altered and even reversed. We will discuss the impact of democracy, modeled as a broader franchise, relative to a nondemocratic regime modeled as a narrower franchise or controlled by a small

Previous Literature

In this section, we survey the literature on the effect of democracy on redistribution and inequality. Our emphasis will be on the empirical literature, though we also discuss some of the theoretical ideas that have played an important role in this literature (several theoretical contributions have already been discussed in the previous section).

Econometric Specification and Data

Given the conflicting results in the theoretical and empirical literature surveyed above, we now present our econometric framework for investigating the relationship between democracy, redistribution, and inequality. We attempt to evaluate the diverse results within a single empirical strategy and sample, and we provide what we view to be some basic robust facts.

In this section, we describe our econometric specifications and our main data. Our approach is to estimate a canonical panel data

The Effect of Democracy on Taxes

Our first results are contained in Table 21.2, which reports estimates of Equation (21.6) with the log of tax revenue to GDP ratio (tax to GDP ratio for short) as the dependent variable.

Column 1 is estimated by OLS imposing ρ = 0 in Equation (21.6). Though biased when ρ > 0, this is a natural benchmark, particularly since it corresponds to a specification often used in the literature. In all columns, we report standard errors corrected for arbitrary heteroskedasticity and serial correlation at the

Conclusion

The effect of democracy on redistribution and inequality is important for understanding how democracies function and use the available policy instruments. Nevertheless, our survey of the relevant literature shows that the social science literature on this topic is far from a consensus or a near-consensus on this topic.

We explained why the baseline expectation in the literature has been that democracy should increase redistribution and reduce inequality (for example, based on Meltzer and

Acknowledgments

We are grateful to the editors for their detailed comments on an earlier draft and to participants in the Handbook conference in Paris, particularly to our discussant José-Víctor Ríos-Rull.

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