Tax farming and the origins of state capacity in England and France

Highlights

• We explain the origins of investment in state capacity in early-modern England and France

• We show why rulers switched from private to public tax collection.

• We apply the theoretical model we develop to explain the rise of centralized tax farming in England and France.

• We show the rise of centralized tax farming created incentives to invest in legal and fiscal infrastructure.

• We explain why cabal tax farming persisted in France but not in England.

Abstract

How did modern and centralized fiscal institutions emerge? We develop a model that explains (i) why pre-industrial states relied on private individuals to collect taxes; (ii) why after 1600 both England and France moved from competitive methods for collecting revenues to allocating the right to collect taxes to a small group of financiers—an intermediate institution that we call cabal tax farming—and (iii) why this centralization led to investments in fiscal capacity and increased fiscal standardization. We provide detailed historical evidence that supports our prediction that rulers abandoned the competitive allocation of tax rights in favor of cabal tax farming in order to gain access to inside credit, and that this transition was accompanied by investments in standardization. Finally (iv) we show why this intermediate institution proved to be self-undermining in England, where it was quickly replaced by direct collection, but lasted in France until the French Revolution.

Introduction

A growing literature argues that state capacity—the ability of a state to raise tax revenues and to uphold the rule of law—is an important determinant of economic prosperity (Besley and Persson, 2011, Fukuyama, 2011, Acemoglu and Robinson, 2012). Much of this research looks at the rise of the fiscal institutions that constitute a modern tax state.¹ However, Charles Tilly observed that scholars of state formation face a selection issue. Economists and political scientists study the institutions that have survived. Tilly raises the possibility that institutions that did not survive to the modern era may have been more than ‘the fading features of the old regime, but the intermediate institutions which were crucial to the emergence of the states we know’. Hence, studies that focus exclusively on the emergence of modern institutions ‘will tend to misrepresent the developmental process’ (Tilly, 1975, 48).

This paper argues that the intermediate institution of cabal tax farming, which was marked by the allocation of tax rights to monopsonistic cabals of financiers rather than using competitive markets, was crucial for the rise of the modern state as it encouraged investment in fiscal capacity. Our investigation focuses on the development of two prototypical modern states: England and France during the early modern period (1500–1800). Both of these polities adopted cabal tax farming and both saw dramatic increases in fiscal capacity in the period before the industrial revolution. In England the intermediate institution of cabal tax farming soon gave way to direct collection and the rise of a bureaucratic fiscal state, whereas in France it persisted until the French Revolution. By studying this institutional divergence we shed new light on the rise of modern fiscal and financial institutions.

We develop a model and analytical narrative that explains (i) why, before 1600, European states relied on markets to perform many functions, including tax collection; (ii) why early modern states moved from decentralized, market-based, methods for collecting revenues towards more centralized and eventually more bureaucratic fiscal institutions; (iii) why this centralization also encouraged investments in fiscal capacity and the standardization of laws and weights and measures; and (iv) why this intermediate institution proved to be self-undermining in the long run.

Our analysis is driven by the two main types of costs facing any early modern ruler. The first was the cost of collecting taxes in economies that were highly heterogeneous and fragmented. High costs to monitoring government agents meant that there was embezzlement and corruption. In response, states privatized tax collection. Tax collection was farmed out to private individuals who bid competitively for their positions, paying a fixed fee or rent to the king and were, in return, the residual claimants on whatever was collected.²

The second cost was that of borrowing. Since early modern monarchs could not credibly commit to repay debts that they incurred, their ability to borrow money was limited; this made them dependent on personal, or inside, finance. Whereas many city states had developed sophisticated forms of borrowing and public finance during the late middle ages, as late as 1650, the rulers of the major territorial states of Europe like England and France remained reliant on short-term loans from moneylenders, merchants, and tax collectors.³

A number of papers study the use of tax farming to overcome the costs of tax collection in the pre-industrial world.⁴ However, this is the first paper to build a model that shows how borrowing, tax farming, and investments in state capacity were interconnected. Our model shows that when credit is less important to the ruler, states use competitive markets to allocate fiscal rights, especially when the costs of collection are high. In this equilibrium, the king has little incentive to invest in increases in state capacity that directly lower the cost of tax collection. However, if the ability of the king to borrow from outside sources of finance is limited, then, as access to credit becomes more important, there is a strong incentive to abandon competitive tax farming since the decentralized institutions which minimize the cost of collecting taxes are incapable of supporting large amounts of inside lending. Hence the model explains why states might move away from competitive allocation of fiscal rights towards monopsonistic allocation and cabal finance.

The move from competitive markets to monopsony grants means that rulers no longer benefit from the information revelation properties of market mechanisms. Under monopsony tax farming, therefore, governments have a greater incentive to lower the costs of directly monitoring the performance of tax collectors than they do under decentralized, competitive, tax farming. This requires investment in fiscal capacity, and in particular, in investments that reduce the cost of tax collection such as the standardization of laws, regulations, and weights and measures.

Nevertheless, the relationship between the king and the cabal of tax farmers is a fragile one. The model shows how it can break down, and why such a breakdown is more likely in an economy with less heterogeneity and more standardized laws, taxes, and regulations. In this case, the crown may eventually find it least costly to collect taxes through direct collection, thus putting the state on the road to the eventual creation of a tax bureaucracy.

This model explains the evolution of fiscal and financial institutions in England and France during the early modern period. We show that while England and France moved from competitive to cabal tax farming in order to gain access to inside lending after 1600, the Dutch Republic and the Spanish monarchy retained systems of competitive tax farming, in part, because they already possessed other sources of credit. Our framework also explains why cabal tax farming was an equilibrium in England for a much shorter period than in France, where it lasted until the French Revolution. Part of this was due to historical happenstance, but part of the explanation is due to the fact that England was simply a more homogenous political entity than France (Heckscher, 1955). This made the intermediate institution of cabal farming less stable in England as it lowered the opportunity cost of defaulting on the tax farmers. Hence, when the switch to cabal finance occurred, the next step to the tax bureaucracy that constituted the ‘sinews of power’ of the English state in the eighteenth century, was relatively smooth (Brewer, 1988). Our analysis thus helps to explain why England was further along in its fiscal and financial revolutions than France by the end of the seventeenth century and sheds light on the reasons why England was the first country to develop modern political and economic institutions.⁵