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European
Economic Perspectives 21
Eat
the Riches
Many developing and
transition countries have appalling growth records despite wonderful
economic endowments. New CEPR research blames the ‘voracity effect’.
A
curious and depressing phenomenon is that many developing countries that
are rich in natural resources or enjoy high export prices have failed to
exploit their good fortune. Oil-rich countries like Nigeria and
Venezuela have actually become poorer during the past 25 years, and
others, such as Mexico, have dissipated much of the potential gain.
Russia today is another graphic illustration of a resource-rich economy
performing far below its potential. It seems that windfalls are often a
curse.
A
recent CEPR Discussion Paper by
Aaron Tornell and Philip Lane tries to explain this phenomenon. These
researchers note that common features of these societies are multiple
power blocs alongside weak countervailing legal-political institutions.
The power blocs may include regional or provincial governments within a
federal system; tribal or ethnic leaders; labour unions or industrial
conglomerates (private or public); parties within a coalition; or
individual ministers within a cabinet. An inadequate legal-political
infrastructure means that private property rights are insecure and
income streams are vulnerable to appropriation.
In
well-ordered economies, there are a variety of controls that prevent
interest groups from arbitrarily obtaining resource transfers from the
rest of society. But in fragmented societies, where legal or political
restrictions are absent, powerful groups may appropriate resources
through their control of the fiscal process - receiving transfers
financed by taxation - or by lobbying for government interventions that
redistribute rents within the economy.
Tornell
and Lane argue that the policy environment of a fragmented society
generates not only a subpar rate of economic growth but also perverse
responses to positive macroeconomic shocks, such as resource discoveries
or terms of trade improvements. Consider the appropriation decision made
by each powerful group with effective access to the fiscal process. Each
group wants to appropriate resources for its own private gain. Yet each
group also realises that excessive taxation is a self-defeating policy,
deterring investment and shrinking the size of the economic pie
available for appropriation in the future. In other words, the
productive economy is the ‘golden goose’ that feeds the various
fiscal groups and hence deserves protection.
But
since the overall tax rate is determined by the sum of the
appropriations sought by all of the fiscal groups, there is a classic
‘collective action’ problem. Each group prefers to maintain a high
rate of appropriation and see taxes reduced by greater self-discipline
on the part of other participants in the fiscal process. Since no group
has the incentive to take the lead in achieving fiscal prudence, the
outcome is an excessive rate of appropriation and taxation - and
consequently, a slow rate of output growth.
A
good analogy is the fishing industry: the oceans are ‘common
property’ and individual fishermen do not consider resource renewal
their individual responsibility. As a result, in the absence of
regulation, there is overfishing. Similarly, allocation decisions in a
fragmented society without institutions to protect the common good can
lead to inefficient outcomes.
The
same mechanism leads to a perverse response to macroeconomic shocks. For
example, an increase in fiscal revenues arising from higher export
prices means that each group feels able to increase its appropriation
rate. But since their common interest is not taken into account, the
aggregate level of appropriation increases more than proportionally
relative to the increased revenues, requiring an actual increase in the
tax burden. Tornell and Lane label this overspending phenomenon the
‘voracity effect’.
There
are many cases of resource booms being dissipated through intensified
appropriation. During the commodity price booms of the 1970s, for
example, several oil-producing countries went on spending binges, with
those favoured groups with access to fiscal revenues borrowing to
finance conspicuous consumption and wasteful prestige investment
projects or to accumulate safe overseas assets immune from domestic
taxation. Similarly, although the 1975-8 coffee boom was clearly
temporary - the result of a frost in Brazil - a number of coffee
producers not only failed to save the windfall but actually ran current
account deficits during the high-revenue period.
Foreign
aid is another powerful example of a windfall gain that can unleash the
voracity effect. It is well-known that aid has often been wasted by
recipient countries, either diverted by corruption or wasted on ‘white
elephant’ projects, as various domestic interest groups seek to obtain
their share of the foreign transfer via ‘rent-seeking’ activities.
The
research suggests that the scale of the voracity problem depends on the
extent to which control of the fiscal process is fragmented. The ideal
situation is one in which the fiscal process is controlled in the common
interest or by one powerful group: in either case, the policy-maker has
an incentive to ensure that fiscal discipline is achieved and that the
country responds efficiently to macroeconomic shocks. A highly polarized
society in which fiscal control is split between two opposing groups is
the worst of all possible worlds: each group is powerful enough to
extract large transfers but wants to pass the adjustment burden to the
other group.
Surprisingly,
a more fractionalized fiscal process, in which many groups engage in
rent-seeking, is preferable to the two-group case. This is because each
group realises that the overall economic pie must be split among many,
leading to moderation in the transfer requests of any individual group.
Not only is growth performance better than in the two-group case, but
the voracity effect in response to revenue shocks is muted.
Tornell
and Lane’s findings are important for evaluating the growth prospects
of developing and transition countries undergoing economic and political
reform. According to their analysis, the impact on growth of a switch
from autocracy to a more decentralized system will depend on the effect
the shift has on the ability of powerful groups to extract transfers.
If
the collapse of an autocracy relaxes restrictions on the behaviour of
powerful groups within a society, decentralization may actually
intensify the rent-distribution struggle in these countries. This will
lead to slower growth and poorer adjustment to shocks. In contrast, if
the shift to decentralization brings with it the destruction of
entrenched interest groups, and power becomes more diffused, then growth
performance and adjustment to shocks will improve.
The
implication is that for sustainable development, legal-political
institutions that protect the common interest must be built in tandem
with liberalization. Furthermore, pro-competition policies - making
market entry easier or exposing domestic behemoths to foreign rivals -
may be as important in terms of altering a country’s propensity to
engage in rent-seeking as in their direct impact on efficiency.
This
highlights the importance of avoiding the creation of very big
conglomerates as has happened in Russia. Since a small number of
individuals wield immense economic power, they can influence the
political process and, as a result, acquire effective access to fiscal
revenues. This implies that it is undesirable to implement a
privatization process that simply allows the creation of behemoths which
pursue fiscal rents rather than economic efficiency.
This
article reviews research reported in ‘Voracity and Growth’ by
Aaron Tornell and Philip Lane, CEPR
Discussion Paper No. 2001 (October 1998). Tornell is at Harvard
University; Lane is at Trinity College, Dublin, and a Research Affiliate
in CEPR’s International Macroeconomics and International Trade
programmes.
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