4

Steal from the Poor, Give to the Rich

WHETHER YOU’RE TAKING CHARGE OF THE OTTOMAN Empire, a corporation, or Liberia, controlling the flow of funds is essential to buying support. However once you’ve emptied the state’s or the corporate coffers by buying off both your essential supporters and their replacements, if necessary, you must reckon with the entirely new challenge of refilling the treasury. If a leader cannot find a reliable source of income, then it is only a matter of time until someone else will offer his supporters greater rewards than he can.

Money is essential for anyone who wants to run any organization. Without their share of the state’s rewards, hardly anyone will stick with an incumbent for long. Liberia’s Prince Johnson knew this when he tortured Samuel Doe, demanding the number of the bank accounts where the state’s treasure had been hidden. Without getting his question answered, Johnson would not be able to secure power for himself. In fact, neither he nor rival insurgent Charles Taylor could secure state revenue enough to buy control of Liberia’s government immediately after Doe was overthrown. The upshot: Samuel Doe died under Prince Johnson’s torture without answering the question, and Liberia degenerated into civil war. Each faction was able to extract enough resources to buy support in a small region, but no one could control the state as a whole.

The succession process in the Ottoman Empire is another illustration of the same point. Upon the death of their father, the Ottoman princes rushed from their provinces to secure the treasury, buy the loyalty of the army and have all their potential rivals (also known as brothers) strangled. Whoever first secured control over the money was likely to win. If no one son triumphed, cleanly wresting the treasury out of his siblings’ control, then no one could summon up the necessary revenues to pay his backers. The common result, as in Liberia, was civil war.

“Knowing where the money is” is particularly important in autocracies—and particularly difficult. Such systems are shrouded in secrecy. Supporters must be paid but there are no accurate accounts detailing stocks and flows of wealth. Of course, this lack of transparency is by design.¹ Thus does chaotic bookkeeping become a kind of insurance policy: it becomes vastly more difficult for a rival to promise to pay supporters if he cannot match existing bribes, or, for that matter, put his hands on the money. Indeed, secrecy not only provides insurance against rivals, it also keeps supporters in the dark about what other supporters are getting. Anyone who has tried to read the annual reports of publicly traded firms will quickly realize that this is a practice induced by dependence on a small winning coalition. In the corporate setting opacity occurs despite having to satisfy strict regulations and accounting standards. Secrecy ensures that everyone gets the deal they can negotiate, not knowing how much it might cost to replace them. Thus every supporter’s price is kept as low as possible, and woe to any supporter who is discovered trying to coordinate with his fellow coalition members to raise their price.

As we saw at the end of the last chapter, it is very difficult for autocrats to survive their early months in office. Good governance is a luxury they cannot afford at a time when they must scramble to find revenues. Little surprise, then, that we so often see looting, confiscations, extraction, and fire sales during political transitions, or conversely, and perhaps ironically, temporary liberal reforms by would-be dictators who are mindful that it is easier for a public goods–producing democrat than an autocrat to survive the first months in office. Thus it is that in the immediate aftermath of a leadership transition we see a few new leaders acting as if they care about the people and many new leaders seizing the people’s wealth and property. Such confiscations of property might well damage long-run revenue, but if a leader does not find money in the short term then the long run is someone else’s problem.

Democrats are generally fortunate enough to know where most of the money is. When David Cameron became prime minister of Britain or Barack Obama became president of the United States, neither needed to torture their predecessor to find the money. Because democracies have well-organized and relatively transparent treasuries, their flow of funds is left undisturbed by leader turnover. There are two reasons for this transparency. First, as we are about to explore, democratic leaders best promote their survival through policies of open government. Second, a larger proportion of revenue in democracies than in autocracies tends to be from the taxation of people at work. Such taxes need to be levied in a clear and transparent way, because just as surely as leaders need money, their constituents want to avoid taxes.

Taxation

We all hate taxes and are impressively inventive in looking for ways to avoid them. Leaders, however, are rather fond of taxes—as long as they don’t have to pay them. Being a dictator can be a terrific job, but it also can be terribly stressful, especially if money is in short supply. Taxes are one of the great antidotes to stress for heads of governments. Taxes, after all, generate much-needed revenue, which can then reward supporters. As a general principle leaders always want to increase taxes. That gives them more resources with which to reward their backers and, not to be forgotten, themselves. Nevertheless, they will find it difficult to raise taxes with impunity.

Leaders face three constraints on how much money they can skim from their subjects. First, taxes diminish how hard people work. Second, some of the tax burden inevitably will fall upon the essential backers of the leader. (In general, the first constraint limits taxes in autocracies and the second constraint sets the boundary on taxes in democracies.) The third consideration is that tax collection requires both expertise and resources. The costs associated with collecting taxes limit what leaders can extract and shapes the choice of taxation methods.

The first and most common complaint about taxes is that they discourage hard work, enterprise, and investment. This is true. People are unlikely to work as hard to put money in government coffers as they do to put money in their own pocket. Economists often like to express taxation and economic activity in terms of pies—when taxes are low, they say, the people work hard to enlarge the pie, but the government only gets a thin slice of the pie. As the government increases taxes, its share of the pie increases but people begin to do less work so the overall size of the pie shrinks. If the government sets tax rates to be extremely low or extremely high, its take will approach zero. In the first case it gets very little of a large pie; in the latter case there is hardly any pie because hardly anyone works. Somewhere between these extremes there is an ideal tax rate that produces the most revenue the state can get from taxation. What that ideal rate is depends on the precise size of the winning coalition. That, in fact, is one of many reasons that it is more helpful to talk about organizations in terms of how many essentials they depend on than to talk about imprecise notions such as autocracy or democracy. The general rule is that the larger the group of essentials, the lower the tax rate. Having said that, we return to the less precise vocabulary of autocracy and democracy, but always mindful that we really mean smaller or bigger coalitions.

Autocrats aim for the rate that maximizes revenue. They want as much money as possible for themselves and their cronies. In contrast, good governance dictates that taxes should only be taken to pay for things that the market is poor at providing, such as national defense and large infrastructure projects. Taking relatively little in taxes therefore encourages the people to lead more productive lives, creating a bigger pie. Democrats are closer to this good governance ideal than autocrats, but they too overtax. The centerpiece of Reaganomics, the economic plan of US president Ronald Reagan (1981–1989), was that US taxes were actually higher than this revenue maximizing level. By reducing taxes, he argued, people would do so much extra work that government revenue would actually go up. That is, a smaller share of a bigger pie would be larger than the bigger share of a smaller pie. Such a win-win policy proved popular, which is why similar appeals are again in vogue. Of course, it did not quite work out this way in fact.

To a certain extent, Reagan was right: lower taxes encouraged people to work and so the pie grew. However, crucially, in democracies it is the coalition’s willingness to bear taxes that is the true constraint on the tax level. Since taxes had not been so high as to squash entrepreneurial zeal in the first place, there wasn’t much appreciable change as a result of Reagan’s tax cuts. The pie grew a little, but not by so much that revenues went up.

Today, the Tea Party wing of the Republican Party seeks to reenact tax-cutting policies similar to Reagan’s. Like him, they argue that tax cuts will grow the economy. The lesson from the Tea Party movement’s electoral success in 2010 is that people don’t like paying taxes. Politician who raise or even maintain current taxes are politically vulnerable, but then so too are politicians who fail to deliver the policies their coalition wants. Herein lies the rub. It may well be that cutting taxes, while increasing the size of the economic pie, fails to make it big enough to generate both more wealth and more effective government policies. The question is and always must be the degree to which the private sector’s efficient but unequal distribution of wealth trumps government’s more equitable, less efficient, but popular economic programs.

Ruling is about staying in power, not about good governance. To this end, leaders buy support by rewarding their essential backers relative to others. Taxation plays a dual role in generating this kind of loyalty. First it provides leaders with the resources to enrich their most essential supporters. Second, it reduces the welfare of those outside of the coalition. Taxation, especially in small-coalition settings, redistributes from those outside the coalition (the poor) to those inside the coalition (the rich). Small coalition systems amply demonstrate this principle, for these are places where people are rich precisely because they are in the winning coalition, and others are poor because they are not. Phillip Chiyangwa, a protégé of Robert Mugabe in Zimbabwe, has stated it bluntly, “I am rich because I belong to Zanu-PF [Mugabe’s ruling party].”² When the coalition changes, so does who is rich and who is poor.

Nor is Zimbabwe an isolated case. Robert Bates, a professor of government at Harvard University, described the link between wealth and political backing in Kenya:

I recall working in western Kenya shortly after Daniel Arap Moi succeeded Jomo Kenyatta as President of Kenya. With the shift in power, the political fortunes of elite politicians had changed. As I drove through the highlands, I encountered boldly lettered signs posted on the gateways of farms announcing the auction of cattle, farm machinery, and buildings and lands. Once they were no longer in favor, politicians found their loans cancelled or called in, their subsidies withdrawn, or their lines of business, which had once been sheltered by the state, exposed to competition. Some whom I had once seen in the hotels of Nairobi, looking sleek and satisfied, I now encountered in rural bars, looking lean and apprehensive, as they contemplated the magnitude of their reversal.³

Needless to say, people want to be sleek and satisfied and not lean and apprehensive. That is why they remain loyal. A heavy tax burden emphasizes the differences between being rich and poor—in or out of the coalition. At the same time, the resulting revenues fund spoils for the lucky few, leaving little for everyone else. Further, the misery such heavy taxes inflict on the general population makes participation in the coalition even more valuable. Fearing exclusion and poverty under an alternative leadership, supporters are all the more fiercely loyal. They will do anything to keep what they have and keep on collecting goodies. Gerard Padró i Miguel of the London School of Economics has shown that the leaders of numerous African nations tax “too” highly (that is, beyond the maximum revenue point) and then turn around and provide subsidies to chosen groups. This may be economic madness, but it is also political genius.⁴

Democrats tax heavily too and for the same reason as autocrats: they provide subsidies to groups that favor them at the polls at the expense of those who oppose them. We will see, for instance, that Democrats and Republicans each use taxation when they can to redistribute wealth from their opponents to their supporters. So democratic governments also have an appetite for taxation but they cannot indulge that appetite to the extent autocrats can. Since their numbers are small, an autocrat can easily compensate his essential backers for the tax burden that falls on them. This option is not available to a democrat because his number of supporters is so large. Tax rates are therefore limited by the need to make coalition members better off than they can expect to be under alternative leadership. On the campaign trail, US president George H. W. Bush told the American people, “Read my lips, no new taxes.” Yet, budget shortfalls left him scrambling for revenue. The result was more taxes. In the wake of the First Gulf War, just eighteen months earlier, Bush had approval ratings of over 90 percent. But a declining economy and his broken promise on taxes led to his ouster in the 1992 election. While all leaders want to generate revenue with which to reward supporters, democratic incumbents are constrained to keep taxes relatively low. A democrat taxes above the good governance minimum, but he does not raise taxes to the autocrat’s revenue maximization point.

The relationship between regime type and taxation can be seen in the recent history of Mexico. Mexico’s first free election came in 1994, and the incumbent party, the Partido Revolucionario Institucional (PRI), lost nationally for the first time in 2000. As can be seen in Figure 4.1, onset of competitive elections (and of democratization) marks the start of the decline in government revenue as a percentage of gross domestic product (GDP). As the size of the winning coalition enlarged, Mexico’s tax rates followed suit by declining, just as they should when politicians need to curry favor with many instead of a few. For instance, the highest marginal tax rate in Mexico in 1979, with the PRI firmly in control, was 55 percent. As the PRI’s one-party rule declined, so did tax rates. By 2000, marking the first truly free, competitive presidential election, Mexico’s highest tax rate was 40 percent.⁵

Members of any autocrat’s small coalition also dislike paying taxes, but they readily endorse high taxes when those taxes are used to funnel great wealth back to them. This was just the case in Bell, California. City Manager Robert Rizzo raised property taxes. The city council could have stopped such increases, but had they done so, the city could not have afforded their bloated consultancy fees. Suppose for simplicity that Rizzo’s coalition was composed of 1 percent of Bell’s 36,000 residents. For every dollar increase in tax per person, Rizzo would have had up to $100 of services and payments he could transfer to each coalition member. Had his coalition been composed of half of Bell’s residents, each dollar increase in tax would provide only $2 per coalition member for transfers and services. It is easy to see why the coalition would sooner endorse higher taxes in the former setup than the latter.

 

FIGURE 4.1 Mexico’s Tax Take and Democratization

Nevertheless, to most of us who live in democracies, the idea that our taxes are actually less than in other systems might sound frankly absurd. If you live in New York City, as we do, you pay federal, state, and local taxes (as well as social security, Medicare, and sales tax). If you earn a reasonably good income, then income taxes suck up about 40 percent of your earnings. By the time you factor in sales, property, and other taxes, a reasonably wealthy New Yorker will have paid more than half her income in tax—hardly a low figure. European democracies, with their extensive social safety nets and universal health care, can tax at even higher rates. In contrast, some autocracies don’t even have income taxes. But the comparison of average tax rates is misleading.

At the income levels taxed in much of the world’s poor autocracies, the tax rate in Europe and the United States is zero. We have to compare taxes at given income levels, not across the board, since most income tax systems are designed to be progressive, taxing higher incomes at higher rates than lower incomes. By looking at how much tax has to be paid at a given income level across countries we get close to comparing apples to apples and oranges to oranges. In the United States, for example, a couple with one child and an income under about $32,400 pays no income tax. If their income were, say, $20,000 they would receive $1,000 from the federal government to help support their child. In China, a family with an income of $32,400 is expected to pay about $6,725 in income tax.⁶ Further, even when nominal rates are low, autocracies have high implicit taxes—if you have something valuable then it simply gets taken.⁷ It’s worth remembering that the wealthiest man in China and the wealthiest man in Russia are both currently in prison.

In 2004, Mikhail Khodorkovsky was the wealthiest man in Russia and the sixteenth wealthiest man in the world. He made his money building up Yukos, an oil company founded in the privatization wave in Russia in 1993. Yukos was the largest nonstate oil company in the world and accounted for about 20 percent of Russian oil production. Khodorkovsky, who had initially been close to the government, spoke out about Putin’s autocratic rule of Russia and he funded several opposition political parties. In 2003, he was arrested on fraud charges and subsequently convicted. The Russian government accused Yukos of tax evasion. According to Yukos, the tax take claimed by Russia from Yukos was substantially higher than that levied on other oil companies and, in some years, exceeded gross revenue. These enormous tax burdens forced Yukos into bankruptcy. With the end of his first eight-year sentence, Khodorkovsky, apparently still seen as a liability by the Russian government, was recently given a second sentence for embezzlement and money laundering.

His Chinese counterpart, Huang Guangyu, also known as Wong Kwong Ku, fared little better. Starting with nothing but $500 and a street cart, Guangyu created Gome, the largest electrical retailer in China. He was repeatedly ranked as China’s richest individual—until he was sentenced to fourteen years in prison for bribery. It is likely that he was guilty since bribery is commonplace in Chinese business dealings. It is also likely that he and others who have been prosecuted for corruption in China were “chosen for political reasons.”⁸

In autocracies, it is unwise to be rich unless it is the government that made you rich. And if this is the case, it is important to be loyal beyond all else. As we noted, it is quite possible that Guangyu and Khodorkovsky were both guilty of fraud and bribery. That is the nature of business in their respective countries. Even so, many others were surely guilty of the same crimes and yet walk free today. What singled them out was that they did not support the government and they had enormous wealth. White farmers in Zimbabwe suffer a similar fate. Robert Mugabe’s government seizes their land. The cover for these seizures is land redistribution to poor blacks who were dispossessed under colonial and white minority rule. The reality is much different. The land invariably ends up in the hands of cronies, none of whom are farmers. When the new owners invariably allow the land to fall into disuse, the farmers lose their investments, farm workers are evicted from their houses, and Zimbabwe, once a huge agricultural exporter, becomes hungrier. But on the other side of the ledger, Robert Mugabe is still in power.

Democrats are less inclined to rewrite the rules and seize wealth. Tempting though extra revenue is, it comes at the cost of lost productivity to the masses. In Shakespeare’s Merchant of Venice, the heroine, Portia, disguises herself as a judge and adjudicates at the trial between Antonio, who pledged his person as security on a loan, and Shylock, who demands his pound of Antonio’s flesh when Antonio does not pay in time.⁹ Bassanio, Antonio’s friend (and Portia’s husband), offers to pay many times the debt due and when Shylock refuses, he appeals to the mercy of the court: “And I beseech you, Wrest once the law to your authority: To do a great right, do a little wrong. . . .”

But Portia recognizes the sanctity of the law: “It must not be; there is no power in Venice Can alter a decree established: ’Twill be recorded for a precedent, And many an error by the same example, Will rush into the state: it cannot be.’”

The many messages of the Merchant of Venice are complicated and controversial, but one message, epitomized by the passage just quoted (but not the reversal in the enforcement of contracts just a bit later in the play) reminds us that rule of law is essential to successful commerce. As one examination of the demands of commerce as seen in the Merchant of Venice makes clear both for Venice and in general, “Contract does not require friendship, but it does require a degree of trust that the market is well-regulated or that the institutions of contract enforcement are appropriately strong.”¹⁰

Tax Collectors

Democrats need resources so they can reward their coalition, but they can’t take too much or they risk alienating those very same supporters. Similar concerns shape how taxes are collected. Leaders want to collect taxes in a “fair” or at least transparent way. Few US citizens would regard the Internal Revenue Service (IRS) as a transparent tax authority, but it is at least governed by rules (albeit an awful lot of them) and enforced by an independent judiciary. As for all the rules and exceptions that make the US tax code so complicated, these inevitably result from politicians doing what politicians inevitably do: rewarding their supporters at the expense of everybody else. This is why sheaves of pages in the tax code are dedicated to farmers—a crucial coalition for some politicians, who need to receive their rewards if their senators and representatives are to remain in power.

Autocrats can be less transparent. As we saw in the case of the unfortunate Messrs Khodorkovsky and Guangyu, when the opportunity arises autocrats will grab whatever they can. Yet even as they work without the constraint of being bound by people’s feelings, autocrats face real issues in the realm of collecting taxes. High taxes will inevitably drive people to hide their work and profits. This makes monitoring their income difficult. Furthermore, the large bureaucracy required to run a comprehensive tax system, such as the one in the United States, can be prohibitively expensive. To put this in context, the US’s Internal Revenue Service spends about $38 per person, or about 0.5 percent of the IRS take, on collecting an average of $7,614 in tax per person.¹¹ This is fine in a nation with per capita GDP of $46,000, but in nations with incomes of only $1,000 per year, such a cost of collecting taxes would be about 23 percent of the revenue. Further, setting up a large bureaucracy makes an autocrat beholden to those who run it. The first rule of office holding is to minimize the number of people whose support you need. To avoid becoming a slave of their own tax collectors, autocrats often use indirect taxation instead. With indirect taxes, the cost of the tax is passed on to someone other than the person actually paying it. For instance, sellers pay sales taxes to municipal governments but sellers pass the cost on to buyers, making sales taxes indirect.

Agricultural marketing boards are a common indirect means of taxing poor farmers in autocracies. In principal such organizations are designed to fulfill a similar function as the European Union’s Common Agricultural Policy (CAP). The CAP guarantees farmers minimum prices for their goods—thus it provides a benefit to the farmers. In many democracies, as in the United States, rural areas are overrepresented electorally. Given the desire to rule with as few supporters as possible, it should be of little surprise that democrats often include farm groups in their coalition and reward them accordingly.¹²

In contrast, farmers are rarely key supporters in autocracies. Farm marketing boards are set up to exploit, rather than help them. Consider Ghana’s Cocoa Marketing Board (CMB). Cocoa is Ghana’s major agricultural export. The CMB fixes a price for cocoa—an implicit tax—and insists that farmers sell all their cocoa to the board at that price, an indirect tax. The board then resells the cocoa on world markets at a higher price and pockets the difference: “The first rung in the long ladder of leeches that feed on the sweat of the cocoa farmers is the Cocoa Marketing Board.”¹³ These rents have been a major source of government revenue in Ghana.

Taxing the poor to pay the rich has plenty of bad economic consequences, but these tend to be “in the long run”—that is, on another leader’s watch. For instance, in Ghana, heavily taxing famers had the longer term consequence of reducing crops. Ghanaian farmers simply stopped planting and caring for cocoa trees. By the 1980s cocoa production had collapsed and farmers tried to smuggle what little they did grow to neighboring Côte d’Ivoire. Case after case proves the point: when taxes are too high, then people either stop working or they find ways to avoid the formal economy.

Privatized Tax Collection

When even indirect taxation proves to be too much trouble, autocrats sometimes turn to outsiders for help extracting funds from their people. For autocrats and for their tax collectors this has a virtue and a liability. People hired to extract money for the government, keeping a portion of what they collect for themselves, have a strong incentive to take in lots of tax revenue. That’s good for them and good for the leader who receives the substantial remainder not kept by prudent tax collectors. But people hired to extract money can also use the power of that money to become a threat to a leader, and that, of course, is dangerous for them and for the incumbent.

The Caliphate was the Muslim empire created by military conquest following the death of the Prophet Muhammad in 632. It ruled much of the Middle East, North Africa, and parts of Europe until 1258. In the tradition of the Romans before them, the caliphs avoided the technical difficulties of tax collection by outsourcing the task altogether. A tax farmer would pay the treasury for the right to collect taxes from a particular territory. Obviously, once they had paid for the privilege, tax farmers extracted everything they could. They were notoriously brutal and always looking for ingenious ways to take more. For instance, they would demand payment in silver coins rather than crops, and then collude with merchants to fix prices. Those who could not pay were punished or even killed.

Naturally, the people resisted. Tax farmers contended with a persistent problem of people fleeing the land rather than paying their property taxes. To prevent this, tax farmers set up patrols to check identities. Non-Muslims were often tattooed or forced to wear “dog tags” with their name and address to prevent them from fleeing.¹⁴ Initially some of the tax collected by the tax farmers was only applicable to non-Muslims. This proved to be a very successful, if not wholly intended, means of encouraging religious conversion. It seems that many non-Muslims, realizing that they could reduce the tax collectors’ reach by becoming Muslim, put their religious beliefs aside and converted. As long as these conversions did not assume massive proportions, the tax farmers made themselves incredibly rich at the expense of the average citizen. When conversion became commonplace, tax farmers adjusted, no longer excluding Muslims from some of the taxes they levied. And from the perspective of the Caliph, they ensured reliable revenue. That they terrorized the people was of no political importance: impoverished and persecuted farmers were not part of the winning coalition.

Autocrats can avoid the technical difficulties of gathering and redistributing wealth by authorizing their supporters to reward themselves directly. For many leaders, corruption is not something bad that needs to be eliminated. Rather it is an essential political tool. Leaders implicitly or sometimes even explicitly condone corruption. Effectively they license the right to extract bribes from the citizens. This avoids the administrative headache of organizing taxation and transferring the funds to supporters. Saddam Hussein’s sons were notorious for smuggling during the 1990s when Iraq was subject to sanctions. They made a fortune from the sanctions that were supposed to harm the regime.

Extraction

“Oil is the Devil’s excrement,” at least according to Juan Pablo Perez Alfonzo, a Venezuelan who founded the Organization of Petroleum Exporting Countries (OPEC), the cartel of oil-producing nations. “Ten years from now, twenty years from now, you will see: oil will bring us ruin.” And he was right.

As many leaders have learned, the problem with raising revenue through taxation is that it requires people to work. Tax too aggressively or fail to provide an environment conducive to economic activity and people simply don’t produce. Actually extracting revenue from the land itself provides a convenient alternative, cutting the people out of the equation altogether.

Take oil, for example. It flows out of the ground whether it is taxed at 0 percent or 100 percent. Labor represents but a small part of the value of oil extraction. This makes it a leader’s dream and the people’s nightmare. In a phenomenon often called the resource curse, nations with readily extractable natural resources systematically underperform nations without such resources.¹⁵ Resource-rich nations have worse economic growth, are more prone to civil wars, and become more autocratic than their resource-poor counterparts.

Nigeria, the most populous nation in Africa, achieved independence from Britain in 1960. At the time of independence it was a poor nation, but expectations were high. These expectations grew with the discovery of oil. Nigeria is believed to have the world’s tenth largest reserves. With the rise in oil prices during the oil crises in the early and late 1970s, Nigeria found itself awash with funds. And yet, by the early 1980s the country was swamped by debt and poverty. From 1970 to 2000, Nigeria had accumulated $350 billion in oil revenue.¹⁶ It has not helped the people. Over the same years, average annual income per capita went from US$1,113 in 1970 to US$1,084 in 2000, making Nigeria one of the poorest nations in the world, in spite of its vast oil wealth. Poverty has risen too. One dollar per day is a common standard used for assessing poverty: in 1970, 36 percent of Nigerians lived on less; by 2000 this figure had jumped to nearly 70 percent. The situation can hardly be said to have improved since then. Even with today’s inflated dollars, a majority of Nigerians earn less than a dollar a day and per capita income has continued to fall. Adjusted for inflation, income is below what it was when Nigeria became independent.

Nigeria is not exceptional. Figure 4.2 shows exactly that. The horizontal axis shows natural resource exports as a percentage of GDP in 1970. The vertical axis shows the average level of economic growth between 1970 and 1990. The trend is clear. Nations flush with oil, copper, gold, diamond, or other minerals grow more slowly.

Nevertheless, natural resources are wonderful for leaders. Unlike getting their subjects to work, leaders don’t have to encourage natural resources to work. Admittedly the minerals need to be extracted, but by and large autocrats can achieve this without the participation of the local population. In Nigeria, for instance, the oil is concentrated in the Niger Delta region. Foreign firms with foreign workers do most of the extraction. Few Nigerians participate. The oil companies run security firms, effectively small private armies, to keep the locals from obstructing the business or complaining about the environmental degradation that results. BP and other foreign firms are free to act with impunity, provided they deliver royalty checks to the government. This is not so much a failing of these companies as the way business must be conducted in countries whose leaders rely on a few cronies to back them up. A company that acts responsibly will necessarily have less money to deliver to the government and that will be enough for them to be replaced by another company that is willing to be more “cooperative.”

 

FIGURE 4.2 Growth and Natural Resource Abundance, 1970–1990

One interesting manifestation of the differences between wealth and poverty in resource-rich lands is the cost of living for expatriates living in these countries. While it is tempting to think that cities like Oslo, Tokyo, or London would top the list as the most expensive places, they don’t. Instead it is Luanda, the capital of the southwestern African state of Angola. It can cost upwards of $10,000 per month for housing in a reasonable neighborhood, and even then water and electricity are intermittent. What makes this so shocking is the surrounding poverty. According to the United Nations Development Program, 68 percent of Angola’s population lives below the poverty line, more than a quarter of children die before their fifth birthday, and male life expectancy is below forty-five years. The most recent year for which income inequality data are available is 2000. These data suggest that the poorest 20 percent of the population have only 2 percent of the wealth. Angola is ranked 143 out of 182 nations in terms of overall human development. Prices in Angola, as in many other West African states, are fueled by oil.

The resource curse enables autocrats to massively reward their supporters and accumulate enormous wealth. This drives prices to the stratospheric heights seen in Luanda, where wealthy expatriates and lucky coalition members can have foie gras flown in from France every day. Yet to make sure the people cannot coordinate, rebel, and take control of the state, leaders endeavor to keep those outside the coalition poor, ignorant, and unorganized. It is ironic that while oil revenues provide the resources to fix societal problems, it creates political incentives to make them far worse.

This effect is much less pernicious in democracies. The trouble is that once a state profits from mineral wealth, it is unlikely to democratize. The easiest way to incentivize the leader to liberalize policy is to force him to rely on tax revenue to generate funds. Once this happens, the incumbent can no longer suppress the population because the people won’t work if he does.

The upshot is that the resource curse can be lifted. If aid organizations want to help the peoples of oil-rich nations, then the logic of our survival-based argument suggests they would achieve more by spending their donations lobbying the governments in the developed world to increase the tax on petroleum than by providing assistance overseas. By raising the price of oil and gas, such taxes would reduce worldwide demand for oil. This in turn would reduce oil revenues and make leaders more reliant on taxation.

Effective taxation requires that the people are motivated to work, but people cannot produce as effectively if they are forbidden such freedoms as freedom to assemble with their fellow workers and free speech—with which to think about, among other things, how to make the workplace perform more effectively, and how to make government regulations less of a burden on the workers.

Borrowing

Borrowing is a wonderful thing for leaders. They get to spend the money to make their supporters happy today, and, if they are sensible, set some aside for themselves. Unless they are fortunate enough to survive in office for a really long time, repaying today’s loan will be another leader’s problem. Autocratic leaders borrow as much as they can, and democratic leaders are enthusiastic borrowers as well.

We are all at least a little bit impatient. It’s in our nature to buy things today when better financial acumen might suggest saving our money. Politics makes financial decision making even more suspect. To understand the logic and see why politicians are profligate borrowers, suppose everyone in a country earns $100 per year and is expected to do so in the future too. The more we spend today, the more we must pay in interest and debt repayment tomorrow. Suppose, for instance, that to spend an extra $100 today we have to give up $10 per year as interest payments in the future. It is reasonable to see that people could differ on whether this is a good idea or not, but politics certainly makes it more attractive. To simplify the issue vastly, suppose leaders simply divide the money they borrow among the members of their coalition. This encourages leaders to borrow more. If a leader has a coalition of half the people and he borrows an amount equivalent to $100 per person, then everyone has to give up $10 in each future year (as taxes to pay the interest). However, since the coalition is only half the population, each coalition member’s immediate benefit from the borrowing is $200. While to some this might still not seem like an attractive deal, it is certainly better than incurring the same debt obligation for $100. Governments of all flavors are more profligate spenders and borrowers than the citizens they rule. And that profligacy is greatly multiplied when we look at small coalition regimes.

As the size of the coalition shrinks, the benefits that the coalition gains from indebtedness go up. If, for instance, the coalition includes one person per hundred then, in exchange for the debt obligation, each coalition member receives $10,000 today instead of the mere $200 in the 50 percent coalition example. This is surely a deal that most of us would jump at. As the coalition size becomes smaller, the incentive to borrow increases.

Of course, borrowing more today means higher indebtedness and a smaller ability to borrow tomorrow. But such arguments are rarely persuasive to a leader. If he takes a financially reasonable position by refusing to incur debt, then he has less to spend on rewards. No such problem will arise for a challenger who offers to take on such debt in exchange for support from members of the current incumbent’s coalition. This makes the current leader vulnerable. Incurring debt today is attractive because, after all, the debt will be inherited by the next administration. That way, it also ties the hands of any future challenger.

A leader should borrow as much as the coalition will endorse and markets will provide. There is surely a challenger out there who will borrow this much and, in doing so, use the money to grab power away from the incumbent. So not borrowing jeopardizes a leader’s hold on power. Heavy borrowing is a feature of small coalition settings. It is not the result, as some economists argue, of ignorance of basic economics by third-world leaders.

In an autocracy, the small size of the coalition means that leaders are virtually always willing to take on more debt. The only effective limit on how much autocrats borrow is how much people are willing to lend them. Earlier we saw the paradoxical result that as Nigeria’s oil revenues grew so did its debt. It wasn’t that the oil itself encouraged borrowing—autocrats always want to borrow more. Rather revenues from oil meant that Nigeria could service a larger debt and so people were more willing to lend.

Although the large coalition size in a democracy places some restrictions on the level of borrowing, democratic leaders are still inclined to be financially irresponsible. Remember, while the debt is paid by all, the benefits disproportionately flow to coalition members. Over the last ten years the economies of many Western nations boomed. This would have been a perfect time to reduce debt. Yet in many cases this did not happen. In 1990, US debt was $2.41 trillion, which was equivalent to 42 percent of GDP. By 2000 this debt had grown in nominal terms to $3.41 trillion, although in relative terms this was a decline to 35.1 percent of GDP. However, as the economy prospered during the 2000s, debt continued to slowly accumulate instead of shrink. In 2007, before the financial crisis, US debt stood at $5.04 trillion or 36.9 percent of GDP. A bigger economy means a greater ability to service debt and a capacity to borrow more.

We may be inclined to explain the expansion of the debt by citing the party politics of the leader in charge. However, ideology offers a poor account of these trends. The major accumulations of US debt in the postwar period both began under Republican administrations: Ronald Reagan (1981–1989) and George W. Bush (2001–2009). This debt grew at a staggering pace during the 2007–2010 recession as the United States underwrote troubled banks and embarked on Keynesian policies of fiscal stimulus. By the third quarter of 2010, debt was $9.13 trillion or 62 percent of GDP. British debt follows a similar pattern. In 2002 debt stood at 29 percent of GDP, but by 2007 it was 37 percent and this has exploded in the wake of the 2008 financial crisis to 71 percent of GDP.

From a Keynesian perspective, many governments are taking the perverse steps of trying to cut spending during a recession instead of stimulating demand. This does not reflect a desire by politicians to borrow less. Rather debt crises in Iceland, Greece, and Ireland have led many investors to doubt the ability of nations to repay. This has pushed up the cost of borrowing and made it much harder to secure new loans. It is supply, not demand, that has shrunk.

Markets limit how much a nation can borrow. If individuals borrow too much and either cannot or will not repay it, then banks and other creditors can seize assets to recover the debt. With sovereign lending to countries, however, creditors cannot repossess property. On a few occasions creditors have tried. For instance, France invaded Mexico in 1862 in an attempt to get Mexico to repay loans. France also invaded the Ruhr, an industrial area of Germany, in 1923 to collect reparation payments due from World War I that Germany had not paid. Both attempts failed. In practice, the only leverage lenders have over nations is to cut them off from future credit. Nevertheless, this has a profound effect, as the ability to engage in borrowing in financial markets is valuable. For this reason nations generally pay their debt.

However, once the value of access to credit is worth less than the cost of servicing the debt then leaders should default. If they don’t then surely a challenger will come along who will offer to do so. This was one of the appeals of Adolf Hitler to the German people in the 1930s. Germany faced a huge debt, in part to pay reparations from World War I. Hitler defaulted on this debt. It was a popular policy with the German people since the cost of servicing the debt was so high.

As debt approaches the balance point where the value of access to credit equals the cost of debt service, lenders refuse to increase the overall size of debt. At this point, if leaders want to borrow more, then they need to increase revenues such that they could service this additional debt. As in the Nigerian case, the discovery of exploitable natural resources provides one means to increase debt service and hence more borrowing. However, without such discoveries, the only way to increase borrowing is to increase tax revenue. For autocratic leaders this means liberalizing their policies to encourage people to work harder because they already tax at a high (implicit) rate. Only when facing financial problems are leaders willing to even consider undertaking such politically risky liberalization. They don’t do it frequently or happily. They liberalize, opening the door to a more democratic, representative and accountable government only when they have no other path to save themselves from being deposed today.

Debt Forgiveness

Debt forgiveness is a popular policy, but one that is generally misguided. Those in favor of forgiving the debt of highly indebted poor countries argue that the debt burden falls on the poor people of the nation who did not benefit in a consequential way from the borrowed funds. This is certainly true. As we have explained, the benefits go to the leader and the coalition while the debt obligation falls on everyone. But people who argue for debt forgiveness construct their arguments in terms of how they think the world should operate, rather than how it actually works.

In the late 1980s, as many poor nations struggled to repay debts, creditors coordinated to reschedule and forgive debt. The French Ministry of the Economy, Finance, and Industry became an important center for negotiations, helping ensure that creditors shared similar losses. These meetings became known as the Paris Club. In 1996 the International Monetary Fund (IMF) and World Bank launched the Heavily Indebted Poor Country (HIPC) initiative. Instead of the previous case-by-case approach, this program provided systematic help to poor nations with writing down their debts. However, nations could only receive debt relief when they passed or made substantial progress towards meeting explicit criteria concerned with poverty alleviation and budget reform. The program received a huge boost under the Millennium Goals program. From 2006 onwards many HIPCs saw very large reductions in their debt. We will have to wait to see the consequences of these programs. However, it is useful to look back at some of the largest debt-relief efforts prior to 2000. It is particularly illustrative to observe how important the nature of governance is. Even though creditors carefully chose those nations that they thought would behave sensibly, in the wake of debt relief many nations started increasing debt again.

As a percentage of debt, the largest debt reliefs prior to 2000 were given to Ethiopia in 1999 (42 percent of debt), Yemen in 1997 (34 percent), Belarus in 1996 (33 percent), Angola in 1996 (33 percent), Nicaragua in 1996 (30 percent) and Mozambique in 1990 (27 percent). ¹⁷ With the exceptions of Angola and Nicaragua, each of these nations promptly started reaccumulating debt. For instance, after a series of small debt reductions, in 1999, with the forgiveness of $4.4 billion, Ethiopia had its debt reduced to $5.7 billion. But by 2003 this debt had risen to $6.9 billion. Despite the forgiveness of $589 million of debt in 1996, Belarus’s debt has steadily risen from $1.8 billion in 1995 to over $4.1 billion in 2005. Even though debt-reduction programs vet candidates, these examples suggest that in many cases for-giveness without institutional reform simply allows leaders to start borrowing again.

 

FIGURE 4.3 Mozambique’s Debt and Forgiveness

Democrats also like to borrow but they are not as profligate as autocrats. They prefer lower levels of indebtedness than autocrats. Democratization promotes successful debt reduction, as the history of Mozambique and Nicaragua illustrate. In 1990, 27 percent of Mozambique’s debt was forgiven. The result was the further accumulation of debt. By the time Mozambique democratized in 1994, debt was over $8 billion. However, this debt has gradually been reduced, as seen in Figure 4.3, aided in part by further forgiveness.

The HIPC program has received much criticism for its slow pace in reducing the debt of poor nations. Our criticism of HIPC is the opposite. These programs are actually too eager to forgive debt. Debt forgiveness simply allows autocratic leaders to start borrowing more money. As we’ll see a little later, financial crises are one of the important reasons leaders are compelled to democratize. Debt reduction, however, relieves financial pressure and enables autocrats to stay in office without reform, continuing to make the lives of their subjects miserable.

It is no wonder that autocrats love debt relief. But how does debt relief look to those who would like to improve governance and who want to start, as we do, from understanding how leaders behave rather than engaging in wishful thinking? We depart for the moment from looking at governance through a leader’s eyes and instead turn our attention to how to change an autocrat’s vision. That is, we turn for the moment to thinking about how we can use the logic of dictatorial rule to give autocrats the right incentives to change their government for the better. We wonder, can we create a desire by at least some autocrats to govern for the people as the best way to ensure their own political survival?

Debt reduction might work in democracies. Since such nations want to reduce excessive debt anyway, debt reduction clearly helps speed the process. But as can be seen in Figure 4.3, Mozambique was already tackling its debt problem prior to large scale forgiveness in 2001 and in 2006. Therefore, we advocate a conservative approach of little or no debt relief as a way to improve the quality of governance and the quality of life of people currently living under wretched, oppressive regimes. We know that debt relief allows autocrats to entrench themselves in office. Debt forgiveness with the promise of subsequent democratization never works. An autocrat might be sincere in his willingness to have meaningful elections in return for funds. Yet once the financial crisis is over and the leader can borrow to pay off the coalition, any promised election will be a sham. For democrats, debt relief, while helpful, is unnecessary. By eliminating debt relief for autocrats we can help precipitate the sorts of rebellions seen in the Middle East in 2011, rebellions that, as discussed later, may very well open the door to better governments in the future.

Taxation, resource extraction, and borrowing are the foremost ways of acquiring funds for enriching a coalition. Discussions that portray taxation differently are either window dressing to make the process seem more palatable or are making arguments based on how people would like the world to work. Leaders tax because they need to spend on their coalition. Successful leaders raise as much revenue as they can. The limits of taxation are: (1) the willingness of people to work as they are taxed; (2) what the coalition is willing to bear; and (3) the cost of collecting taxes.

Having filled government coffers, leaders spend resources in three ways. First they provide public goods. That is, policies that benefit all. Second, they deliver private rewards to their coalition members. This mix of private and public benefits differs across political systems, and it’s worth noting that any resources left over after paying off the coalition are discretionary. Leaders therefore have a third choice to make about spending money. They could spend discretionary money promoting their pet projects. Alternatively, and all too commonly, as we shall see, they can hide them in a rainy-day fund.