metadata: authors: 0: author: Edwards, Sebastian
1: author: Tabellini, Guido
docna: 0: docna: The political economy of fiscal policy and
            inflation in developing countries : an empirical analysis
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Social Analysis,Quality of Life & Leisure,National Governance,Government Policies,Public Sector Economics,International Trade and Trade Rules,Youth and Governance,Inflation,Public Finance Decentralization and
            Poverty Reduction
teratopic: Public Sector Development
abstracts: cdata!: Most economists treat fiscal policy as
            exogenous and consider policymakers as machines to be
            programmed. Rarely do they seek to determine why, for
            instance, some countries rely on the inflation tax while
            others use direct taxation, let alone what political factors
            affect such decisions. Yet without a theory of how fiscal
            policymakers behave, at both the revenue and the expenditure
            levels, there is no guarantee that policy advice will turn
            out to be sound. The authors present the results of an
            empirical analysis of the political economy of fiscal policy
            for a group of developing countries. They look at
            alternative ways of incorporating political variables into
            the explanation of government policy actions. Dividing their
            results into three sections, one each for inflation, budget
            deficits, and devaluations, they find that: (a) the
            equilibrium inflation rate is higher the more citizens
            disagree about which party should hold office, and the more
            unlikely it is that the government currently in office will
            be reappointed; (b) political instability and polarization
            lead to a collective myopia that sometimes tempts
            policymakers to borrow too heavily and to leave the bills to
            their successors; and (c) governments tend to implement
            adjustment policies early in their tenure when they command
            political authority, but if political conflict arises, they
            may lack the strength to change the macroeconomic status quo
            and will resort instead to inflation and deficits.
repnme: repnme: The political economy of fiscal policy and
            inflation in developing countries : an empirical analysis
display_title: The political economy of fiscal
            policy and inflation in developing countries : an empirical analysis
listing_relative_url: /research/1991/06/699940/political-economy-fiscal-policy-inflation-developing-countries-empirical-analysis
topicv3: Political Economy of Reform m1326263 836,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Fiscal Policy m1327144 445,Taxation m1327615 1121
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Public Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 85
model_extractions: **Policy, Psearch, and External Affairs**

<!-- Start of picture text --> Pubilc Economics<br>WPS 703<br><!-- End of picture text --> This paper-a product of the Public Economics Division, Country Economics Department-is part of a larger effort in PRE to study the political economy of fiiscal policies in developing countries. Copies are available frec from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Ann Bhalla, room N10-061, extension 37699 (80 pages, with tables).

Most economists treat fiscal policy as exogenous and consider. licymakers as machines to be programmed. Rarely do they seek to determine why, for instance, some countries rely on the inflation tax while others use direct taxation, let alone what political factors affect such decisions. Yet without a theory of how fiscal policymakers behave, at both the revenue and the expenditure levels, there is no guarantee that policy advice will turn out to be sound.

policymakers to borrow too heavily and to leave the bills to their successors.

- Governments tend to implement adjustment - policies -including major devaluations early in their tenure in office, when they command political authority. But if political conflict arises, they may lack the strength to change the macroeconomic status quo and will resort instead to inflation and deficits.

Edwards and Tabellini present the results of an empirical analysis of the political economy of fiscal policy for a group of developing countries. They look at alternative ways of incorporating political variables into the explanation of government policy actions. Dividing their results into three sections, one each for inflation, budget deficits, and devaluations, they find that: The equilibrium inflation rate is higher the more citizens disagree about which party should hold office, and the more unlikely it is that the government currently in office will be reappointed.

Edwards and Tabellini argue that their results have important implications for the design of adjustment and stabilization programs. Institutional reforms that make it hardtr for a government to reverse course without warning will increase the credibility of the reforms, thereby reducing political instability - **and** the equilibrium level of inflation. The creation of independent central banks should also be a priority. This and other teforms .hat take money creation out of the hands of governments will boost macroeconomic stability Their results serve as a general endorsement of World Bank conditionality.

* Political instability and polarization lead to a collective myopia that sometimes tempts

The PRE Working Paper Series disseminates the findings of work under way in thc Bank's Policy, Research. and Extemal I Affairs Complex. An objective of the series isto get these findings out quickly, even if presentations are less than fully polished. i The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the PRE Dissemination Center
# The Political Economy of Fiscal Policy and Inflation in Developing Countries: An Empirical Analysis*

# by Sebastian Edwards and Guido Tabellini

# Table of Contents

|I.|Introd|uction|1|
|---|---|---|---|
|II.|Inflat|ion|3|
||11.1<br>11.2<br>11.3|The Inflation Tax<br>Credibility and Inflation<br>Long Run Seigniorage, Tax Reforms, and Political Instability|4<br>6<br>10|
|III.|Fiscal|Deficit|16|
||111.1|Government "Borrowing" from the Monetary System and<br>Fiscal Deficits: The Evidence|16|
||111.2|<br>Political Instability and Budget Deficits|18|
|IV.|Stabil|ization Attempts, Devaluations, and Politics|22|
||IV. 1|The Politics of Successful Devaluation Programs: Some<br>Preliminary Empirical Evidence|27|
|||IV.1.1<br>The Data Set<br> <br>|27<br>|
|||IV.1.2<br>The Timing of Devaluations<br>IV. 1.3<br>Political Determinants of Successful Devaluations|30<br>31|
|V.|Concl|uding Remarks|35|
|Appen|dix I: T|he Theory of Optimal Taxation: Theory and Tests|39|
|Appen|dix II:|The Measurement of Political Instability|45|
|Refere|nces||49|
|Tables|||52|

> * This paper is part of a World Bank research project on "The Political Economy of Fiscal Policies in Developing Countries: A Pilot Study" (RPO 675-59). We have benefitted from extensive comments by Chad Leechor. We wish t-i thank Javad Shirazi and Ajay Chhibber for their support and the participants of two World bank seminars for helpful comments. Bela Balassa provided thorough comments to a previous version of this paper. M. Savastano, J. Santaella, and T. Harris provided excellent research assistance. A previous version entitled "Explaining Fiscal Policies and Inflation in Developing Countries" was presented at the Arizona State University Conference on Political Economy,
1 The importance of fiscal policy in the developing countries has long been recognized. More and more economists have recently argued that fiscal policy plays a crucial role in the determination of overall economic performance In the LDCs. In fact, new empirical studies suggest that macroeconomic (and especially fiscal) stability nay indeed be **an** important element in explaining the difference in real performance between the East Asian and the Latin American countries.I However, in spite of important recent developments in theoretical, and to some extent empirical, aspects of the macroeconomics of fiscal policy, modern analyses have until now failed to address the key question of what determines a country's fiscal stance. In a phrase, the problem Is that economists most of the time treat fiscal policy as exogenous, and consider the policymaker to be like a machine that can be programmed. Very few studies ask questions like: 'Why do some countries rely heavily on the Inflation tax, while others use primarily direct taxation?" Or, "Why do some Central Banks (or monetary systems for that matter) allocate a high proportion of their credit to the public sector and others don't?"<sup>Even</sup> fewer studies have used modern economic analysis to ask what type of institutions or legal arrangements will help maintain fiscal discipline and sustain stabilization efforts. There **is** little hope that we will be able to provide lasting policy advice until we understand the forces underlying the Iin nost (but not all) Latin American countries we observe cycles that go from fiscal Indiscipline to real exchange rate overvaluation, to increased trade restrictions and exchange controls. There is wide agreement that this scenario Is translated Into poor economic performance. On the other hand, this typo of behavior has been largely absent in the East Asian nations. See, for example, the Wiorld Develonment ReaD= 1988 as well as the abundant literature on adjustment that has emanated in the last few yeari from the World Bank and the IMF.
**2**

di,!- rences in fiscal hehavio 6 , both **at** the revenue **and** expenditure levels. To answer these questions we need to formulate a positive theory of how policymakers behave.

> A relatively small but growing body of literature has **Indeed** recently pursued a positive approach to the theory of monetary **and** fiscal policy, building on insights developed from **game** theory **and** irom **the** theory of public **choice.** This literature, **whit. h.as** come to **be** known collectively as the litical Scon2m approach to macroeconomic policy, tries to explain specific macroeconomic actions of policymakers, including their inclination towards given expenditure patterns, and their reliance on particular sources of revenue. Most of this literature, however, has been theoretical and has dealt almost exclusively with the advanced nations. The purpose of this paper is to provide a (partial) remedy to this situation, by presenting a series of empirical results on the political econoay of inflation and fiscal pollcy for a group of developing countries. More specifically, we discuss in detail alternative vays of incorporating empirically political variables into the explanation of government policy actions. In doing this we both survey some of the limited existing empirical literature on the subject, and we report new results for a cross section of countries. The emphasis of the paper is eminently e£1rxLal. This has been delibera%e, since we believe that it is precisely in this area wh2re a major research effort is required. In fact, throughout the paper we argue that many of _tho_ Insights and implications of the political economy models can be empirically tested, and we suggest specLfic ways of doing so. Those readers interested in pursulng ln greater detail the theoretical angles of this topic are referred to the survey by Pemason and Tabellinl (1990), and to the literature cited there.
3 The paper is divided into three parts that deal, respectively, with inflation, budget deficits and devaluations. In the first phrt the recent literature on the theory of inflation is .eviewed, and time series and crosscountry data are used to investigate the validity of a number of recent theoretical propositions. We report results that support the view that variables related to political factors help explain cross-country differentials in the inflation tax. The second part of the paper reviews the theory and th avidence on government budget deficits, and government borrowing. Here, the central finding is that more unstable political systems tend to be associated with larger borrowing. Finally, the third pa&t of the paper focuses on the stabilization episodes in developing countries. We argue that the failure of some of these episodes is rooted In both political weakness of the government and on political instability of the country. We analyze this proposition empirically by focusing on 39 stabilization periods. Our findings, based on nonparametric techniques, support the hypothesis that stabilizations tend to fail in those nations with more unstable politics. The last section contains brief concluding remarks and proposes new directions for future research. Finally, the paper has two appendices: Appendix 7 deals with tests of the optimal tax theory of Inflation; Appendix II deals with the measurement of political instability.

In this section we systematically analyze the theory and evidence on Inflation for a large group of developing countries. We start by providing a broad analysis of the data and then move to test whether political yariables help explain the observed cross country variability in the inflation tax. More specifically, we investigate the most important empirical
4 Implications of credibility based models and of models that rely on the Idea cf strategic government behavior.

# 11.1 IL Inflation Tax

Table 1 contains data on Inflation and on seignorage for 52 devaloping countries for four subperiods between 1963 and 1987: 1963-73, 1973-13, 197883 and 1983-87. For each subperiod we have presented data on the averaL rate of inflation -- that is the average rate of change In the consumption price index -- as well as the average revenue from the Inflation tax, expressed as a per_entage of GDP. For every year this revenue was computed as: R NM vzm(1) where w is the inflation rate, m is the monetary base and y is GDP.<sup>3</sup> All the data were obtained from the most recent IFS tape.<sup>4</sup> These figures strikingly illustrate a wide variabtlity in the inflation tax, both across countries and across time. First, In almost every case there Is an important increase in the rate of the inflation tytY in the late 1970s and early 1980s. Second, the croa country variability is remarkable, both regarding the rates _as_ well as revenues. For the period 1963-73 the ratio of higher to lower rate of the inflation tax was 41 times For 1983-

## 2The countries have been grouped geographically.

3In the actual computations we used nominal m and y. If real base and GDP are used the results would be the same, **as** long as we use the CDP deflator to compute the real stock of monetary base. 4A i..roblem with the raw IFS data is that while the price level is _a_ yearly average the monetary figures are wend of year*. This was tackled by "centering* the monetary variables and, thus, constructing yearly waverage" figures for the monetary variables.
5 87 this ratio had climbed to more than one thousand timesl<sup>5</sup> Third, In some countries such as Ghana (A3-78 vs. 78-83); Malawi (73-78 vs. 78-83); Zaire (73-78 vs. 78-83); and tolle (63.73 **vs.** _i._ 78), Increases In the rate of the inflation tax (a) were associated with daclines in revenue from the Inflation tax.6 Fourth, contrary to the popular belief, we observe very wlde differences In behavior within Latin America. For example, in every period we can find some Latin American countries with a very low rate of Inflation; in fact, lower than the average of the Asian nations. This is an important finding since it provides a devastating counterexample to the popular "geographical" or 'cultural' theory of inflation differentials across countrles. According to that view cultural reasons explain why Latin America is fiscally irresponsible. Our data, however, show that Latin America is far from being a homogeneous group. Thus, any good theory that attempts to explain the determinants of fiscal policy and the Inflation tax should be capable of explaining the different behavior encountered within the Latin American regicn.

Figures 1 through 3 depict the relatiorahip between the rate of inflation and the log of the inflation tax revew%e for a group of selected countries. These diagrams suggest that In most of tnese coantries there is a Laffer curve type relation between the rate of inflation and the Inflation tax revenue. Moreover, they also suggest that at one point or another some of these countries may indeed have been on the 'wrong side' of this curve.

5This excludes Togo which has a negative recorded r4te of Inflation tax. 6The extent of this phenomenon is probably greater than what Is apparent from Table 1, since, as argued by Tanzi (1977) and Oliver& (1967), inflation may reduce the base of other taxes -- either through encouraging the underground economy or because of collection lags.
6 To sum up, then, the data presented here shows a remarkable variety of cross-country experiences with the inflation tax. The empiricai challenge faced by the analyst is to expl&in these differences in behavior across countries and time. In the rest of this section we take up this challenge by empirically investigating the way in which political variables affect the degree of reliance on the inflation tax.

# II.2 Credibility and Inflation

A number of authors have recently investigated whether the evolution of inflation conforms to the theory of optimal taxation.7 These studies have found that for most countries the central implications of that theory are rejected by the data.8 The main exception to these findings is the U.S. (see Mankiw 1987). In Appendix I to this paper the regression results we report for 29 csveloping nations shlow that the hypothesis that inflation follows an optimal path is rejected.

Perhaps the simplest explanation of why governments do not behave according to the theory of optimal taxation is that they lack credibility. Since the work of Calvo (1978) and Kydland-Prescott (1977), it is well known that the optimal inflation tax is time-inec.nsistent in the absence of binding policy commitments. In a credible (or time consistent) equilibrium with policy discretion, the government relies too much on the inflation tax. The reason for this is that once the public has chosen its money balances it is in the government's interest to rely more heavily on inflation as a

> 7The most important implication of the theory of inflation as optimal taxation is that, to the extent that all taxes have distortionary effects, they should exhibit co-movements through time. The reason for this is that a government that minimizes welfare costs will equalize the marginal cost of different taxes at r mome Ln tL e

8A battery of tests have been used to investigate the validity of the optimal tax implications. See the brief review in Appendix I of this paper.
7 source of revenue. Moreover, in any such equilibrium, the inflation tax is a residual: any change in government spending is reflected one-for-one in higher inflation, with little or no effect on other sources of revenue (see Persson-Tabellini (1990)). Also, as Calvo (1978) and Persson-Tabellini (1990) have pointed out, policy discretion generally results in multiple equilibria. Thus, any specific equilibrium is intrinsically "fragile". This may result in sudden bursts of accelerating inflation, accompanied by devaluations and speculative attacks on fixed ecchange rate regimes.9 The recent literature on credibility has argued that reputation can be a substitute for commitments. This suggests an obvious line of attack: to try and explain differences in the observed rates of inflation in various countries as due to differences in the strength of reputational incentives in each country. Persson and Tabellini (1990) have formulated a simple model of reputation with enough institutional content to yield positive predictions. The model is built on three cc :al assumptions: (X.) unexpected policy actions disrupt the system of expectations of private economic agents (for instance, leading to higher erpected inflation and to higher nowinal wages); (il) this disruption of economic expectations has negative welfare effects on tha voters; (iii) electing a new government reduces the extent nf the disruption (i.e., stabil!zes expectations), as the economy focuses on a new set of policy proposals. This model of reputation points out that the government incentive to maintain its reputation has an important political dimension: the cost of policy surprises is that the government is less 9 These qualitative properties of models with policy discretion are remarkably consistent with the empirical evidence reported in Section II.3 on optimal taxation and with evidence on devaluations reported in Section IV below. Moreover, they are robust: for instance, they would also result (with some qualifications) from models in which even actual (and not just expected) inflation is distorting or undesirable.
8 lilkel, to be reappointed in office. The citizens realize that reappointing a government who created policy surprlnes means higher expected inflation in the future, and hence lower social welfare. Thus, they are less likely to reappoint him. If the government cares about being in office, this "punishment" creates incentives not to engage in policy surprises.

The Persson-Tabellini model of reputation yields two central pofit.ve implications, which can, In printiple, be subject to some form of empirical testing. First, the equilibrium inflation rate is higher the more the citizens disagree about which governrent they prefer to hold office. In ether words, more polarized and "heterogeneous" societies encounter greater difficulty in enforcing low inflation through reputatio%Pl forc"s. Second, the equilibrium inflation rate tends to be higher the more unlikAly it is that the government currently in office will be reappointed. In ot.er words, reputation is not very effective if the government is "weak". Intuitively, the threat of being thrown out of office becomes less powerful if society is very polarized, or if the government is already weak. In the last case, this occurs because a weak government has little to lose (since it is already likely to be thrown out of office anyway). In the former case, it occurs because if society is very polarized, citizens are unwilling to switch party and punish a government just because it created policy surprises.

A serious problem in testing the main implications of the PerssonTabellini model (and, for that matter, of most political economy models) resides on finding empirical counterparts for the key political variables, such as political instability, weakness atnd polarLzation. In this paper we have tackled this problem by using two broad data sets on political and institutional characteristics of countries, assembled by Banks and Taylor and Jodice (1983), to construct proxies for these theoretical concepts. These
9 data sets include time series information on changes in government, coup attempts (successful or unsuccessful) and political motivated riots, among others, and canv, thus, be used to both classify countries into different political categories and to construct Indexes of political instability. In Appendix II of this paper we include a detailed discussion on possible alternative ways of actually measuring political variables and we explain, at some length, the procedures that we have actually used in this paper. In Table 2 we report some preliminary evidence consistent with the two main implications of the Persson-Tabellini model on credibility and reputation. This table reports the results of estimeting a simple OLS regression of avera3e inflation against various measures of political instability and polarization, on cross-country data (see Appendix II for greater details on measurement issues,. In the first spi.Jification of Table 2, political instability is measured as the frequency of (regular and irregular) govern-aent changes during the relevant time interval. We interpret this variable as beirxg a proxy for the probability -f the governmenc being replaced. In the second specification we distinguish between the frequency of regular government changes and the frequency of coups. Since the latter form of government transfer is likely to Involve a more radical change in the ideology of the government, the frequency of coups is a measure of both instability snd polarization of the political system. The results are quite striking: the estimated coefficients are always positive and generally highly significant for most time periods.10 10The same results are obtained if we replace the actual frequency of government change with the expected probability of a government change, estimated from a probit model. ThiF alternative measure of political instability, used for the first time in Cukierman, Edwards and Tabellini (1989), i. d'4scussed later in the text and described in greater detail Appendix.
10 Naturally, the evidence reported in Table 2 could have several other explanati-ns, some of which will ba addressed in later sections of the paper. One such explanation, however, is the one summarized in the previous pages: more unstable and polarized countries have greater credibility problems, because the reputational incentives of a government are weaker.<sup>11</sup> 11.3 Long Run Seigrora2e. Tax Reforms and Political Instability Our preceding analysis centered on the behavior of inflation and government debt in developing countries through time. We now turn to the question of how to compare the Iona-run properties of these same variables across countries.

According to the theory of optimal taxation, the long-run properties of the inflaf;ion tax rate and of government debt will depend on the cost of administering tax collection. High tax collectlon costs and tax evasion force developing countries to rely on highly inefficient forms of taxation, 11In a recent paper David Romer (1989) has propcsed an alternative procedure for testing whether the absence of commitment matters in monetary policy. H.s main proposition is that in the absence of commitment, there will be an inverse relationship between Inflation and openness. The reason -- for this, Romer argues, is that engaging in surprice monetary expansions as a government will tend to do in the absence of commitment *- will generate an exchange rate depreciation. To the extent that the cost of depreciation increases with openness, more open countries will, in the absence of commitment, tend to have lower inflation. Using a sample of 57 countries (both industrialized as well as LDCs) Romer finds some empirical support for his model. Indeed when only developing nations are considered, he obtains coefficients for openness that range from -1.237 to -2.417, and are always significant. Although Romer's work constitutes an early attempt at empirically testing the credibility hypothesis, and his results are somewhat suggestive, his analysis is not free of problems. Perhaps the most important limitation of this study is the contention that expansive monetary surprises will generate a depreciation. This is only valid in the context of freely fluctuating nominal exchange rate regimes. If, on the other hand, the country in question has a predetermined nominal exchange rate system -- as most LDCs do -- surprise monetary expansions will generally tend to result in no immediate change in the nominal exchange rate and in a real exchange rate appreciation, rather than depreciation. Only eventually, once international reserves are exhausted, will monetary surprises result in a devaluation crisis.
11 such as inflation or trade related taxes. This explanation raises a natural question. Why do some countries have higher tax collection costs and higher tax evasion than others? In the traditional development literature, this question is answered by arguing that the taxing capacity of a country is technologically constrained by its stage of development and by the structure of its economy: a country with a large agricultural sector, for instance, is more susceptible to tax evasion than a country with a large corporate manufacturing industry. Cukierman, Edwards and Tabellini (1990) have explored an alternative answer to this question. Namely, that the evolution of the tax system of a country depends on the features of its political system, and not just on those of its economy.

Their central idea can be stated as follows. An inefficien **t** ax system (i.e., one that facilitates tax evasion and imposes high tax collection costs) acts as a constraint on the revenue collecting capacities of the government. This constraint may be welcomed by those who disagree with the goals pursued by the current goverNment. In particular, a government (or a legislative majority) may deliberately refrain from reforming a tax system, for fear that a more efficient tax apparatus will be used in the future to carry out spending or redistributive programs that the current government disapproves of. Of course, this is more likely to happen in countries with more unstable and polarized political systems. Hence, more unstable and polarized political systems rely on inefficien **t** axes, such as soignorage and trade taxes, to a greater extent than more stable and homogeneous countries. Cuikerman, Edwards, Tabellini (1990) (CET) confront the data by estimating an equation of the following form: y _ f(x,p)
12

- where y - fraction of total revenue collected through seignorage

- x - vector of variables measuring the available tax bases (such as size of the manufacturing, mining, and agricultural sectors, size of imports and exports, per capita income, etc. -- see Tait, Gratz and Eichengreen (1979)).

p * vector of political variables measuring the political instability and/or polarization of the country. The key empirical issue addressed by CET refers to the explanatory power of the political variables, once we control for the structural economic variables. CET use an estimated cross-country probit equation in order to compute an index of the probabillty of government change for a particular country in any given year. This probit equation, which is explained in great detail in Appendix II, regresses instances of actual government changes against political variables (riots, repressions, and so on), economic variables (consumption growth, inflation, income per capita) and institutional variables. With respect to polarization they use two alternative proxies: (i) freqtency of coup attempts; (ii) an index of income distribution. This constructed indicator of political instability differs from the index of actual frequency of government change used in Table 2, in that it provldes a measure of the expects probability of government change, derived from broad cross country evidence.

In addition to the political instabillity index, in thelr regressions on seignorage, CET included the following structural variables: (a) share of agriculture in GDP. Its sign **is** expected to be positive: since it is relatively costly to tax agriculture, governments with a large agricultural sector will tend to rely more heavily on taxes with low administering cost, such as seignorage and trade taxes; (b) share of mining and manufacturLng
13 on GDP. Its sign is expected to be negative, also for cost effective reasons; (c) foreign trade share on GDP. Its sign is expected to be positive, since in an open economy it is easier to tax international trade; (d) GDP per capita whose sign is expected to be negative. Moti advanced nations are able to implement more sophisticated and efficient tax systems, and thus will tend to rely less heavily on easy to collect but highly distortive taxes such as trade taxes; and (e) urbanization ratio, whose sign is expected to be negative. The reason is that it is relatively easier to tax the urban population than the rural population.

For a sample of 58 developing nations, CET obtained the following results from an OLS regression (standard errors in parentheses) of seignor12 age on political instability and other structural variables: Seignorage - - 0.020 + 0.0021 Share of Agriculture in GDP (0.032) (0.0005)

- 0.0431 Openness - 0.44E-5 GDP Capita (0.0182) (0.024E-5)

+ 0.0019 Urbanization + 0.1583 Political Instability Index (0.0004) (0.0539) -2 - 0.44 S.E. - 0.049 The CET results are very suggestive. Not only does the regression explain a high percentage of the cross-country variability of seigniorage, 1<sup>2</sup> A1l variables are measured as averages for 1971 - 1982. Seigniorage is the change of high powered money as a percentage of government tax revenue plus increase in high powered money. Openness is measured as Import plus export over GDP. Notice that this equation excludes the mining and manufacturing shares. Including results in an insignificant coefficient, with the expected sign, with no other changes in the regression.
14 but all variables have the expected sign. Moreover, the coefficient of the political instability index is highly significant. When a broader group of countries that includes industrialized nations was considered, the results were similar to those reported here. All in all, then, the CET results provide broad support for the hypothesis that, even after controlling for other structural variables, political variables play an important role in explaining lone-run cross-country differentials in inflation.

An interesting empirical extension of the CET (1990) model is that the use of other inefficien **t** axes, such as import tariffs and export taxes, should also be positively related to political instability. That is, just as in the case of seignorage, after controlling for other structural variables, political instability and the reliance on taxes on foreign trade should be positively related in cross-country data. This conjecture is tested in Table 3 on a cross section of industrialized and developing14 countries. The dependent variable is the ratio of trade taxes as a percentage of government revenues obtained from the IMF Govenment Financial jtaiiGajL. As in the CET seignorage paper structural and political variables are included as regressors. The political variables are the estimated political instability index described above, the observed frequency of regular (democratic) government change and the frequency of coups. In addition, we incorporated a dummy variable for industrialized nations and one for Latin American countries.

13Urbanization has a positive rather than negative coefficient. This however is consistent with the view that political polarization matters: political disagreement is generally considered by political scientists to be more acute in urban areas.

> 14 See Appendix for list of countries.
15 The results in Table 3 are mixed. First the coefficients for the structural variables, with the exception of GDP per capita in two of the regressions, have the expected sign, and some of them are highly significant. 5 Second, in both regressions where it is included, the political instability index has the expected positive sign; however, in neither was its coefficient significant. Third, when the frequency of coups is added, as a proxy for political polarization, its coefficient is positive as expected but. again, it is not significant at conventiona **l** evels. Moreover, in this last regression, the frequency of regular government transfers has the wrong sign. These less than fully satisfactory results on trade taxes contrast with the highly supportive results obtained by CET (1990) for seigniorage. A possible explanation for these differences is that, contrary to the case of seigniorage, trade taxes also play an important role in determining the productive structure of a country. Indeed, by providing protection to certain sectors these types of taxes shape the incentive structure of the economy. An additional difference between seignorage and trade taxes is that, while seignorage can be manipulated through administrative decisions, changes in trade taxes usually require congressional approval. Once these elements are incorporated into the analysis, the straightforward implication of the CET model of strategic government behavior may not be applicable to trade taxes.

The empirical evidence discussed in this section can be summarized as follows: (1) the data for a large number of developing nations rejects the optimal taxation hypothesis of seignorage. This means, then, that explanations of cross country differences in inflation and seignorage should be 15 In fact, for many of the coefficients with t-statistics below two, the probability that they had the expected sijn was fairly high.
16 sought outside of the realm of the optimal policy framework; (2) the incorporation of political and institutional variables, such as frequency of government changes, military coups and a corstructed political instability index, indicate that these variables play an important role in explaining cross country variability in inflation. More specifically, we find evidence supporting the most important empirical implications of the "credibilitybased theory" of economic policy and of the strategic political government behavior of tax reforms.

# III. Fiscal Deficit

In this section we move away from inflation, and turn our attention to fiscal deficits. More specifically, we investigate the evidence on government borrowing and we attempt to explain observed cross country differences with the help of some recent developments in the positive theory of fiscal policy.

# III.1 Government "Borrowing" From the Monetary System and Fiscal Deficits: The Eyide=c

Tables 4 and 5 contain important data on two indicators of fiscal policy for our 52 countries. Table 7A contains two measures of the size of budget deficits: the ptblic sector borrowing from the domestic monetary system, and the fiscal deficits of the central government, both as percentages of GDP. Both variables are imperfect measures of the true budget deficit, but for different reasons. The most important limitation of the first variable is that it excludes borrowing by the government from private non-bank investors and from foreign creditors. The second variable, on the other hand, in principle includes all the borrowing done by the central government, irrespective of who is the creditor. But the quality of the data Is much less reliable, and it is less directly comparable across
17 countries since the definition of what is included in the central government accounts differs greatly across countries -- see, for example, World Develovment Report 1988, p. 47, and Blejer and Chu (1988).

Table 4B displays the correlation coefficients between these two alternative measures of budget deficit, for different time periods. They are always positive and quite high at least over some time periods. On the other hand, the fact that in many cases the correlation coefficient is low highlights the measurement problems faced in this area of macroeconomics.

Most of the main conclusions obtained for the inflation tax are applicable to both indicators in Table 4A: we observe important differences across countries and across time, as well as across countries within a region. Moreover, there is a clear relation between Table 1 and Table 4A, tending to support the long maintained hypothesis that budget deficits are an important determinant of inflation. This suggestion is further strengthened by the evidence reported in Table 5. This table contains data on the proportion of the Central Bank's credit that goes to the (central) government. These data are quite striking, showing that while in some countries (mainly in Africa) the government gets as much of 80% of the credit, in others it obtains as little as 15 percent (e.g., Korea). These differences across countries are possibly capturing a number of characteristics of these countries, including the degree of development of the domestic capital market, the stage of development of the countries and their ability to borrow from the world capital market. However, the cross country differences appear to be too large to be explained by economic variables only. This indeed suggests that Institutional and political aspects play an important role in explaining these differences in behavior. Studying the role of these political and institutional variables is the main purpose of
18 the receni **t** heory that we describe, and scrutiniz **e** mpirically, in the remainder of this section.

# II.2 PoLtical Instability and Budget Deficit

We have argued in the preceding sections that political instability and disagreement between current and future political majorities can explain why countries retain inefficient tax<sup>systems</sup> without attempting to reform them. The reason for this is that political instability can lead to a form of collective myopia. This same intuitive reason has been investigated in a number of recent papers by Tabellini and Alesina (1990), Alesina and Tabellini (1989, 1990', and Persson and Svensson (1989), to explain the occurrence of budget deficits.

Consider a policymaker (or a political majority) who must choose how much to spend and tax in the current period, and what to spend on or<sup>whom to</sup> tax. When setting policy, this<sup>policymaker</sup> chooses both the intertemporal profile of spending and taxes as well as how to allocate the resources acquired by issuing debt (or the resources lost through a surplus). Suppose that this policymaker is aware that in the future he may<sup>be replaced</sup> by a policymaker (or majority) with different preferences about some aspects of fiscal policy. Moreover, he realizes that, whereas he is in control of<sup>how</sup> to allocate the proceeds of his borrowing, the allocation of the burden of repaying the debt in the future<sup>may not be under his control. This</sup> asymmetry may prevent today's policymaker from fully internalizing<sup>the costs</sup> of running a deficit, the more so the greater is the difference between his preferences and the expected preferences of the future majority. In simple terms, the policymaker may wish to borrow in excess of the<sup>optimum,</sup> and let his successors "pay the bills." Thus, political instability and polarLzation **lead** to a form of collective myopia, even if the policymaker and the
19 voters are rational and forward looking.

In a recent paper, Alesina and Tabellini (1989) have developed a variant of this model for the case of developing countries. They consider an economy wit'i two groups of agents identified by their proluctive role: "workers" (wage earners) and "capitalists" (owners of physical capital and profit earners). The two groups have their own political representatives ("parties") that alternate in office. Each party, when in office, attempts to redistribute income in favor of its constituency. With political uncertainty (i.e., with uncertainty about the identity of future governments), the government in office finds it optimal to issue debt. This occurs because the current government does not fully internalize the future costs of servicing the debt. The government that borrows (say the capitalist one) also controls how the proceeds of the debt issue are allocated: they are transferred to the capitalist constituiency. However, if there is a change of government, and the "workers" take over the government, they will have to pay this debt by reducing the transferL. to their constituency (wage earners). The most important implication of this setup is that, since borrowing costs are not internalized, the government in office overoorrows.16 The idea that political alternation among groups with different preferences and ideologies induces the government to choose strategically the time path of a state variable, has several other applications yet to be investigated (such as to the choice of capital versus current public spend16Alesina and Tabellini (1990), in a more general setting, show that this result extends to the case in which current and future governments disagree about the composition of spending (rather than the distribution of income). And Tabellini and Alesina (1990) show that the results go through even if the policies are chosen directly by the voters (rather than by the party in office), provided that current majorities are uncertain about the identity and preferences on future majorities.
20 ing, or the choice of investment in legal and social infrastructures). Moreover, the existing theoretical research on this subject has very sharp testable implications. We now ask whether the evidence is consistent with these implications.

In Tables 6A and 6B we include two _sets_ of cross-country regressions. The dependent variables are the two measures of budget deficit reported in Table 4A: (1) change in the moneta-y system's credit to the government (as a percentage of GDP); and (2) the deficit of the central government as percent of GDP. The explanatory variables, on the other hand, are: (i) indicators of the structure of the economy and (ii) alternative measures of political instability. The structural variables are the same used in the analysis of seignorage reported above, namely, per capita income, the share of agriculture in total output, the share of exports pl.us imports in total output, and the degree of urbanization (averaged over the relevant time periods). With respect to political instability, we tried, as in the results reported previously, alternative variables. Table 6A uses the actual frequency of government change (lumping together coups and regular government transfers), while Table 6B distinguishes between the frequency of coups and of regular government transfers. As pointed out previously, our view is that coups are associated with more radical changes in the nature and ideological preferences of the government, and thus they should have a stronger positive impact on the budget deficit.

We see from these tables that our measure of political instability is generally positively related to budget deficits: its estimated coefficient is almost always positive, and in some (but not all of them) it is significant. As expected, coups and regular government changes have different coefficients and, again as expected, coups generally have larger estimated
21 coefficients.

To assess the robustness of these estimates we added a set of dummy variables that grouped countries into different geographical regions: Asia, Africa and Latin America. These dummy variables were generally insignificant and the remaining coefficients were not affected. Finally, as in the regressions on trade taxes reported in Table 3 above, we also tried other measures of political instability, constructed along the lines of CET (1989). The results were very similar to those reported in Tables 6A and 6B. These results provide some suggestive preliminary evidence supporting the view that are politically more unstable tend to have larger budget deficits.

It may be argued that a possible problem with this evidence is the presence of reverse causation, and that budget deficits lead to instability, rather than vice versa. This is unlikely. Instability is a deep-rooted feature of a political system, that generally reflects institutional and sociological factors, and is generally not affected by short term economic performance of a government. Moreover, the same results reported in Tables 6A and 6B hold when we measure political instability as the frequency of government change from 1950 up to the end of each of the periods reported in Table 6A (rather than just the frequency of government change in each of those time intervals).17 Although the results reported in Tables 6A and 6B are encouraging, they are not as positive as those on inflation and on seignorage. Moreover, we are aware that they leave ample room for improvements; they ought to be regarded as preliminary and suggestive. First, as already mentioned, our 17Moreover, instrumental variables estimates in Cukierman, Edwards and Tabellini (1989) show that the results on the role of political stability on the inflation tax hold after correcting for (potential) reversed causation.
22 measures of budget deficit contain measurement error. Second, it is not unlikely that we have omitted some relevant economic variables that way influence a country decision of how much to borrow. Finally, our measures of political polarization are not fully reliable; and yet, according to tho theory, political instability matters more in m:re polarized countries. Of course, all of this indicates that the next steps in this research program should be aimed at trying to solve these problems. In spite of this, however, we think that these results, together with those on inflation and seignorage reported in the previous section, clearly show that it is possible to implement serious tests on the main implications of political economy models of macroeconomic policies. Moreover, the preliminary evidence is largely supportive of these models.

# XV. Stabllization Atteots. Deauation, and EPoLlt

Historically, cross-country differences in fiscal behavior have not only been present in long term trends, but also during macroeconomic adjustment programs, such as stabilization attempts and devaluations. A key question that has long haunted macroeconomists is what determines the degree of success of these adjustment programs. Why are some stabilizations and adjustment devaluations able to achieve thelr goals, while others fail so miserably? This question is also related to the political economy of macroeconomic policy.

It is well known that in order for a nominal devaluation to be successful -- in the sense of generating a _rmAl_ exchange adjustment and, thus, positively affecting the external sector -- it is necessary to supplement it with restrictive fiscal and credit policies. However, a number of countries that embark on an adjustment program **OM** devaluation
23 fail to implement the required restrictive tiscal corrections. In these cases instead of achieving external sector equilibrium, the country will tend to move towards more severe macroeconomic imbalance, higher inflation and a more serious balance of payments crisis.

An important element in trying to understand why some stabilization programs (including their devaluation component) succeed while others fail, is understanding the fundamental asymmetry between inflation and borrowinW, on the one hand, and other fiscal policy actions, such as reducing expenditure and increasing taxes. Printing money and issuing government debt are generally administrative decisions that can be taken in a (relatively) arbitrary fashion; raising taxes or cutting spending, on the contrary, are usually policy decisions that require a political consensus. A government who is unable for political reasons to balance the budget, may still be able to print money. This suggests that failed devaluations and stabilizations may reflect tne inability to make a collective decision to change the macroeconomic status quo (as opposed to being the result of a deliberate policy decision). In other words, a faLled devaluation may simply be due to a political deadlock that precludes the government from undertaking those fiscal policy actions required to assure its success.

i This line of thought may explain why in many developing countries inflation and government borrowing are often residual sources of government funds, and why implementing a successful stabilizations and devaluations may be so difficult. When the resolution of political conflict is difficult, inflation and government deficit may be the only way out, if no political consensus can be reached on other policy decisions. In this section we briefly discuss two possible theoretical avenues for formalizing this view

-- decentralized policymaking and bargaining and coalitions -- and we
24 provide empirical evidence that supports the hypothesis that stabilizations attempts typically fail in countries that exhibit high political instability.

A first promising approach for understanding the sources of failed stabilizations and devaluations is based on the policy consequences of decentralized gglievmakinf. A feature of several developing countries is that their fiscal policy decision process is decentralized<sup>amongst</sup> several decision units: local governments, public corporations, and different parts of the central government de facto have some spending authority. This decentralized process can lead to decisions that are mutually incompatible and against the collective interest. Inflation and deficits may be the only way to restore compatibility.

Within this setting, it is easy to show that the decentralization of the decisionmaking process results in overspending in the local public goods. Intuitively, each individual realizes that the cost of financing its good falls on the rest of the community, and that he pays only a fraction 1/N of this cost where N is the number of individuals in this country. Hence, he does not fully internalize the costs of spending in this type of good. The result is too much public spending and too little private consumption, the more so the larger is the number of "decentralized" policymakers. Intuitively, decentralizati **o** n f the fiscal policy decision process leads to excessive government spending. 1 9

> 1 8 A second useful analytical approach for understanding the outcome of stabilization programs is based on models of bargaining and coalition formation. 19A version of this simple ldea has been applied by Weingast et al. (1979) to explain the size of government in industrial societies. Aizenman (1990) explolts it to explain the excessive use of the inflation tax. Sanguinett' (1990) adds to a similar framework an optimizing and 'benevolent"
25 Models of bargalning and coalition formation provide a second natural avenue for the analysis of how political pressures influence fiscal policy in developing countries. Consider a gove,oment, or a legislature, or a cabinet who has to decide whether or not to undertake some unpopular policy action, such as introducing some spending cuts, or raising some taxes to supplement a devaluation. The groups negatively affected by this policy action have the option to use "voice", in the sense of Hirschman (1970), as a protest against the government decision. Suppose further that "voice" actions hurt the government (for instance, because they inflict losses on other groups of the population, or because they lead to a loss of economic resources for society as a whole). Then we have a bargaining situation, similar to a "war of attrition", where the bargaining power of the government and of the opposing social groups determines whether the unpopular policy is implemented, or whether it is interrupted, or whether protests occur.0 This general framework can be applied to several economic or political situations, including the determinants of the degree of success of a stabillzation program, or a nominal devaluation adjustment. It can also be used to explain why a government prolongs an unsustainable fiscal regime despite its commitment to fixed exchange rates or, even when it is clear that a fiscal adjustment is required for a devaluation to become successful. This line of federal government that decides on the profile of a federal tax. He shows that in the non-cooperative equilibri.m, the government spends more than if there is cooperation among the federal and local fiscal authorities.

20Alesina and Drazen (1990) study a model of this kind, along the lines pioneered by Bliss and Nalebuff (1986). In the Alesira-Drazen paper, the decision to stabilize requires the consent of two rival groups of citizens. The two groups are engaged in a war of attrition: the first one to give in bears a disproportionate burden of the stabilization. In equilibrium, both groups refrain from accepting the stabilization right away. As a result, the stabilization is delayed, even though such a delay is inefficient for society as a whole.
26 research is indirectly supported by several<sup>empirical findings. For example,</sup> Berg and Sachs (1988) find that debt repayment<sup>difficulties are more</sup> pronounced in countries where the political conflict<sup>is more polarized.21</sup> The above discussion suggests a number<sup>of avenues for empirically</sup> analyzing the role of political consider.ations in the outcome of devaluation episodes. Our central proposition is that<sup>governments that are politically</sup> stronger will generally find it easier to implement<sup>the fiscal adjustment</sup> required as a supplement to a successful devaluation.<sup>A first specific test</sup> is to inquire - using non-parametric methods, for example -- whether devaluations indeed tend to fail in those countries<sup>with more unstable and</sup> polarized political environment. A second test would<sup>be to investigate the</sup> timing of devaluation episodes. Since, in democratic<sup>regimes governments</sup> are usually stronger at the beginning of their administration,<sup>we would</sup> expect to find most devaluation attempts<sup>taking place in the early years of</sup> a government's tenure in office. A third potentiel<sup>test is related to the</sup> idea of decentralization and policy coordination. In general, we would expect that in those nations with more decentralized<sup>(and more polarized)</sup> political systems, it would be more difficult<sup>to implement the fiscal</sup> 21Similar casual evidence is provided by Dornbusch (1987). Both studies hence support the idea that<sup>changing the status quo and implementing</sup> unpopular policy decisions is more difficult<sup>in more polarized and divided</sup> countries. This is indeed an implication<sup>of the Alesina and Drazen (1989)</sup> theoretical model. Perhaps even more<sup>to the point, Roubini and Sachs (1988)</sup> find that different industrial countries<sup>have had very different fiscal</sup> responses to adverse economic shocks. The countries<sup>that have relied on</sup> government borrowing to a greater eAcent<sup>are typically led by unstable</sup> coalition governments. Roubini and Sachs<sup>(1988) interpret this finding as</sup> evidence that fiscal deficits and lack<sup>of fiscal discipline reflecta</sup> country's inability to change the status<sup>quo in the face of adverse economic</sup> circumstances. This inability is more<sup>pronounced in political systems</sup> fractionalized among many small parties,<sup>in which coalitions are fragile and</sup> each coalition member has a veto power<sup>but no capacity to impose its will on</sup> the political majority.
27 adjustment required by a successful devaluation. In the subsection that follows we use data on 39 devaluation episodes to implement the first two tests described here.<sup>22</sup> IV.l The Politics of Successful DevaluAtion Prozrams: Some Preliminar EmDirical Evidec The purpose of this subsection is to use a cross country data set to investigate the extent to which political considerations determine the degree of success of 39 devaluation programs.

IV.1.lTh QASJbaL_iE The data set on devaluations used in *ur empirical investigation corresponds to that assembled by Edwards (1989) in his study on real exchange rates in developing countries. The episodes are listed in Table 7, and have been classified into a group (Panel A) of countries that implemented a stepwise devaluation and a group (Panel B) that adopted a crawling peg after devaluing. As can be seen all devaluations are substantial -- of at least 15 percent.

The stated objective of these devaluations, and their accompanying packages, was to help solve the external crises in these countries by reversing the real exchange rate overvaluation -- that is, by generating a real exchange rate depreciation -- improving the current account and improving the net foreign position. Edwards analyzed the degree of econgomi success of these devaluations using a two step procedure. First, he analyzed the evolution of a set of external sector indicators -- the real exchange rate, the current account, and the net foreign asset position -- in 22We don't attempt, however, to directly test the decentralization hypothesis. 23 These are in fact the stated objectives of the IMF programs that were associated with most of these devaluations.
28 the period following the devaluations. The second step consisted of analy24 zing the behavior of a group of macroeconomic indicators..

In classifying these episodes in successful and unsuccessful Edwards concentrated on the behavior of three key indicators during the period following the devaluations: (1) Real exchange rates. The focus here was on the behavior of an effectiveness index defined as the ex-post real exchange rate elasticity of nominal devaluations; (2) behavior of net foreign assets of the monetary system; and (3) behavior of the current account ratio. Given the difficulties associated with classifying in a clear cut fashion some of these episodes as successful or unsuccessful, a three way classification was used: (1) successful episodes; (2) unsuccessful episodes; (3) devaluations with a limited degree of success. 25 24Although this approach is highly revealing it does have some problems, including the fact that other variables are not kept constant. For a discussion of the methodological limitations of this approach see Edwards (1989c).

251n order for an episode to qualify as sgccessful the following two conditions had to be met: (1) three years after the devaluation the effectiveness index had to exceed 0.3; &4 (2) three years after the devaluation either the current account or net foreign assets indicators had to exhibit an improvement relative to the year before the crisis. The first requirement implies that in order for an episode to be classified as successful no more than 70% of the devaluation impact on the teal exchange rate has to be eroded in three years. The second requirement means that a real depreciatio **n** erLse is not enough for the nominal devaluation to be considered a success; in addition, the external sector accounts had to be improved. An episode was defined as msmg.caLu2fl if three years after the devaluation the real exchange rate was below its value the year before the crisis -- that is, the effectiveness index was negative -- or If even when the effectiveness index was posltive (but still below 0.3) both the net foreign assets &Da current account positions had worsened 1 &nd 3 years after the devaluation. These definitions of success and failure are quite strict and are able to sharply discriminate between countries. A number of episodes, however, sit in between these two extreme groups. We have called them limited-success episodes, since in most of them we observe some improvement in the level of the real exchange rate and/or the external sector accounts.
29 Table 8 contains Edwards' 39 episodes classified according to this criterion. As can be seen, among the 29 stepwise devaluers, there are 13 clearcut successful cases, 9 clearcut failures and 7 limited-success cases. For the 10 crawlers there are three successful episodes, five unsuccessful ones and two cases of limited success. The 13 successful stepwise devaluers (Panel A.1 of Table 7) were able to sustain substantial real depreciations in the medium term. The average for the effectiveness Lndex after 3 years is 0.66 indicating that on average 2/3 of these nominal devaluations had been transmitted into a real devaluation. For these 13 countries as a group, 3 years after the crisis the RER stood on average 66% higher than its value immediately before the devaluations. For the 9 stepwise cases with limited success (Panel A.2 in Table 7) the average value of the effectiveness index is still an impressive 0.49. On the whole, then, this evidence strongly shows that for a large number of cases nominal devaluations have been helpful in generating real exchange rate realignments.

For the 9 unsuccessful stepwise episodes, on the other hand, the index of devaluation effectiveness had an average of -0.21 three years after the crisis, indicating that at that time the _RER_ was more then 20% ba1l its value immediately prior to the crisis. For these cases devaluations not only failed to generate a real exchange realignment, but even worse, three years after the event the magnitude of the external disequilibrium had greatly increased. In fact, for tbese countries in the three years following the devaluation the net foreign assets ratio declined on average by more than 10%.

Discriminant analy_is was used to test whether it was possible to statistically discriminate among successful and unsuccessful groups based on _the_ behavior of macroeconomic variables only. The two gro4ups of countries
30 pursued macroeconomic policies (domestic<sup>credit and fiscal policies) that</sup> were significantly different from a statistical<sup>point of view. In fact, the</sup> results obtained from the discriminant<sup>analysis were quite striking,</sup> indicating that by and large it was<sup>possible to statistically discriminate</sup> between these two groups on the basis<sup>of their Dacrgeconomic</sup> nolicies only. According to these results, three<sup>years after the devaluation only one</sup> country which was classified as successful<sup>in Table 8 did not belong to that</sup> group: Egypt 1979. The posterior probability<sup>of it belonging to the</sup> successful group was only 2%. These results,<sup>then, confirm the existence of</sup> a strong and statistically significant<sup>relation between macroeconomic (and</sup> especially fiscal) policies and<sup>successful stepwise devaluations. The</sup> question that remains to be answered<sup>is why some countries were able to</sup> indeed implement corrective fiscal<sup>policies alongside devaluations and</sup> others weren't. As argued in the<sup>preceding discussion, our answer is that</sup> this has to do with the political economy<sup>of fiscal policy. In the rest of</sup> this section we turn to the empirical<sup>analysis of this hypothesis. In doing</sup> this Edwards grouped the successful<sup>and limited success countries into a</sup> broad success group.

# IV.1.2 The Timing of Devaluatlins

An important empirical implication of<sup>the approach to stabilization</sup> discussed above is that governments<sup>will tend to implement adjustment</sup> policies -- including major devaluations<sup>--earlier in their tenure in</sup> office. The reason for this<sup>is that at this time governments in democratic</sup> regimes are usually politically<sup>stronger than later in their period. We</sup> analyzed this implication of<sup>the theory by investigating the timing of the</sup> devaluations in each country.<sup>Two indicators were constructed: (1) number</sup> of years elapsed between the<sup>last government change and the devaluation, and</sup>
31 (2) number of years between the devaluation and the next government change. Additionally countries were classified according to their political regime into three groups: presidential democracies, where the date of the election is predetermined; parliamentary democracies and dictatorial rule. Classifying some of these countries into a political regime is not completely straightforward. Two particularly difficult cases refer to Egypt under Nassar and Cyprus under Makarios, where the leaders term was extended beyond what was considered 'normal". Both cases, however, were labelled as democratic presidential regimes.

Table 9 contains summary statistics for the timing of these 39 devaluations episodes. This information is quite impressive, showing that, as was expected from the discussion, in democratic regimes devaluations indeed tend to take place during the early years of each administration; very few devaluation attempts have indeed taken place during the last few years. An additional interesting piece of information in this table is that there is no evidence that dictatorships front-load their devaluations. IV.1.3 Polical Determinants of Successfu Devaluations The most important empirical implication of our previous discussion is that countries with a weaker, more unstable and polarized political environment will generally have greater difficulties in implementing the fiscal adjustment required for a devaluation to be successful. This suggests that it should be possible to "predict" the degree of success of a devaluation through the use of political variables only. This is indeed what we do in this section through the implementation of a series of discriminant analyses on our 39 devaluation episodes. We used the Jodice and Taylor data set to define three groups of political indicators for the different devaluation episodes. The first set
32 captures the historical political environment of the countries previous to the devaluation. It measures a number of variables, such as political riots, successful coups and the like, from 1948 (the first year in the data set) to the year prior to the devaluation. The second and third sets of indicators deal with the political environment in the period immediately following the devaluation. They measure the same political indicators one year after the devaluation and for the three year period following the devaluation.

Ten variables in each of these sets of indicators for measuring the degree of political instability were actually used:

- (1) politically motivated attacks;

- (2) politically related deaths;

- (3) successful coups attempts;

- (4) politically motivated strikes;

- (5) political demonstrations and riots;

- (6) politically motivated assassinations;

- (7) frequency of government transfers, either regular or unscheduled (via coups);

- (8) an overall measure of violence defined as the frequency of protests, strikes, deaths, assassination attempts and attacks;

- (9) frequency of unsuccessful government transfers, including unsuccessful coups;

- (10) frequency of political repression computed as the number of related executions plus political sanctions imposed by the government on its opponents.

In order to correct by country size, those variables were defined in per capita terms. Table 10 contains some summary statistics for our last four indicators -- frequency of government change, violence index, unsuccessful
33 transfers and repression index. Additionally, in order to shed additional light on these data we have added the frequency of successful coups. Once these data sets were assembled we proceeded in the following way: we selected subsets of these political indicators to test whether we could discriminate between successful and unsuccessful devaluations on the basis of the political environment only. The results obtained were very encouraging, showing that in most cases by using political variables we could classify most devaluation episodes correctly. In what follows we provide a detailed discussion of 2 of these exercises DISCRIMINANT ANALYSIS 1: The purpose of this exercise was to classify the devaluation episodes into three groups: successful devaluations, limited success and unsuccessful devaluations. In this first discriminant analysis we used the following political indicators: successful coups; attacks; assassinations, deaths, strikes and riots; that is, we used variables (1) through (6) from our list. Each of them was defined for both the country's political history as well as for the 3 year period following the devaluation. As can be seen from Table 11, only 2 of the 39 devaluations episodes were misclassified: Jamaica 1967 and Kenya. According to the economic classification criterion summarized in Table 7 both of these devaluations were of limited success. However, according to the political indicators criterion they were classified as successful. The posterior probability of these episodes belonging to the successful devaluation group were 0.63 for Jamaica and 0.91 for Kenya.

Overall, these results are extremely supportive of our contention that the political environment is clearly related to the degree of success of adjustment and devaluation episodes: only 2 episodes out of 39 appear to be risclassified. However, a possible problem with these results Is that the
34 discriminant analysis incorporates too many variables (12) for purposes of classification. More specifically, it is possible to think that by incorporating the political indexes for the period of 3 years following the devaluation we are providing "too much" information. In order to investigate how the results were affected by these considerations we also undertook discriminant analyses using separately the historical political variables, on the one hand, and the post-devaluation indexes on the other. When historical variables only were used the results were still very supportive of the theory: only five of the episodes were misclassified. One of the episodes classified as successful on economic grounds (Chile) is classified as "limited success" on political grounds; another 3 economically successful (Ecuador 1979, Colombia 1967, and Egypt 1970) devaluations are misclassified as unsuccessful when the political criterion is used; finally one of the episodes classified as unsuccessful on economic grounds (Israel, 1971) is misclassified as having had limited success when the political criteria is used. All in all, however, the<sup>results arestill</sup> remarkable with only 12.8% of the episodes being misclassified.26 DISCRIMINANT ANALYSIS 2: In this exercise we used indicators on frequency of government change, overall violence, unsuccessful transfer attempts and political executions (variable (7) through (10) in our list). In the initial analysis we used these indicators for all three time periods: historical, for one year after and three years after the<sup>devaluation.</sup> When this was done, all 39 episodes were classified correctlyl In order to check for the robustness of these results, we also performed a discriminan **t** est

> 26When instead of using the hs.tgriAlc politLcal variables only, we restricted the analysis to the post (3 years) devaluation indicators, the results were similar: only 5 (different) episodes were misclassified.
35 where these four political indicators were defined for the historical period and for the three years after the devaluation. The results obtained in this case are reported in Table 12. As can be seen they are still remarkably strong, with only 6 episodes out of 39 being misclassified.

It may be argued that the classification of the 39 episodes into three groups (successful, limited success and unsuccessful) reported in Table 7 is somewhat arbitrary. In order to determine whether this three-way classification indeed affected our analysis, we reclassified the devaluation episodes into two groups: successful -- which now pulls together the previous successful and limited success groups -- and unsuccessful. The rationale behind this is that there are at least some grounds for arguing that in the so-called "limited success episodes' some of the objectives of the devaluation programs were accomplished. When our discriminant analysis No. 1 was redone for this two-way classification of the degree of success of the devaluations the results were even more favorable than before: now every episode is classified correctly. When other groups of -'ariables were used in two-way classification discriminant analyses, the results were also very satisfactory; in most cases every episode was correctly classified.

To summarize, then, the discriminant analyses reported here indicate, in a substantive way, that as the political economy approach predicts, there is a close relationship between political instability and the ability to undertake painful stabilization ad,astment.

# V. 0oncima **rks**

There are very large differences in the monetary and fiscal policies implemented by different countries or in the same country at different points in time. In this paper we have asked how can these differences be
36 explained? In the previous pages we argued that this is one of the central questions to be addressed by the theory of economic policy, and we suggested that an answer can be found by focusing on the incentive constraints faced by the policymakers. In particular, we emphasized credibility constraints and various political incentives. Our empirical findings are very supportive of this line of research. In our sample of developing countries, inflation and budget deficits are systematically related to political variables, and in particular to different measures of political instability. Moreover, our empirical analysis clearly suggests that the degree of success of stabiliza-icn and devaluation programs is closely related to the polit 4 iA. -.1 institutional framework in specific countries.

The the.:uical models reviewed and formulated in this paper offer at least three different hypotheses of how political instability and more generally political institutions influence the policy formation process. First, political instability and polarization determines the strength of reputational incentives, and hence ultimately the government credibility. Second, political instability determines the rate of time preference of sooziety as a whole, and hence matters for any collective intertemporal decision, Third, political institutions and in particular the degree of political cohesion influences a society's capacity to make decisions and to change the status quo in the face of adverse economic circumstances. As the empirical results reported in this paper indicate, some of the most important implications of models based on these three hypotheses cannot be rejected. Thus, discriminating among them, and assessing their relative importance in concrete instances 1i an important task of future research.

The results reported in this paper provide some important policy implications that can be exploited to advantage in the design of adjustment
37 and stabilization programs. More specifically, according to these results inseitutional. reforms that reduce government's ability to engage in discretionary unexpected policies will increase their credibility and, thus, will tend to reduce political instability and the equilibrium level of inflation. Our results also indicate that reforms that take away from government's hand money creation, and thus the possibility of using the inflation tax as a residual source of funds, will reduce the reliance on seignorage ard inflation. At a more general level, these results indicate that any reform that limits government's ability to behave strategically in an intertemporal sense, will increase macroeconomic stability, reduce inflation and result in lower deficits and domestic debt. In that regard a particularly important reform is the creation of an independent Central Banks that cannot be manipulated at will by the party in office. The recent (late 1989) Chilean and New Zealand experiences in this direction are, in fact, promising and are likely to be an important material for analysis in the years to come. From a more specific political angle the results reported in this paper also suggest that institutional reforms aimed at generating reduced polarization and lower (perceived) political instability will tend to result in a more stable macroeconomic environment. For example, it may be argued that an institutional setting with a reduced number of political parties (although not necessarily two) will in general, and with other things given, tend to result in lower deficits and inflation. Also policy actions tending - at reducing the degree of polarization such as, for example, reducing the extent of income inequality or the level of poverty -- are likely to end up resulting in a more stable macro environment.

Finally, and at a more practical level, these results can also be interpreted as providing empirical support for World Bank conditionality.
38 Indeed to the extent that the Bank resources are only made available on the condition of some policy actions being undertaken, governments abilities to act strategically will be reduced. It is still open, however, whether the current style of conditionality is the more appropriate or if, in the light of our results regarding the importance of political factors, alternative forms of conditionality should be sought.
39 APPENDIX I

# The Theory PE ORtIMMlTAxation: Theory and Tests

An important question is whether the observed pattern of the inflation tax can be explained as the optimal government response to a politically desired path of public spending. The modern theory of public finance lends some support to this point of view. Under the eminently plausible assumptions of tax evasion, and administrative tax collection costs it is optimal for the government to rely (at least partially) on the inflation tax (see, for example, Aizenman (1987)).27 Suppose that the government can use the inflation tax (i) and other tax rates on output (r) to finance its expenditures. Both taxes are distortionary and impose a welfare cost that is increasing on their rate. The cost of the output tax rate is f(r) while that of the inflation tax is h(ff). Then Mankiw (1987) shows that the optimal tax policy implies:

- h'(wf ) kf'(r ) (A.1)

where k is a parameter of the money demand function. Thus, at the optimum the marginal cost of each tax has to be equated in every period. This implies that as government expenditure changes, inflation and non-inflation taxes move together. Mankiw (1987) tests this implication using U.S. data for 1951-82; his results show that there has indeed been a positive relationship between inflation and the tax rate. Mankiw interprets this finding as providing support for the theory of optimal taxation as a positive theory of policy behavior.

27This result is true even if money facilitates the process of exchanige and reduces transaction costs, as in the models of Faig (1988) and Kimbrough (1987), so that money essentially acts like an intermediate input.
40 More rocently a number of authors have extended Mankiw's work both theoretically and empirically. Vittorio Grilli (1989) has pointed out that Mankiw's tests fail to exploit a number of important implications of the theory, including the fact that seignorage and income taxes should have a unit root, and that there should exist cointegration between different measures of government revenue and between revenues and expectations. His empirical results for a group of 10 European nations are mixed, suggesting that while in some countries seignorage has behaved as piedicted by optimal taxation theory, in others it has not done so. Grilli also extends Mankiw's work by allowing the possibility of a variable velocity and by explicitly incorporating the fact that fixed exchange rate agreements constraint the ability to use seignorage.

Poterba and Rotemberg (1990) make a distinction between governments that can commit to a course of action and those that cannot do so. In their model, in the commitment case inflation and taxes will be positively correlated, while in the absence of commitment inflation will 1.. a positive function of both taxes and total government liabilities as a percentage of GNP. They estimate both versions of the model, using OLS and instrumental variables, on time series data for five countries -- France, Germany, Japan, the U.K., and the U.S. -- and conclude that the evidence does not provide a generalized support to the optimal taxation view of inflation. As in previous cases this theory only seems to hold for the case of the United States. This type of work has recently been criticized on two different counts. On the one hand, Dornbusch (1989) has pointed out that while the theory is based on Max&inal tax rates, most (if not all) empirical tests have used computed avage rrtes. On the other hand, Judd (1990) points out that the welfare costs of the inflation tax should be related to expected inflation,
41 rather than to actual inflation. Thus, according to the theory of optimal taxation, tax rates and expected inflation should move in the same direction. Moreover, any innovation in government spending or the tax bases should result in unexpected changes in actual inflation. While Judd's distinction between expected and uwsexpected inflation is important, his argument that only expected inflation has welfare costs is not generally valid (for instance, it relies on the government neglecting the redistributions within the private sector that are brought about by unexpected inflation or deflation). We return to this point below.

As Grilli (1989) has pointed out, a necessary (but not sufficient) empirical implication of the optimal taxation theory is that both the inflation rate and the tax rate should have a unit root.28 In Tables A.1 and A.2 we use the augmented Dickey-Fuller (ADF) test for unit roots on these two variables for a large number of developing countries. While Table A.1 presents results obtained using annual data for kQgh inflation and tax rates, Table 5 presents ADF tests on quarterly data for the inflation tax rate only. (There are no quarterly data on tax rates.)29 As can be seen from Table A.1, in all cases, except inflation in India, the unit root hypothesis cannot be rejected. The results in Table A.3 show that, as in the case of Table A.2, for the vast majority of the countries the hypothesis that inflation follows a unit root cannot be rejected.

28That is, their time series should have the following form: xt - xt1 + ut, where ut is an error term.

29The taxation rate is computed, as In Mankiw, as the ratio of goverrnent tax revenues to GDP. The raw data were obtained from the IMF Government Financial Statistics. While Table 2 contains data for those 21 countrles with data on both f and *, Table 3 presents data on w only for a larger group of 44 nations.
42 However, a unit root is a necessary but not sufficient condition of the optimal taxation theory. Indeed, the theory says that in order to maintain the optimalty condition (1) in the presence of shocks, seignorage should be positively correlated with the rate of the income tax. To investigate this aspect of the optimal taxation theory for the LDCs we estimated a Mankiw type regression for the countries in Table A.l. The following equation was estimated on the first differences of the rate of inflation and the tax rate: AINFt a0 + 1 ATAXt + et (A.2) where INF is the yearly rate of inflation and TAX is the (implicit) yearly rate of tax on output computed, as in Table A.1 and in Mankiw (1987), as the ratio of tax revenues to GDP. If the theory of optimal taxation presented above is correct, a1 would be significantly positive. Moreover, Mankiw argues that it should be roughly one.30 The results obtained from running these regressions using both OLS and instrumental variables are reported in Table A.3.31 As can be seen, for most countries, t'h:qse results strongly reject the hypothesis that there is a positive relation between the output tax rate and the inflation tax rate. Other preliminary work not reported here for reasons of space indicates that at the core of this rejection lies a striking stylized fact: the inflation tax often behaves as a residal source of government revenue. It goes up when spending increases or when 30Mankiw's results for the U.S. were (standard deviations in parentheses). AINF _-_ -0.1 + 1.44 &TAX. When the change in the nominal (0.4) (0.49) interest rate was used instead of AINF the coefficient of ATAX was much closer to unity.

31Instrumental variables estimation was used in order to account for possible endogeneity of the TAX variable as a result of the Tanzi-Olivera effect. When cointegration tests were computed the results were Y= similar to those obtained from the regression analysis, rejecting the hypothesis that TAX and INF moved jointly through time.
43 other sources of revenue fall. There are a number of possible explanations for these results, including that the optimal taxation theory does not apply to these countries.<sup>32</sup> It has recently been argued by Judd (1990) that one possible explanation for the empirical rejection of the implications of the theory of optimal taxation is that expected inflation, and not actual inflation, imposes welfare costs. In this case, it would indeed be optimal for the government to respond to innovations to government spending and tax bases by means of unexpected inflation and deflation (i.e., to let inflation be a residual source of government revenue). Judd, in fact, has argued that when analyzing inflation, 1.U its effects on government revenues (and not only seigniorage) should be considered. More specifically, Judd points out that inflation should be primarily treated as a tax on a stock of liabilities, including (especially) the government debt.33 Judd then shows that if money demand is 32 For example, there may be serious measurement problems; alternatively we may be facing a two way causality problem stemming from the presence of a Tanzi type effect where inflation reduces the effective tax rate. However, the fact that the optimal taxation hypothesis fails for countries with very low average inflation suggests that the Tanzi effect is not very important. Also, the instrumental variables estimation was undertaken in order to eliminate this endogeneity problem. In developing more complicated versions of this model a numbe- of institutional characteristics proper of the LDCs should be considered. For example, one ought to take into account the fact that often domestic capital markets are not well developed. Hence most public borrowing has to be done abroad, using external debt. This introduces two complications that may change the nature of the optimal policy. First, developing countries generally face credit constraints in international capital markets. Secondly, to the extent that they can borrow abroad, they can only borrow in foreign currency; this means that external debt may increase exposure to exchange rate risk or terms of trade risk. Both of these complications presumably weaken the tax smoothing principle, since they raise the cost of issuing public debt. However, they do not alter the prescr:ption that the inflation rate should covary positively with other tax rates. 33Judd correctly points out that in the U.S., the monetary base is very small relative to the stock of Federal Government debt, and this concentrating on the seigniorage impact of inflation is misleading. This,
44 derived from a specific transaction cost model and depends on expected future inflation, as in Turnovsky and Brock (1980), the optimal inflation rate is white noise.<sup>34</sup> In the case of the developing nations the results reported in Tables 2 and 3 indicate that contrary to Judd's implications, for the vast majority of cases the hypothesis of unit root cannot be rejected. Moreover, Ljung-Box test for those countries for which a unit root was rejected indicate that inflation did not follow a white noise process.

To summarize, then, the results reported in this Appendix clearly indicate that the various versions of the theory of inflation as a component of a dynamic optimal tax plan, are rejected by the data. This, then, provides a sound empirical motivation for investigating alternative explanations for the observed cross country differentials in inflation illustrated on Table 1.

of course, is a valid point for the U.S. and other industrial countries. However, most of our developing nations have very l domestic government debt. Moreover, in many of them this debt is insexed.

34This contention, of course, is exactly the opposite to that of the Crilli and Poterba and Rotemberg models discussed above, where a white process for inflation means a rejection of the optimal taxation policy. This sharp difference in implications is due to the fact that Grilli and Poterba and Summers postulate that actual (rather than expected) inflation imposes welfare costs.