Freedom through taxation: the effect of fiscal capacity on the rule of law

Abstract

This paper explores the effects of fiscal capacity on the rule of law. We view the question as a natural outgrowth of the stationary bandit model, that rulers are incentivized to make investments in public goods when they are able to extract wealth effectively. We test the relationship using fiscal capacity and rule of law data from the Varieties of Democracy dataset. We leverage the lengthy time-series found in the dataset by employing the dynamic common correlated effects (DCCE) estimator to supplement standard panel methods. Unlike the widely used fixed effects method, DCCE method adjusts for the presence of econometric issues including cross-sectional dependence, heterogeneous slopes, and unobservable common factors that plague the error-structure in panel data. We observe small, positive effects of fiscal capacity on the rule of law, but robustness checks lead us to conclude that our findings, overall, only weakly support the hypothesis.