Thursday
Jan302014

Democracy vs. Inequality

President Obama’s State of the Union address promised a renewed focus on economic inequality in the last two years of his administration. But many have already despaired about the ability of American democracy to tackle increasing economic inequalities. Indeed, wage and income inequality have continued to rise over the last four decades during both periods of economic expansion and contraction. But these trends are not unique to the United States. Many OECD countries have also experienced increasing wage income inequality over the last several decades.

That these widening gaps between rich and poor should be taking place in established democracies is puzzling. The workhorse models of democracy are based on the idea that the median voter will use his democratic power to redistribute resources away from the rich towards himself. When the gap between the rich (or mean income in society) and the median voter (who is typically close to the median of the income distribution) is greater, this redistributive tendency should be greater.

Moreover, as Meltzer and Richard’s seminal paper emphasized, the more democratic is a society (meaning the wider is the voting franchise), the more redistribution there should be. This is a simple consequence of the fact that with ae wider franchise, expanded towards the bottom of the income distribution, the median voter will be poorer and thus keener on redistributing away from the rich towards herself.

These strong predictions notwithstanding, the evidence on this topic is decidedly mixed.

Our recent paper, joint with Suresh Naidu and Pascual Restrepo, “Democracy, Redistribution and Inequality” revisits these questions.

Theoretically, we point out why the relationship between democracy, redistribution and inequality may be more complex, and thus more tenuous, than the above expectations might suggest.

First, democracy may be “captured” or “constrained”. In particular, even though democracy clearly changes the distribution of de jure power in society, policy outcomes and inequality depend not just on the de jure but also the de facto distribution of power. This is a point we had previously argued in “Persistence of Power, Elites and Institutions”. Elites who see their de jure power eroded by democratization may sufficiently increase their investments in de facto power, for example by controlling local law enforcement, mobilizing non-state armed actors, lobbying, or capturing the party system. This will then enable them to continue their control of the political process. If so, we would not see much impact of democratization on redistribution and inequality. Even if not thus captured, a democracy may be constrained by either other de jure institutions such as constitutions, conservative political parties, and judiciaries, or by de facto threats of coups, capital flight, or widespread tax evasion by the elite.

Second, democracy may lead to “Inequality-Increasing Market Opportunities”.  Nondemocracy may exclude a large fraction of the population from productive occupations, for example from skilled occupations and entrepreneurship, as starkly illustrated by Apartheid South Africa or perhaps also by the former Soviet Union. To the extent that there is significant heterogeneity within this population, the freedom to take part in economic activities on a more level playing field with the previous elite may actually increase inequality within the excluded or repressed group and consequently within the entire society.

Finally, consistent with Stigler’s “Director’s Law”, democracy may transfer political power to the middle class—-rather than the poor. If so, redistribution may increase and inequality may be curtailed only if the middle class is in favor of such redistribution.

So theory may not speak as loudly as one might have first thought.

What about the facts? This is where the previous literature has been pretty contentious. Some have found inequality-reducing effects of democracy and some not.

We argue that these questions cannot be easily answered with cross-sectional (cross-national) regressions because democracies are significantly different from nondemocracies in so many dimensions.

Instead, we provide evidence from panel data regressions (with fixed effects) from a consistent post-war sample.

The facts are intriguing.

First, there is a robust and quantitatively large effect of democracy on tax revenues as a percentage of GDP (and also on total government revenues as a percentage of GDP). The long-run effect of democracy is about a 16 percent increase in tax revenues as a fraction of GDP.

Second, there is also a significant impact of democracy on secondary school enrollment and the extent of structural transformation, for example as captured by the nonagricultural share of employment or output.

Third, and in stark contrast to these results, there is a much more limited effect of democracy on inequality. Democracy just doesn’t seem to affect inequality much. Though this might reflect the poorer quality of inequality data, there is likely more to this lack of correlation between democracy and inequality. In fact, we do find heterogeneous effects of democracy on inequality consistent with the theories mentioned above, which would not have been possible if the poor quality of inequality data made it hard to find any empirical relationship.

Overall, our results suggest that democracy does represent a real shift in political power away from elites and has first-order consequences for redistribution and government policy. But the impact of democracy on inequality may be more limited than one might have expected.

Though our work does not shed light on why this is so, there are several plausible hypotheses. The limited impact of democracy on inequality might be because recent increases in inequality are “market induced” in the sense of being caused by technological change. But equally, this may be because, as in the Director’s Law, the middle classes use democracy to redistribute to themselves.

But the Director’s s Law is unlikely to explain the inability of the US political system to confront inequality, since the middle classes have largely been losers in the widening inequality trends.

Could it be that US democracy is captured? This seems unlikely when looked at from the viewpoint of our typical models of captured democracies. But perhaps there are other ways of thinking about this problem that might relate the increasingly paralyzing gridlock in US politics to capture-related ideas. 

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