Redistributive promises, transfers to special interests, and the political economy of reform with limited state capacity

Abstract

An enduring question in political economy is why ‘potentially Pareto-improving’ economic reforms are often so politically difficult to adopt. One explanation might be that reform typically entails the creation of losers as well as winners. Hence, redistributive compensation from winners to losers is key, even when the limited state capacity of the government constrains its ability to implement tax-and-transfer policies. This paper examines, more specifically, how the presence of special interest groups on the one hand, and limited taxation capacity on the part of the state on the other, might affect the implementation of redistributive policies, and hence political support for reform. Voters recognize that the government, in compensating losers, has an incentive to misuse this redistributive mechanism to disproportionately steer compensation towards its supporters, or to other special interest groups. Hence, efficiency-enhancing reforms might not win popular support, especially in countries with low state capacity, where the need for reforms is often likely to be the most.