democracy and income (distribution) and income3.pdfdemocracy and income the questions will be: 1 why...

Democracy and Income (Distribution)

Jess Benhabib

May 1, 2013

Jess Benhabib (NYU) Democracy and Income (Distribution) May 1, 2013 1 / 46

Democracy and Income

The questions will be:

1 Why is democracy more sustainable at high levels of income but notat low levels?

2 Are growth, and democracy, driven by good institutions (propertyrights, rule of law, constraints on executive) or are they endogenous,primarily a function of wealth or income?

First: a sketch of some theory, an overview of the recent work, andthen the empirics of Democracy and Income.

(Let’s postpone the definition of Democracy to later.)

Inequality, Growth and Democracy

Let me start however, with Democracy and Inequality.

The most obvious hypothesis is that excessive and persistentinequality leads to social conflict and coups, and is incompatible withdemocracy. In the absence of redistribution that mediates andameliorates inequality, democracy cannot survive.

But this may be too simplistic: the goverment may redistribute onlyto the point which avoids revolt by the poor (left), or stop short of thelevel of redistribution that would trigger a coup by the rich (right).

Here specifics of the distribution of power, the costs of collectiveaction , the degree of repression and the potential use of force allmatter. (For example recently new social media may have reducedcollective action costs.)

So political economy is diffi cult. Empirically, what do we know fromsome classic papers?

"We are specifically interested in two questions:

I. Does income inequality increase political instability?2. Does political instability reduce investment?

According to our findings, the answer to both questions is ’yes’. First,more unequal societies are more politically unstable: in particular, ourresults suggest that political stability is enhanced by the presence of awealthy middle class. Second, political instability has an adverse effect oninvestment and, therefore, on growth. Furthermore, these two effects(from inequality to instability, and from instability to investment) are notonly statistically significant, but also economically significant."

A. Alesina and R. Perotti "Income distribution, political instability, andinvestment" EER, 1996.

"More equal societies have lower fertility rates and higher rates ofinvestment in education. Both are reflected in higher rates of growth.Also, very unequal societies tend to be politically and sociallyunstable, which is reflected in lower rates of investment and thereforegrowth. Finally, the data do not support the idea that moreequal societies, particularly those with democratic institutions,grow faster because they generate fewer demands forredistribution and therefore fewer distortions."

R. Perotti, "Growth, Income Distribution, and Democracy: What the DataSay," Journal of Economic Growth, (1996)

Here we also have hints of inequality retarding growth through creditmarket imperfections and social instability.

The point in bold: In more equal countries with democraticinstitutions, typically richer countries, there may be moreredistribution, rather than less. Redistribution is mediated by thegovernment and a welfare state. Maybe because the stakes arehigher?

"Evidence from a broad panel of countries shows little overall relationbetween income inequality and rates of growth and investment. Forgrowth, higher inequality tends to retard growth in poor countries andencourage growth in richer places."

R. Barro, "Inequality and Growth in a Panel of Countries," JOEG, (2000).

Note the differential impact of inequality between rich and poor. Canricher countries tolerate more inequality with less social disruptionand adverse effects on growth?

"Evidence from a broad panel of countries shows little overall relationbetween income inequality and rates of growth and investment. Forgrowth, higher inequality tends to retard growth in poor countries andencourage growth in richer places."

R. Barro, "Inequality and Growth in a Panel of Countries," JOEG, (2000).

Note the differential impact of inequality between rich and poor. Canricher countries tolerate more inequality with less social disruptionand adverse effects on growth?

Income, Growth and DemocracyProperty Rights?

So let’s move to explore the relationship of income, rather than incomedistribution, on growth and democracy.

A key concept, often measured and included in econometricspecifications, is the "security of property rights." The followingsketch of model, though problematic and too abstract, can set sometentative initial ideas.

What if "property rights / institutions" are endogenous, a function ofmore basic fundamentals, like wealth or income?

Income, Growth and DemocracyProperty Rights?

So let’s move to explore the relationship of income, rather than incomedistribution, on growth and democracy.

A key concept, often measured and included in econometricspecifications, is the "security of property rights." The followingsketch of model, though problematic and too abstract, can set sometentative initial ideas.

What if "property rights / institutions" are endogenous, a function ofmore basic fundamentals, like wealth or income?

Expropriation, Appropriation, Tragedy of the Commons

Expropriative redistributive activities can result from nationalizations,confiscations, required bribes to offi cials, arbitrary taxes, coups...

Appropriative redistributive activities can have legitimate, clientelistforms: subsidies, regulations, wage and price controls, taxes targetedto specific groups, an overvalued currency to favor urban vs ruralareas producing exportables (agricultural and mineral goods),restrictions on mineral and agricultural exports to be channeledthrough govenment marketing boards, govenment fertilizermonopolies, allocation of civil service jobs... (whether the governmentis elected or not.)To simplify, the absence of well-defined property rights over thelong-horizon may give rise to a dynamic "Tragedy of the Commons".(Benhabib and Radner, 1992, Benhabib and Rustichini, 1996).With various interest groups engaging of appropriation/expropriation(even with pre or post fisc equality) expected returns on productiveactivities are reduced, and growth can slow down, or get trapped.

Expropriative redistributive activities can result from nationalizations,confiscations, required bribes to offi cials, arbitrary taxes, coups...Appropriative redistributive activities can have legitimate, clientelistforms: subsidies, regulations, wage and price controls, taxes targetedto specific groups, an overvalued currency to favor urban vs ruralareas producing exportables (agricultural and mineral goods),restrictions on mineral and agricultural exports to be channeledthrough govenment marketing boards, govenment fertilizermonopolies, allocation of civil service jobs... (whether the governmentis elected or not.)

To simplify, the absence of well-defined property rights over thelong-horizon may give rise to a dynamic "Tragedy of the Commons".(Benhabib and Radner, 1992, Benhabib and Rustichini, 1996).With various interest groups engaging of appropriation/expropriation(even with pre or post fisc equality) expected returns on productiveactivities are reduced, and growth can slow down, or get trapped.

Expropriative redistributive activities can result from nationalizations,confiscations, required bribes to offi cials, arbitrary taxes, coups...Appropriative redistributive activities can have legitimate, clientelistforms: subsidies, regulations, wage and price controls, taxes targetedto specific groups, an overvalued currency to favor urban vs ruralareas producing exportables (agricultural and mineral goods),restrictions on mineral and agricultural exports to be channeledthrough govenment marketing boards, govenment fertilizermonopolies, allocation of civil service jobs... (whether the governmentis elected or not.)To simplify, the absence of well-defined property rights over thelong-horizon may give rise to a dynamic "Tragedy of the Commons".(Benhabib and Radner, 1992, Benhabib and Rustichini, 1996).

With various interest groups engaging of appropriation/expropriation(even with pre or post fisc equality) expected returns on productiveactivities are reduced, and growth can slow down, or get trapped.

Expropriative redistributive activities can result from nationalizations,confiscations, required bribes to offi cials, arbitrary taxes, coups...Appropriative redistributive activities can have legitimate, clientelistforms: subsidies, regulations, wage and price controls, taxes targetedto specific groups, an overvalued currency to favor urban vs ruralareas producing exportables (agricultural and mineral goods),restrictions on mineral and agricultural exports to be channeledthrough govenment marketing boards, govenment fertilizermonopolies, allocation of civil service jobs... (whether the governmentis elected or not.)To simplify, the absence of well-defined property rights over thelong-horizon may give rise to a dynamic "Tragedy of the Commons".(Benhabib and Radner, 1992, Benhabib and Rustichini, 1996).With various interest groups engaging of appropriation/expropriation(even with pre or post fisc equality) expected returns on productiveactivities are reduced, and growth can slow down, or get trapped.

Questions

With actors or interest groups having long term, forward-lookingobjectives, this problem can get complicated.

Does it pay for the various interest groups to adhere to institutionalconstrains and refrain from short-term expropriation in order tosustain higher growth and future well-being?

Can you sustain cooperation because the high short-term payoff ofrevolt and too high expropriation is just not worth it in the long run?

The twist we are looking for is whether cooperative actions aresustainable from income/wealth levels above a treshold, but notbelow it (for a given discount rate).

Questions

Sustainable Growth: A Model Too Abstract

Suppose groups voluntarily agree not to expropriate, or revolt becausethe one time gain is not worth trigerring a bad (high appropriation)equilibrium with low and uncertain effective returns for the longer run.

Suppose a first-best cooperative outcome with growth isself-sustaining as an equilibrium from high income levels.

But it may not be at lower income levels: The marginal utility of onetime expropriation is smaller at high levels of income, and the lossassociated with reversion to a bad equilibrium too big...

The same is not true at low wealth and income levels: marginalutilities are high and the benefits of slow accumulation are distant...

Rocking the boat is not worth it if you are rich, only if you are poor..

Second Best?

The second-best sustainable equilibrium may entail slower growth andaccumulation until a treshold wealth level is crossed, or in theextreme, we could get a poverty trap. (all for a given discount rate).

Redistributive pressures arising from inequality, or conflicts over thedistribution of income and wealth may be mediated through politicaland democratic processes, but may in certain cases lead to socialinstability, coups or repression in poorer countries.

So we may observe expropriative activities and coups more frequentlyat lower income/wealth levels.

Second Best?

In a Picture

Think of "a" as repression"

“Now the basis for the priority of liberty is roughly as follows: as theconditions of civilization improve, the marginal significance for our good offurther economic and social advantages diminishes relative to the interestsof liberty, which become stronger as the conditions for the exercise of theequal freedoms are more fully realized. Beyond some point it becomes andthen remains irrational from the standpoint of the original position toacknowledge a lesser liberty for the sake of greater material means andamenities of offi ce... First of all as the general level of well-being rises ( asindicated by the index of primary goods the less favored can expect) onlythe less urgent wants remain to be met by further advances, at leastinsofar as men’s wants are not largely created by institutions and socialforms. At the same time the obstacles to the exercise of equal libertiesdecline and a growing insistence upon the right to pursue our spiritual andcultural interests asserts itself...To be sure, it is not the case that when the priority of liberty holds, allmaterial wants are satisfied. Rather these desires are not so compelling asto make it rational for the persons in the original position to agree tosatisfy them by accepting a less than equal freedom.”

John Rawls, Theory of Justice, p. 543Jess Benhabib (NYU) Democracy and Income (Distribution) May 1, 2013 13 / 46

Digression: Homotheticity

A technical digression about homogeneity: Why should enforcability ofcooperation depend on wealth if production and preferences arehomothetic? Even if if production and preferences are homothetic, butthere is a fixed factor, you can get this result: (there may be a maximumtime endowment to be allocated between labor and leisure for example. )

Role of Institutions?

We can already signal a basic question to be addressed later:

Can good institutions (property rights, rule of law, constraints on theexecutive, etc) secure cooperation and good behavior, or areinstitutions endogenous, so that they evolve to reflect (or theirimplementation reflects) self interested computations by variousgroups?

We’ll get to this.

Some problems with the model

First, a significant source of growth is TFP, not investment.

Second, TFP growth diffuses from technology leaders and can(irresistibly) drive growth, despite the political regimes andexpropriations. Distance to the leader and educational levels maydrive technology adoption and the diffusion rate.

Parente and Prescott (1993, 2002) reintroduce politics to explainTFP diffusion across countries. They make the point that technologyadoption can be blocked or retarded by vested interests throughvarious political barriers.

Nevertheless so far the analysis, while it is dynamic and allowsforward looking agents, is too abstract and too much of a black box.

A model of sustainable democracy (Benhabib-Przeworski,ET (2006))

Now we switch from sustainability of high growth rates tosustainability of democracy.

Democracy here is the median voter setting taxes and redistributions(Note: we show the median voter thm holds in our context even withthe infinite sequence of taxes)

Agents are long-lived, and heterogeneous in initial wealth.

The upper x% and the lower y% of the wealth tail may attempt acoup if they find the redistribution excessive or insuffi cient, that istheir long-term expected utility is higher under the coup for everyonein that tail.

If the left or the right revolts there is a probabilistic outcome of a leftor right dictatorship.

Under a right dictatorship taxes and redistrubutions are zero, under aleft dictatorship rediredistribution equalizes wealth immediately (withzero taxes afterwards. An interesting tangential issue here: willinequality nevertheless re-emerge in some form? Remember Pareto.)

All else equal, everyone prefers democracy. There is a fixed cost underdictatorship (which can differ for the right and left, depending who isin power.).

RESULTS

We ask what redistributions of income and assets are feasible in ademocracy, given the initial assets and their distribution.

The question is motivated by the possibility that if redistribution isinsuffi cient for the poor or excessive for the rich, they may turnagainst democracy.

In turn, if no redistribution simultaneously satisfies the poor and thewealthy, democracy cannot be sustained.

RESULTS

RESULTS CONT’D

Hence, the corollary question concerns the conditions under whichdemocracy is sustainable. We find that democracies survive inwealthy societies.

Conditional on the initial income distribution, each country has athreshold of capital stock above which democracy survives.

This threshold is lower when the distribution of initial endowments ismore equal and when the revolutionary prowess of right or left groupsin the tails are lower.

Yet in poor unequal countries there exist no redistribution schemewhich would be accepted both by the poor and the wealthy.Hence,democracy cannot survive.

RESULTS CONT’D

As endowments increase, redistribution schemes that satisfy both thepoor and the wealthy emerge.

Moreover, as capital stock grows the wealthy tolerate more and thepoor less redistribution, so that the set of feasible redistributionsbecomes larger.

Since the median voter prefers one such scheme to the dictatorship ofeither group, democracy survives.

RESULTS CONT’D

EMPIRICS (based on Przeworski et al, 2000)

Modernization Theory

"The general income level of a nation also affects its receptivity todemocratic norms. If there is enough wealth in the country so that it doesmake too much difference whether some redistribution takes place, it iseasier to accept the idea that it does not matter greatly which side is inpower. But if loss of offi ce means serious losses for major groups, they willseek to retain offi ce by any means available."

Lipset, S.M.: Political man: the social bases of politics. Garden City:Doubleday 1960.

What is democracy?

Robert A Dahl (1971): Electoral Competition and Participation

Przeworski et al (2000):

Countries are democratic if the following all hold:1 The chief executive is elected2 The legislature is elected3 There is more than one party competing in the elections4 An alternation in power under identical electoral rules has taken place

Otherwise, countries are coded as dictatorships. This is a binary measure.

Polity IV

The Polity measure of democracy is the difference of two scores.

1 Democracy score2 Autocracy score

The Polity IV measure is based on attributes:

1 competitiveness of executive recruitment2 openness of executive recruitment3 constraints that exist on the executive4 regulation of political participation5 competitiveness of political participation

This is a continuous measure from aggegating the above, ranging from -10to 10.

Freedom House

Freedom House’s annual measure has two dimensions that produce acontinuous measure:

1 Political rights dimension2 Civil rights dimension

Raters score 10 questions, from 0 to 4, summed to produce a score from 0to 40. The 0-40 score is converted into a 1 to 7 scale.

Freedom House Cont’d

Example questions used to develop the political rights dimension:

1 Is the head of state elected in free and fair elections?2 Is there pervasive corruption?3 Is the government open, accountable, and transparent between elections?4 Is there a competitive opposition?

Example questions used to develop the civil rights dimension:

1 Are the media free and independent?2 Is there an independent judiciary?3 Is there equal treatment under the law?4 Is there equality of opportunity?5 Do citizens have the right to own property?

Vanhannen

Scores are generated from multiplying two attributes and dividing by 100:

Competition: 1−% of votes to the largest partyParticipation: % of total population voting

Note: The democracy indices are highly correlated.

Institutions and Critical Junctures in History

"We favor another explanation for this pattern. Even in the absence of asimple causal link from income to democracy, political and economicdevelopment paths are interlinked and are jointly affected by variousfactors. Societies may embark on divergent political-economicdevelopment paths, some leading to relative prosperity and democracy,others to relative poverty and dictatorship. Our hypothesis is that thepositive cross-sectional relationship and the 500-year correlationbetween changes in income and democracy are caused by the factthat countries have embarked on divergent development paths atsome critical junctures during the past 500 years."

Acemoglu, Johnson, Robinson, Yared, "Income and Democracy" (AER,2008)

Using Settler Mortality as Instrument for Institutions

"We provide support for this hypothesis by documenting that the positiveassociation between changes in income and democracy over the past 500years is largely accounted for by a range of historical variables. For thewhole world sample, the positive association is considerably weakenedwhen we control for date of independence, early constraints on theexecutive, and religion. We then turn to the sample of former Europeancolonies, where we have better proxies for factors that have influenced thedevelopment paths of nations. AJR(2001, 2002) and Engerman andSokoloff (1997) argue that differences in European colonizationstrategies have been a major determinant of the divergentdevelopment paths of colonial societies. This suggests that thecritical juncture for most societies corresponds to their experienceunder European colonization."

Acemoglu, Johnson, Robinson, Yared, "Income and Democracy" (AER,2008)

"Furthermore, AJR(2002) show that the density of indigenous populationsat the time of colonization has been a particularly important variable inshaping colonization strategies, and provide estimates of populationdensities in the year 1500 (before colonization). When we useinformation on population density, as well as on independence yearand early constraints on the executive, the 500-year relationshipbetween changes in income and democracy in the former coloniessample disappears. This is consistent with the hypothesis that thepositive cross-sectional relationship between income and democracy todayis the result of societies embarking on divergent development paths atcertain critical junctures during the past 500 years"

AJRY (2008)

Using Fixed Effects for Divergent Paths at Colonization

Do Institutions Persist?

"Following AJR, statistical studies of the impact of institutions adopt thefollowing procedure:1) Regress current incomes for a recent date (or an average of recentdates) on recent institutions and some control variables;2) Instrument recent institutions by instrumenting institutions at sometime immemorial.Yet this assumption is patently false. Here is a crosstab of institutionalquality as measured by the variable used by AJR (“constraints on the chiefexecutive”), of exit-year institutions (when countries ceased to exist orinformation is last available) by entry-year institutions (the year ofindependence or soon after) for all countries that appear in the PolityIVdata set (including those that were never colonies)."

A. Przeworski, "The Last Instance: Are Institutions the Primary CauseofEconomic Development?", Arch.europ.sociol.,(2004).

Another Hypothesis on Settlers

"The correlation between AJR’s proposed instruments and their preferredmeasures of institutions is very high indeed. For example, the logarithm ofsettler mortality is correlated at -.54 with average executive constraints,and -.51 with average expropriation risk, while the logarithm of populationdensity in 1500s is correlated at -.35 and -.40 with the same measures ofinstitutions.

Edward L. Glaeser, Rafael La Porta, Florencio Lopez-de-Silanes, andAndrei Shleifer, "Do Institutions Cause Growth?" Journal of EconomicGrowth, 2004"

Settlers and Human Capital, Income and Growth

"...Still, both settler mortality and 1500 population density are stronglycorrelated with today’s per capita income. Why might this be so?... Wehave seen that human capital is an important determinant of economicgrowth. The importance of malaria in determining current income pointsin the same direction. Could the influence of AJR’s proposed instrumentson today’s development work through human capital? Put differently,perhaps when colonizers settled, they brought with them their know-howrather than constraints on the executive."

Glaeser et al, JOEG, 2004.

Settlers, Human Capital, Growth, Income and Democracy

"Our evidence suggests in contrast that the Lipset-Przeworski-Barro viewof the world is more accurate: countries that emerge from povertyaccumulate human and physical capital under dictatorships, and then,once they become richer, are increasingly likely to improve theirinstitutions." Glaeser et al, JOEG, 2004.

Benhabib, Corvalan, Spiegel, 2011 on Fixed EffectRegressions

Our analysis confronts two primary issues:

First, more and better-measured data on both income and democracyhas become available since the publication of AJRY (2008). Thisdevelopment is crucial because the inclusion of country fixed effectsreduces inference to that based on within-country variation in thedata. However, as we show below, the initial Penn World Tables 6.1(PWT 6.1) sample has data for shorter time spans than thoseavailable in either the newer Penn World Tables 6.3 data set [Heston,et al, (2009)] (PWT 6.3), or the alternative Maddison (2003) dataset.There is reason to believe that these new panels will be moreinformative, as the (within country) coeffi cients of variation in all ofthe democracy measures considered increases when one goes from theoriginal PWT 6.1 data set to either the PWT 6.3 or Maddisonalternatives.Jess Benhabib (NYU) Democracy and Income (Distribution) May 1, 2013 39 / 46

Second, the measures of democracy used in AJRY are discrete(Przeworski et al), or censored (Freedom House, Polity (two-sided),Vanhanen (one-sided)) violating the maintained assumptions underOLS. We respond to this issue by using either a two-sided Tobitspecification or the double-censoring specification of Alan, Honoré,and Leth-Petersen (2008) and we use conditional and unconditionalLogit specifications to obtain estimates for the binary Przeworskimeasure. Additionally, for the four measures of democracy —FreedomHouse, Polity, Index of Democratization and DD —we also use theWooldridge (2005) estimator (WE). This estimator generalizes theChamberlain (1980) estimator used by AJRY (2009) andparameterizes the fixed effects as well as the initial conditions in adynamic panel.

***p<0.001, **p<0.05, *p<0.1. Country, time fixed effects suppressed.Jess Benhabib (NYU) Democracy and Income (Distribution) May 1, 2013 42 / 46

Point estimates indicate that substantial movements in income can havenotable implications for measured democracy levels. Income spurts areexceptional, but they do occur. In the balanced panel of 88 emergingmarket economies for which we have complete income data between 1960and 2000, 18 countries, or 20.5% of the panel, experienced a growth spurtwhere income doubled within a 20 year period. To interpret the impact ofsuch a growth spurt, consider that the mean coeffi cient for lagged incomein all our specifications is 0.07. As lagged democracy is 0.5, the long runeffect of income is 0.14. This effect implies that doubling income wouldresult in an increase in measured democracy of about 0.10 . Using themost recent 2008 Polity data, one could go from the democracy levelfound in Malaysia to those the one found in Belgium.

TABLE 2: Results with binary democracy/dictatorship measure ofdemocracy

Estimates for Chamberlain and Wooldridge correspond to marginal effects.*** indicates statistical significance at 1% confidence level, ** at 5%confidence level, and *** at 10% confidence level. Country and time fixedeffect estimates suppressed.

Our estimated coeffi cients indicate that the presence or absence ofdemocracy is extremely sensitive to income: a two standard deviationincrease in income would lead to 52% and 30% increases in the probabilityof democracy using the Chamberlain-adjusted probit estimator, and by55% and 32% respectively using the Wooldridge estimator. For a countrywith average income, our Wooldridge estimation point estimates indicatethat doubling income would result in a 15% increase in the probability ofbeing a democracy using the PWT 7.0 data, and an 11% increase in theprobability of being a democracy using the Maddison data.

Conclusion

Why is Democracy more sustainable at high levels of income but notat low levels?

1 Current wealth and current democracy are both the result of earlyand persistent institutions that secure property and constrain theexecutive.

2 Democracies survive in wealthy societies. The general income level ofa nation affects its receptivity to democratic norms: "Higher incomesreduce the intensity of conflict over the distribution of income, andthereby give way to democratic institutions that discourageexpropriation and support redistributive fiscal policies under the ruleof law." (Benhabib, Corvalan, Spiegel, 2011).

We think the second explanation is more likely.

Conclusion

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