Can democracy help with inequality?

There is a great deal of concern at the moment about the consequences of rising levels of inequality in North America and Western Europe. Will this lead to an oligarchisation of the political system, and imperil political and social stability? Many find such dynamics puzzling given that it is happening in democratic countries. In democratic societies, there ought to be political mechanisms that can inhibit or reverse large rises in inequality, most likely through the fiscal system. Indeed, one of the most central models in political economy, due originally to Meltzer and Richard (1981), suggests that high inequality in a democracy should lead the politically powerful (in their model the voter at the median of the income distribution) to vote for higher levels of taxes and redistribution, which would partially offset rising inequality.

But before asking about what happens in a democracy, we could start with some even more fundamental questions. Is it correct factually that democracies redistribute more income than dictatorships? When a country becomes democratic, does this tend to increase redistribution and reduce inequality? The existing scholarship on these questions, though vast, is quite contradictory. Historical studies, such as Acemoglu and Robinson (2000) and Lindert (2004), tend to suggest that democratisation increases redistribution and reduces inequality. Using cross-national data, Gil et al. (2004) find no correlation between democracy as measured by the Polity score and any government spending or policy outcome. The evidence on the impact of democracy on inequality is similarly puzzling. An early survey by Sirowy and Inkeles (1990) concludes, “the existing evidence suggests that the level of political democracy as measured at one point in time tends not to be widely associated with lower levels of income inequality” (p. 151), though Rodrik (1999) finds that both the Freedom House and Polity III measures of democracy were positively correlated with average real wages in manufacturing and the share of wages in national income (in specifications that also control for productivity, GDP per capita, and a price index).

In a recent working paper (Acemoglu et al. 2013), we revisit these questions both theoretically and empirically.

Theoretical nuances

Theoretically, we point out why the relationship between democracy, redistribution, and inequality may be more complex than the discussion above 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. Acemoglu and Robinson (2008) argue that, under certain circumstances, elites who see their de jure power eroded by democratisation may sufficiently increase their investments in de facto power (e.g. via control of local law enforcement, mobilisation of non-state armed actors, lobbying, and other means of capturing the party system) in order to continue to control the political process. If so, we would not see much impact of democratisation on redistribution and inequality. Similarly, democracy may be constrained by 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.

Democratisation can also result in ‘inequality-increasing market opportunities’. Nondemocracy may exclude a large fraction of the population from productive occupations (e.g. skilled occupations) and entrepreneurship (including lucrative contracts), as in Apartheid South Africa or 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 the entire society.

Finally, consistent with Stigler’s ‘Director’s Law’ (1970), 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 favour of such redistribution.
But what are the basic robust facts, and do they support any of these mechanisms?

Empirical evidence

Cross-sectional (cross-national) regressions, or regressions that do not control for country fixed effects, will be heavily confounded with other factors likely to be simultaneously correlated with democracy and inequality. In our work we therefore focus on a consistent panel of countries, and investigate whether countries that become democratic redistribute more and reduce inequality relative to others. We also focus on a consistent definition of democratisation based on Freedom House and Polity indices, building on the work by Papaioannou and Siourounis (2008).

One of the problems of these indices is the significant measurement error, which creates spurious movements in democracy. To minimise the influence of such measurement error, we create a dichotomous measure of democracy using information from both the Freedom House and Polity data sets, as well as other codings of democracies, to resolve ambiguous cases. This leads to a binary measure of democracy for 184 countries annually from 1960 (or post-1960 year of independence) to 2010. We also pay special attention to modeling the dynamics of our outcomes of interest – taxes as a percentage of GDP, and various measures of structural change and inequality.

Our empirical investigation uncovers a number of interesting patterns. First, we find 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 in our preferred specification is about a 16% increase in tax revenues as a fraction of GDP. This pattern is robust to various different econometric techniques and to the inclusion of other potential determinants of taxes, such as unrest, war, and education.

Second, we find an effect of democracy on secondary school enrolment and the extent of structural transformation (e.g. an impact on the nonagricultural shares of employment and output).

Third, however, we find a much more limited effect of democracy on inequality. Even though some measures and some specifications indicate that inequality declines after democratisation, there is no robust pattern in the data (certainly nothing comparable to the results on taxes and government revenue). This may reflect the poorer quality of inequality data. But we also suspect it may be related to the more complex, nuanced theoretical relationships between democracy and inequality pointed out above.

Fourth, we investigate whether there are heterogeneous effects of democracy on taxes and inequality consistent with these more nuanced theoretical relationships. The evidence here points to an inequality-increasing impact of democracy in societies with a high degree of land inequality, which we interpret as evidence of (partial) capture of democratic decision-making by landed elites. We also find that inequality increases following a democratisation in relatively nonagricultural societies, and also when the extent of disequalising economic activities is greater in the global economy as measured by US top income shares (though this effect is less robust). These correlations are consistent with the inequality-inducing effects of access to market opportunities created by democracy. We also find that democracy tends to increase inequality and taxation when the middle class are relatively richer compared to the rich and poor. These correlations are consistent with Director’s Law, which suggests that democracy allows the middle class to redistribute from both the rich and the poor to itself.

Conclusions

These results do suggest that some of our basic intuitions about democracy are right – democracy does represent a real shift in political power away from elites that 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.

This might be because recent increases in inequality are ‘market-induced’ in the sense of being caused by technological change. But at the same time, our work also suggests reasons why democracy may not counteract inequality. Most importantly, this may be because, as in the Director’s Law, the middle classes use democracy to redistribute to themselves. Nevertheless, since the increase in inequality in the US has been associated with a significant surge in the share of income accruing to the very rich, compared to both the middle class and the poor, Director’s Law-type mechanisms seem unlikely to be able to explain why policy has not changed to counteract this. Clearly other political mechanisms must be at work, the nature of which requires a great deal of research.

References

Acemoglu, Daron and James A Robinson (2000), “Why Did the West Extend the Franchise?”, Quarterly Journal of Economics, 115: 1167–1199.

Acemoglu, Daron and James A Robinson (2008), “Persistence of Power, Elites and Institutions”, The American Economic Review, 98: 267–291.

Daron Acemoglu, Suresh Naidu, Pascual Restrepo, and James A Robinson (2013), “Democracy, Redistribution and Inequality”, NBER Working Paper 19746.

Gil, Ricard, Casey B Mulligan, and Xavier Sala-i-Martin (2004), “Do Democracies have different Public Policies than Nondemocracies?”, Journal of Economic Perspectives, 18: 51–74.

Lindert, Peter H (2004), Growing Public: Social Spending and Economic Growth since the Eighteenth Century, New York: Cambridge University Press.

Meltzer, Allan M and Scott F Richard (1981), “A Rational Theory of the Size of Government”, Journal of Political Economy, 89: 914–927.

Papaioannou, Elias and Gregorios Siourounis (2008), “Democratisation and Growth”, Economic Journal, 118(532): 1520–1551.

Rodrik, Dani (1999), “Democracies Pay Higher Wages”, Quarterly Journal of Economics, 114: 707–738.

Sirowy, Larry and Alex Inkeles (1990), “The Effects of Democracy on Economic Growth and Inequality: A Review”, Studies in Comparative International Development, 25: 126–157.

Stigler, George J (1970), “Director’s Law of public income redistribution”, Journal of Law and Economics, 13: 1–10.