Unpleasant Implications of Insecure Property for Optimal Fiscal Policy and Growth

Received wisdom maintains that LDCs ought to pursue pro-growth fiscal policy if it is incentive-feasible. We extend a standard model of growth to include imperfect, endogenously determined, property rights, and re-examine the welfare consequences of fiscal policy. Contrary to conventional wisdom, our analysis indicates that pro-growth fiscal policy might be undesirable in societies that lack the rule of law. The interaction of two externalities is highlighted: an investment externality and a ``conflict'' externality. Imperfection in property rights results in inefficiently low growth because private agents appropriate less than the full returns of their investment activities. For any given growth rate, conflict over economic distribution diverts resources from current consumption into investment in the self-provision of effective property rights. A tradeoff between current consumption and growth arises because faster growth exacerbates diversion. A combination of lump-sum and income taxes and subsidies allows a benevolent government to optimize social welfare with respect to the economy's rate of growth, taking into account both the direct welfare impact of changes in growth and the indirect effect working through the conflict externality. Under plausible circumstances, optimal fiscal policy calls for an income tax in order to lower the economy's growth rate and increase current consumption. The impact of the conflict externality can be ameliorated through an investment subsidy and through appropriate provision of productive government services