Regulation and rent‐seeking: The role of the distribution of political and economic power

• Published date: 01 October 2017
• Date: 01 October 2017
• DOI: http://doi.org/10.1111/jpet.12231
• Author: Fernando Del Rio,Francisco‐Xavier Lores

Received: 12 July 2016 Accepted: 1 August 2016

DOI: 10.1111/jpet.12231

ARTICLE

Regulation and rent-seeking: The role

of the distribution of political and economic power

Fernando Del Rio1Francisco-Xavier Lores2

1Universidadede Santiago de Compostela

2Universidadede Santiago de Compostela

FernandoDel Rio, Universidade de Santiago de

Compostela,Departamento de Fundamentos da

AnáliseEconómica, Facultade de CC. Económi-

case Empresariais, Avda. Burgo das Nacións

s/n,15782, Santiago de Compostela, Spain.

(fernando.delrio@usc.es).

Francisco-XavierLores, Universidadede Santiago

deCompostela, Departamento de Fundamentos

daAnálise Económica, Facultade de CC. Económi-

case Empresariais, Avda. Burgo das Nacións

s/n,15782, Santiago de Compostela, Spain.

(franciscoxavier.lores@usc.es)

Theauthors gratefully acknowledge financial

supportfrom Xunta de Galicia research pro-

gramGPC2013-045 and the European Regional

DevelopmentFund (ERDF), as well as from the

SpanishMinistry of Economy and Competitive-

nessresearch program ECO2013-48884-C3-1-P.

It is shown that the joint distribution of economic and political power

plays a keyrole in determining regulatory and tax policies of national

and subnational governments. If both economic and political power

are evenly distributed across individuals, then regulatory and tax

policies are efficient, but if they are unevenly distributed and posi-

tively correlated, then regulatory policy is used by subnational gov-

ernments to redistribute income in favor of individuals with higher

economic and political power at the expenseof productivity and out-

put. Consequently,the national government has to raise the tax rate

tofinance public expenditure. Moreover, if there existsa positive cor-

relation between economic and political power, then the higher the

fiscal gap, the larger the gap between equilibrium and efficient poli-

cies because subnational governments underestimate more the fall

of public revenues caused by inefficient policies.

1INTRODUCTION

The role of government regulation of economy is controversial.Regulation may enhance productivity and output pro-

tecting against diversion (Acemoglu, Johnson, and Robinson, 2001; Hall & Jones, 1999) or correcting market failures

(Pigou, 1932), but it may also be used for rent-seeking (Tullock, 1967), reducing social welfare and redistributing

income among individuals. As pointed out by Hall and Jones (1999), “Regulations and laws may protect against diver-

sion, but they all too often constitute the chief vehicle of diversionin an economy.”

As pointed out by Olson (2000), we need to understand the logic of power in order to understand prosperity of

nations. Olson (2000) argues that individuals with coercive power will implement predatory policies if they havea tiny

or restricted participation in society, whereas they will implement policies fostering prosperity if they havean inclu-

sive interest. The willingness of governmentto use regulation to redistribute income among individuals might crucially

depend on the ability of different groups of individuals to influence the government—we call it political power—and to

capture the rents generated by regulation—we call it economic power.Therefore, to understand regulatory policy it is

necessary to take into account the distribution of power in society.

Some cross-country empirical evidence suggests that more regulation is related to more corruption and lower

productivity.The relationship between the index of business freedom elaborated by the Heritage Foundation and the

index of control of corruption elaborated by the WorldBank is positive (see Figure 1). The index of business freedom

Journal of Public Economic Theory.2017;19:986–1008. wileyonlinelibrary.com/journal/jpet c

2017 Wiley Periodicals,Inc. 986

DELRIO ANDLORES 987

FIGURE 1 Business freedom and control of corruption

is also positively correlated with GDP per capita (see Figure 2).1The index of business freedom is a component of a

generalindex of economic freedom elaborated by the Heritage Foundation, and its inverse can be seen as a proxy of the

extentto which business activities are regulated. The index of control of corruption is taken from the worldwide gover-

nance indicators elaborated by the World Bank (see Kaufmann, Kraay,and Mastruzzi, 2010, www.govindicators.org).

This index reflects perceptions of the extent to which public power is exercisedfor private gain, including both petty

and grand forms of corruption, as well as “capture” of the state by elites and private interests. We use a sample of

175 countries for year 2013.

Some empirical evidencealso suggests that regulatory quality and corruption are related to the distribution of polit-

icalpower in society. The relationship between the index of business freedom and two indexesof political freedom—the

indexof political rights and the index of civil liberties, both elaborated by Freedom House (www.freedomhouse.org)—is

displayed in Figure 3.2Assuming that political and economic powers are more evenly distributed in a society in which

citizens benefit from higher political freedom, then the relationships displayed in Figure 3 suggest that taking into

account the distribution of power is important to understand the regulatory policy of governments. Moreover, the

indexes of political rights and civil liberties are also significatively correlated with the index of control of corruption

(see Figure 4), which suggests a positive relationship between economic and political power.

The objective of this paper is to explore how the distribution of economic and political powers across individu-

als influences regulatory and tax policies in a context in which regulations affect productivity and they are used for

rent-seeking by individuals owning different economic and political power. To this end, a model with a continuum of

atomistic subnational governments and a national government is developed.The national government sets a common

tax rate to all subnational jurisdictions and each subnational government sets the regulatory level in its jurisdiction.

A fiscal gap exists because a local public good is financed with own tax revenues of the subnational government and

with transfers from the national government. Regulation affects productivity of all individuals and generates income

1Dataon business freedom and GDP per capita are provided by the Heritage Foundation (www.heritage.org).

2Alower value of these indexes means a better condition of political rights and civil liberties.