Resource-rich countries have weaker governance (Figure 1). This widely documented finding has led to the suggestion that people in these countries might be better off if the government transferred oil revenues directly to the citizens (see here, here, and here). But this raises the question: Why would the elites in government, who clearly benefit from these resource rents, give them away as cash transfers to the people?
Figure 1. Resource-rich countries have weaker governance
In recently published research, Quy-Toan Do and I provide a partial answer to this question. We begin by noting that in addition to poor governance, resource-rich countries also have lower tax levels (Figure 2).
Figure 2. Resource-rich countries have lower levels of taxation
By definition, resource-rich countries do not need to depend on fiscal revenue because they have resource revenue. But this may also be the reason for poor governance in these countries. Taxes have long been a way for citizens to hold governments accountable for public spending. In resource-rich countries, where oil revenues (for example) go directly from the oil company to the government without going through the hands of the citizens, government officials have more control over the spending of money, including to their family and friends.
We formalize this intuition in a game theoretic model in which the choice of good governance is costly: government can choose to be accountable (in which public projects succeed, but earn few bribes) or corrupt (in which projects are less successful but the government gets “Special” benefits greater than projects). In addition to resource revenue, the government can earn fiscal revenue by taxing citizens. Citizens can choose to pay taxes (if they think the government will be responsible) or not (if they think the government will be corrupt). Therefore, good governance is a necessary condition for citizens to comply with their tax obligations.
Using this simple framework, we derive four possible scenarios, each of which is a unique equilibrium, depending on certain parameters.
- Resource Curse: Resource revenues are so huge that the government does not need tax revenues to finance public projects. In this case, the government chooses to be corrupt and build public projects of poor quality but with special advantages. Knowing this, citizens refuse to pay taxes. The result is an equilibrium with low taxes and weak governance – unlike many of the resource-rich countries in the bottom two figures above.
- credibility trap: Either because revenues decrease from falling prices or declining reserves or because expenditures increase due to a growing and aging population, the government can no longer rely exclusively on resource revenues to fund public projects. He needs to raise taxes. But citizens will only pay taxes if they are confident that the government will not embezzle the money. Given its reputation for corruption, the government cannot be reliably held accountable. Once citizens pay taxes, the government, having promised to be accountable, has an incentive to steal the money. So taxes remain low and governance weak, although everyone would be better off with high taxes and accountable government.
- Cash transfers: Falling into the credibility trap, the government diverts some of the resource revenues as cash transfers to citizens. Now the government’s incentives have changed. If it was corrupt, citizens would withhold future tax payments, and the government would forgo both tax revenue and cash transfers. This makes the cost to the government due to corruption very high, and it is decided that they will be responsible. Recognizing this, citizens pay their taxes, and the economy achieves a high tax/strong governance mix. This is a situation where a corrupt government finds it in its interest to offer cash transfers to citizens as a way of increasing the costs of corruption upon itself. This signal has the effect of urging the citizens to pay their taxes.
- The poverty trap: If the government, while in a credibility trap, does not transfer money to citizens, it will remain in the trap, with less productive projects. The result may be that resource revenues continue to decline (due to unproductive investments) and the economy reaches a point where, even if the government wanted it, there are not enough revenues to transfer to citizens to build credibility. In this case, the economy is destined to remain in a poverty trap.
Transferring resource revenue back to citizens has always made good economic sense, but it was not clear if it made political sense. When governments need tax revenue and can’t reliably hold accountable (especially given their track record when resource revenues were plentiful), cash transfers can provide incentives for government not to be corrupt—and citizens with a signal that government will now be accountable. With lower fossil fuel prices due to carbon taxes, and higher government spending needs from population growth or the desire to build a new capital city (to take an example), a credibility trap scenario is likely to become common among resource-rich countries. Cash transfers are an economically and politically viable way to escape the trap.