Journal of Public Economics 53 (1994) 187-204.

North-Holland

Proprietary public finance and economic

welfare
Herschel I. Grossman
Department of Economics, Brown University, Providence, RI 02912, USA

Suk Jae Noh

Department of Economics, Hallym University, I Okchon-Dong, Chunchon, Kangwon-Do 200-702,
Korea

Received December 1991, final version received November 1992

We develop a positive theory of public finance in which the objective of tax and spending policy
is to extract rents for the incumbent ruler. The analysis shows how dependence of the incumbent
ruler’s survival probability on his tax and spending policy can lower the equilibrium tax rate
and increase the equilibrium amount of spending on productive public services, but only until
the minimum credible tax rate, which depends on the ruler’s endogenous survival probability,
becomes a binding constraint. The central result of the analysis is that, if a relatively benevolent
tax and spending policy is both necessary and suficient for a high survival probability, then the
ruler’s equilibrium policy is relatively benevolent.

1. Introduction

In First Samuel 84-22, the people request that Samuel ‘make us a king . . .
[who] may judge us, and go out before us, and fight our battles’, but Samuel
warns them that a king will impose all manner of heavy taxes for his own
benefit and cause them to ‘cry out in that day because of your king whom ye
shall have chosen you’. The theory of proprietary public finance begins with
the observation that in order for government to serve its essential social
functions, which include the definition and enforcement of property rights
and the provision of other public services, the citizenry must subject itself to
the ruler’s sovereign power to act as the highest legal authority and to the
associated sovereign powers to tax and to spend. The resulting dilemma of
government, recognized as we see even in biblical times, is that, with these
essential sovereign powers in hand, the ruler is free to choose a tax and

Correspondence to: Professor Herschel I. Grossman, Department of Economics, Brown

University, Providence, RI 02912, USA.

0047-2727/94/$07.00 0 1994-Elsevier Science B.V. All rights reserved

SSDI 0047-2727(93)01351-V
188 H.I. Grossman and S.J. Noh, Proprietary public finance and economic welfare

spending policy that furthers his own self interest rather than one that
promotes the welfare of the citizenry.
Taking this dilemma as given, the theory of proprietary public finance
models the governmental enterprise - that is, the exercise of sovereign power
- analogously to a private enterprise in standard economic theory.’ As the
analog to the profit-maximization objective of the proprietor of a private
enterprise, the theory of the proprietary public finance assumes that the
objective of the proprietor of governmental enterprise, whom we denote as
the ‘ruler’, is to maximize political rents.’ We suggest that it is useful to take
this objective to be a generic property of rulers and to model differences in
policy choices as resulting from differences in the constraints that the actions
or potential actions of outsiders - that is, subjects who are not members of
the incumbent ruling class or political establishment, groups of such subjects
(interest groups), or even foreigners - impose on the ruler’s use of sovereign
power to extract political rents. To be specific, we conjecture that political
leaders such as Marcos and Mobutu, had they been presidents of the United
States rather than of the Philippines and Zaire, would have pursued policies
similar to (say) Presidents Johnson and Nixon, and vice versa.3 The objective
of the theory is to derive the equilibrium configuration of taxation and

‘In contrast to this modelling strategy, existing positive theories of economic policy typically
assume that politicians and political organizations seek power either for its own sake or for the
purpose of instituting policies that further the economic or ‘ideological’ goals for their given
constituencies. Alesina (1988) and Tollison (1989) Drovide brief summaries and references to
relevant literature in both economics and political science. Recent exceptions that endorse the
approach taken in the present paper include Bardhan (1990) and Findlay (1990). Bardhan argues
that ‘both traditional Marxist and neoclassical theories of political economy often err in taking
the state merely as an arena of group competition, rather than [developing models in which] the
state elite is an autonomous actor’. Findlay develops ‘a theory of the autonomous state’, which
he contrasts with the usual view of the ‘state as passive’. Footnote 7 below compares Findlay’s
model with the model in the present paper.
‘The ruler is an abstract representation of the group that comprises the existing ruling class
or political establishment. Historical examples of such groups include a monarchy and its court,
the professional politicians, the bureaucrats, the members of the ruling party, the military, or the
clients of any of these groups. In a stable democracy like the United States, the existing political
establishment can be an implicit coalition that draws in political factions regardless of party
labels. As the Wall Street Journal (24 October 1990) has observed, ‘Republicans and Democrats
have forged a political class to divvy up the spoils, fighting only over precisely how to pick
pockets.’ The present analysis takes the existence of the incumbent political establishment and its
actual or potential rivals as given. We are not concerned here with analyzing the processes by
which political groups and coalitions are formed and by which their coherence is maintained.
We also do not analyze the choice of the size of the political establishment, a choice that would
involve the possibility of enhancing political support by sharing political rents more widely.
Furthermore, the present analysis abstracts from the agency problems stressed by North (1981)
and by Bardhan (1990). We implicitly assume that the process by which the ruler appoints and
removes individual policymakers ensures that policy choices reflect the ruler’s objectives.
jOf course, one can accept that the theory of proprietary public finance is useful for studying
particular cases without agreeing that it is relevant for all cases. For example, Findlay (1990)
suggests that the objective of maximization of political rents applies to LDCs but not to
advanced industrial countries.
 H.I. Grossman and S.J. Noh, Proprietary publicjnance and economic welfare 189

spending that results from the maximization of political rents subject to the
constraints that rulers face.
A welfare-maximizing policy in a simple production economy would
require an expansion of the provision of productive public services until the
marginal product of public services equals unity and would imply a tax rate
just high enough to generate sufficient revenue to pay for this amount of
public services. In contrast, the self-interested ruler, in order to maximize
political rents, generally sets a higher tax rate, collects more revenue, and
also spends less on productive public services. For example, if the ruler were
constrained only by the disincentive effects of high expected tax rates, the
maximization of political rents would imply a tax rate at the peak of the
Laffer curve with only a fraction of tax revenues spent on productive public
services, although, as shown below, the political-rent-maximizing policy also
implies that the marginal product of public services equals unity.
In many economies, however, tax and spending policies seem to be, if not
welfare maximizing, at least more benevolent than this simple Laffer-curve
analysis would suggest. To account for this observation, and, more generally,
to develop a framework for explaining differences across economies in the
relative benevolence of tax and spending policies, the analysis emphasizes an
additional constraint that relates the ruler’s probability of surviving in power
to his tax and spending policy. Our modelling of this constraint views the
political process and survival probability generically without distinguishing
between peaceful elections and the possibility of revolution or conquest
involving the extralegal use of force. The analysis shows how, if the ruler’s
likelihood of being able to collect political rents in the future depends on his
current tax and spending policy, then the equilibrium tax rate can be lower
than at the peak of the Laffer curve and correspondingly more can be spent
in equilibrium on productive public services.4
But, the analysis also shows that dependence of survival probability on
current tax and spending policy is not a sufficient condition for a relatively
benevolent policy. The problem is that for the sovereign power to act
without being answerable to higher legal authority, although required for
government to serve its essential social functions, precludes the ruler from
irrevocably committing future policy choices. Without irrevocable commit-

*This analysis would extend in a more general framework to the more basic policy choice
emphasized by North (1981) between a structure of property rights that facilitates the extraction
of political rents and a structure that enhances the welfare of citizenry. The present model
implicitly takes as given the stucture of property rights and exchange and other determinants of
the economy’s production possibilities, except for the provision of productive public services.
Moreover, the analysis does not consider the possible use of either punitive measures, as in
Roemer (1985), or defensive measures, as in Grossman (1991), to increase the ruler’s survival
probability by suppressing dissent. The analysis also takes the fiscal jurisdiction as given - see
Friedman (1977) for a relevant analysis - and abstracts from the threat of secession, a possibility
analyzed by Buchanan and Faith (1987).
190 H.I. Grossman and S.J. Noh, Proprietary publicfinance und economic welfare

ments, an expectation about future policy can be rational, and an announce-

ment about future policy can be credible, only if this expectation or
announcement is time consistent -~ that is, only if the ruler will not be able to
do better in the future than to validate this expectation or announcement. In
particular, the credibility requirement restricts the equilibrium tax rate to be
sufficiently high that the ruler will resist the temptation to set the actual tax
rate higher than this expected rate. The essential tension in the theory is that
the ruler’s concern about his survival probability can lower the equilibrium
tax rate and can raise the equilibrium amount of spending on productive
public services, but only until the credibility requirement becomes a binding
constraint.5
Assuming a linkage between current policy choices and expectations about
future policy the minimum credible tax rate is lower the more that the
incumbent ruler values prospective future political rents - that is, the higher
his time-discount factor. But, the value of prospective future political rents
itself depends on the incumbent ruler’s survival probability, which in this
model depends in turn, as already indicated, on his current tax and spending
policy. By solving this system of interdependencies, we derive the ruler’s
equilibrium survival probability and, hence, his time-discount factor, the
minimum credible tax rate, as well as the equilibrium tax and spending
policy all as endogenous variables the values of which are functions of the
structural parameters of the production technology and the structural
parameters of the political process that govern the ruler’s survival
probability.

2. Welfare maximization

Consider a simple production economy in which between any dates t and

t+ 1 the representative producer divides his time between a non-negative

5Political theory sometimes argues that the constitutional device of an independent judiciary,
and more generally the constitutional devices of checks and balances and separation of powers,
can limit possible abuses of sovereign power and also can mitigate time-consistency problems.
Some contributors to the ‘public choice’ literature - for example, Brennan and Buchanan (1980)
- have extended the idea of constitutional safeguards to the prescription of constitutional limits
on taxation and spending. This literature. however, does not provide an analysis of the viability
of constitutional rules. To quote Brennan and Buchanan, ‘our whole construction is based on
the belief, or faith, that constitutions can work, and that tax rules imposed within a constitution
will prevail’ (p. 10). Similarly, Rogoff (1985) suggests that the ruler could solve the time-
consistency problem by delegating power to an agent whose own preferences are such that the
agent opportunistically chooses the same policies that the ruler would choose if the ruler could
make binding policy commitments. But, Rogoff does not explain how the ruler commits himself
not to revoke the authority of the agent. The present analysis, in contrast, focuses on the
behavioral factors that underly the political-economic equilibrium. It abstracts from the
institutional question of whether or not this equilibrium is embodied in formal constitution.
 H.I. Grossman and S.J. Noh, Proprietary puhlicjinance and economic wevare 191

fraction P, devoted to the production of a marketable good and a non-

negative fraction 1 --tt devoted to production of a non-marketable good,
which could be leisure. For present purposes, the operational distinction
between marketable output and non-marketable output is that only market-
able output can feasibly be taxed. Production of the marketable good
requires combining the time of the producer with a fixed factor (e.g. land)
that he owns and with a productive public service.
Allowing for a productive public service recognizes the social function of
government and provides an explicit rationale for why the producers
willingly subject themselves to the ru!er’s sovereign powers to tax and to
spend. For simplicity, the analysis treats productive expenditures and
political rents as distinct, although in practice particular budgeted expendi-
tures typically have both productive components and rent components,
which outsiders probably are unable to distinguish. With the amount of
marketable output, which provides the tax base, depending on the provision
of an essential public service, the ruler’s objective of maximizing political
rents requires the spending of some fraction of tax revenues on this public
service. At date t, the ruler provides this public service to the representative
producer in amount gt, g, 20.
Output of the marketable good is a concave function of the variable
factors !, and g, and arrives in quantity y,+i at date t + 1. Output of the
non-marketable good is a linear function of 1-P, and arrives in quantity z[ + 1
at date t+ 1. The assumed technologies, summarized by the parameters a and
/I and scaled to simplify the subsequent algebra, are

Ir
Y,+,=e;
0 5 ,
B
cc>O,~>O,a+p< 1

zr+1 =a(1 -a,(1 -P,).

According to eq. (l), producers’ time and public services have positive and
diminishing marginal products and are complementary inputs, both of which
are essential for production of the marketable good. Also, returns to scale in
the variable factors are diminishing. The analysis assumes that neither form
of output is storable. [In the limit as /I approaches zero, public services
become unimportant and the results derived below approach the results
derived in Grossman and Noh (1990).]
The temporal interval between inputs of producers’ time and public
services and output of the marketable good is a consequence of the
production technology. For example, the calendar time between date t and
192 H.1. Grossman and S.J. Noh, Proprietary publicjinance and economic werfare

date t + 1 could represent an agricultural growing season. Given that, for

whatever reason, the production interval is finite, the allocation of producers’
time to marketable output involves an irreversible investment. This irreversi-
bility forces producers to form expectations about future tax rates and
creates the problem of the time consistency of tax policy.
At date t + 1, the ruler imposes a tax on marketable output at rate x,+ r,
05x *+1 5 1. The utility that the representative producer receives, denoted by
U t+17 is a linear function of his non-marketable output at date t + 1 and of
his marketable output at date t + 1 net of taxes - specifically,

At date t, the representative producer observes g, and forms an expectation,

denoted by x:, r, of the tax rate at date t + 1. Using this expectation, the
representative producer calculates that his expected utility, denoted by u;+ r,
is

u:+1=zt+l+(l-x:+l)Y,+1. (3)

The simplifying assumption that the utility function is linear enables us to

limit attention to the expectation of the tax rate and to avoid having to
specify other properties of its distribution.
Because the analysis abstracts from storage, the representative producer’s
problem at date t is simply to choose d, to maximize uL+r. Given x:+r, g,,
and the production possibilities specified by eqs. (1) and (2), the solution to
this problem is

(4)

According to eq. (4), C, is positive if and only if the expected tax rate is less
than unity and the amount of public services is positive. Moreover, rl is
larger the lower is x:+ 1 and the larger is g,.6
Substituting eqs. (l), (2) and (4) into eq. (3) we obtain

u:+1= (1-B)Ca+(l-aV,)l. (5)

Eq. (5) implies that the representative producer’s expected utility is positively

6Eq. (4) is relevant for any set of values of xf,, and g, such that the RHS does not exceed
unity. The equilibrium values of x:+, and g,, derived below, form such a set. In an extended
model, the dependence of !, on x:, 1 and .g, also could involve the relocation of taxable activity
outside the jurisdiction of this ruler, a possibility analyzed in the literature stemming from the
work of Tiebout (1956) and also emphasized by Friedman (1977) and by North (1981).
related to his choice of e, and, hence, depends negatively on the expected tax
rate and positively on the amount of productive public services.
Because public services are provided at date t, but tax revenues are
received at date t+ 1, assume that the provision of g, is financed with
tax-anticipation notes that mature at date t+ 1. Also, assume, for simplicity
that these notes are fully collateralized, so that debt repudiation is not a
concern, and that the interest rate is zero. Given that the cost of a unit of
public services is a unit of marketable output, for tax revenue to be sufficient
to pay for g,, x,+ 1 must satisfy the fiscal budget constraint x,+ ry,, r zg,.
A welfare-maximizing policy in this model would solve the standard
problem in normative public finance of choosing an optimal amount of
public expenditure that has to be financed by distortionary taxation. Given
the preferences and behavior of the representative producer, this problem
reduces to the problem of choosing g, and xF+1 to maximize uf+ 1, subject to
the fiscal budget constraint and to x;+ 1 =x,+~. The time-invariant solution
for this problem, denoted by g and 2, equates the marginal product of public
services to unity, thereby maximizing the net contribution of public services
to marketable output, and satisfies the fiscal budget constraint as an equality,
which implies that political rents are zero. Specifically, g and R satisfy

e=(g/py-’ = 1, or, equivalently, g = By, (6)

and

xy=g. (7)

Combining eqs. (4) and (6), we see that if the marginal product of public
services equals unity, then & is related to x according to

(1 -PM1 -a-B)
[P

( >
I-x
1-B
(8)

and that g is related to x according to

1 a/Cl -e-P)

0
_x

g=8
1-B
This inverse relation between g and x obtains because a higher value of x implies
a smaller value of 8 and, hence, a lower marginal product of public services.
Eqs. (6) and (7) also imply that the optimal tax rate, 2, equals the elasticity
of output with respect to public services, /?. Thus, from eqs. (8) and (5) we see
that with a welfare-maximizing policy of x equal to /?, e would equal unity
and the implied maximized value of u:+ r, denoted by ii, would equal 1 --/I?.
194 publicfinance and economic weljare

[These values result from the assumed functional forms of eqs. (l)-(3), but
they are not critical for the qualitative conclusions derived below.]

3. Political-rent maximization and probabilistic survival

The ruler’s assumed objective is not to maximize the representative

producer’s expected utility, u:+ 1. Rather, the ruler wants to maximize the
sum of current and expected future political rents.’ In any period t + 1,
political rents, denoted by rl+ r, are equal to current tax revenues, x,, ty,, r,
minus g,.
Because y, + 1 is a fixed function of L’,and g,, and C, is a fixed function of
x:+1, the ruler knows exactly how r,, 1 depends on XT+r, x,+ t, and g,. The
relevant future, however, extends to an horizon, denoted by date t + h, h 10,
that is a random variable corresponding to the prospective longevity of the
ruler’s survival in power. Thus, at any date t, the sum of current and
expected future political rents, denoted by R,, is given by

f+h

R,=r,+E, 1 r,=r,+E,R1+,, (10)

r=f+l

where E, is an operator that denotes an expectation taken over possible

realizations of h conditional on information available at date t.8
To evaluate the expectaion in eq. (lo), assume that the probability that the
incumbent ruler being in power at date t will not survive to date t + 1 is
l-&+1, where 05~ f + 1 5 1. Given this stochastic process, and given that h is
the only stochastic element in the model, the expectation in eq. (10) equals a
discounted sum of political rents over an infinite horizon, namely

(11)

According to eq. (1 l), the contribution of political rents at any future date to
R, is larger the larger is the probability that the incumbent ruler will still be
in power at that date.
We come now to the critical element in the analysis. To model the

‘Findlay (1990) analyzes a model similar to eqs. (1)<8), but he specifies the objective of the
ruler to be the maximization of current political rents only and he does not allow for a
temporal interval between inputs and outputs. Accordingly, he does not consider either the issue
of survival in power or the problem of time consistency.
*Eq. (10) assumes that a ruler’s loss of power is irreversible. If, alternatively, a ruler who lost
power had a positive probability of regaining power, then the discount factors for future
political rents given in eq. (11) would be increased by an appropriate set of constants. Eq. (10)
also assumes without loss of generality that the ruler does not discount revenues received before
or at date t + h.
 H.I. Grossman and S.J. Noh, Proprietary public finance and economic wel&are 195

dependence of these survival probabilities on the incumbent rulers’ tax and

spending policies, assume that

P,+l =8-q{l-[(+ - +&I”-‘-“““-“‘~, OSq<fJ<l. (12)

In eq. (12), the parameter 8 denotes the maximum survival probability that
the incumbent ruler can achieve by enhancing the economic welfare of his
subjects. In this way, 8 summarizes the effect on survival probability of all
factors other than tax and spending policy. If the political establishment is
cohesive and faces a negligible external threat of conquest, then 0 should be
close to unity. Alternatively, either internal discord or external aggression
could make 0 much smaller than unity.
The other parameter, q, in eq. (12) measures the effect of currently
expected utility, and hence of g, and x:, 1, on the current survival probability.
If q is positive, then pt+, is positively related to u:,,, and pr+ 1 equals 8 if
and only if u:+~ equals 6. [Given the stationary structure of the model, no
generality is lost by relating pt+l only to u:+~ without taking explicit
account of expected utility for all future dates.]
Eq. (12) represents a generic model of the ruler’s survival probability that
is applicable whatever the relative importance of internal or external threats
to the ruler’s survival and whether these threats involve peaceful elections or
the possibility of revolution or conquest. The treatment of 8 and q as
exogenous structural parameters, however, represents unfinished business. An
extended analysis would specify the political process, including the technol-
ogical and resource constraints that govern the strategies and outcomes of
elections, revolutions, or conquests, and would derive 0 and q endogenously.’
Substituting eq. (5) into eq. (12) and recalling that ii equals l-p, we
obtain the simple and convenient relation
=(j-q(l _/y-B)i(l-8))
pt+l
(13)
Eq. (13) says that if q is positive, then the incumbent ruler’s survival
probability is positively related to 8, and, hence, by eq. (4), depends

‘In related literature, Alesina and Cukierman (1990) analyze electoral competition in a model
of two political parties in which policy choices can influence the incumbent’s probability of re-
election. But Alesina and Cukierman assume that the policy goal of one of the parties evolves as
an exogenous stochastic process whose realization is private information, and they focus their
analysis on the voters’ problem of forming an expectation of this policy goal. Grossman (1991)
analyzes a model in which the incumbent faces the possibility that the citizenry will join an
insurrection. But, this model, like the model of Alesina and Cukierman, abstracts from the time-
consistency problem on which the present paper focuses. In other related literature, Roemer
(1985) develops a model of revolution, but in his model, as in the seminal work of Downs (19571
on electoral competition, political power is sought only for its own sake.

J.P.E. B
196 H.I. Grossman and S.J. Noh, Proprietary public finance and economic welfare

negatively on the expected tax rate and positively on the amount of

productive public services.” Given OS/, g 1, the ranges of 0 and 4 imply
that p, + 1 is bounded between zero and unity.

4. An irrevocable tax-rate commitment

Suppose, hypothetically, that at any date t the ruler could irrevocably
commit himself to set a specific preannounced tax rate at date t + 1.
Moreover, assume, for simplicity, that this preannounced tax rate is operative
whether or not the incumbent ruler survives to date t + 1. (If the incumbent
ruler does not survive to date t + 1, then his replacement receives the tax
revenue associated with the preannounced tax rate.) Denoting the pre-
announced tax rate as tx, + 1, this tax-rate commitment would imply

X ff 1 =txt+1, (14)

and also would imply that the representative producer’s expectation of the
tax rate would be

x,e+r =tx,+r. (15)

With an irrevocable tax-rate commitment, current political rents, x,y,, are
predetermined. Hence, to maximize R,, the ruler at date t has only to choose
1X,+1 and g,, as part of a program {r~r+ r,g,}pZt, to maximize expected future
political rents, E,R, + 1, as given by eq. (1 l), subject to the constraints given
by the technology for production of marketable output, eq. (I), the behavior
of the representative producer, eqs. (4) and (15), the political process, eq. (13),
and the tax-rate commitment, eq. (14). Moreover, if the incumbent ruler
survives, he would face the same problem in choosing (, + r~,+~,g, + r ),
(1+2x,+3,gt+ 2), etc. Thus, the problem is equivalent to the problem of
choosing a constant announced and actual tax rate, denoted by x‘, and a
constant amount of productive public services, denoted by g’, to maximize
ER= [p/(1 - ~13.
The first-order conditions for a maximum value of ER are that the
derivatives of ER with respect to x and with respect to g equal zero. Thus, x’
and g’ satisfy

ar p._
+ap-L--=0 (16)
ax i-p axpPj2 ’
‘%I this setup, pr+i does not depend on x,,,. the actual tax rate imposed at date I + 1. In
other words, the ruler’s survival to date t+ 1 is determined before x,,, is imposed. An
alternative formulation, which would be tractible but would complicate the analysis of the
equilibrium, would have p,+r depend on x,+ ,, rather than on x:,,. with survival in power to
date t + 1 - that is, the ability to collect political rents at date t + 1 - determined after the ruler
attempts to impose x,, ,
 H.I. Grossman and S.J. Nob, Proprietary public fmance and economic welfare 197

where

de -y
a,‘(1 -a)(1 -/I)’
and
ar_A_ + at!.-_L __ = 0
(17)
agi-p ag(l-p)2 ’
where
ar_ by 1 af ,qL23!p:‘l-a, aeand
ag u-4g ’ ag 1-D ag
ae (1-4BY
&=(l -cL)(l-B)i’

Eq. (16) says that the political-rent-maximizing policy equates the expected
marginal revenue from taxation to the marginal cost of the tax rate in
reducing the probability of surviving to collect future political rents. Eq. (17)
says that the political-rent-maximizing policy also equates the expected
marginal cost of public services in reducing current political rents to the
marginal benefit of public services in increasing the survival probability.
Eqs. (16) and (17) together imply that g’ and x’, like 2 and 2, satisfy eqs.
(6) and (9). [To confirm this result, note that with g=/Iy, eq. (17) becomes
identical to eq. (16).] This result says that the political-rent-maximizing
policy, like the welfare-maximizing policy, equates the marginal product of
public services to unity. Given that he is also setting the tax rate to maximize
ER, the self-interested ruler spends a sufficient amount on productive public
services to maximize the net contribution of public services to marketable
output. By maximizing the tax base associated with the chosen tax rate, this
spending rule maximizes expected political rents.”
The self-interested ruler, however, in general does not choose the tax rate
and provide the amount of productive public services that would maximize
welfare. For example, if q equals zero, then eq. (16) requires &/ax equal to
zero. Hence x’ equals 1 -TV, which is the tax rate that maximizes tax revenue.

“One might conjecture (incorrectly) that the marginal effect of public services on tax revenue
is the product of the tax rate and the marginal product of public services and, hence, that the
political-rent-maximizing policy equates the marginal product of public services to the inverse of
the tax rate rather than to unity. This conjecture is wrong because it ignores the positive effect
of g on d. The marginal product of public services is By/g, but d(xy)/dg equals x/ly/( 1 -a)g,
which is larger than xay/g.
198 H.1. Grossman and S.J. Noh, Proprietary publicfinance and economic welfare

If the survival probability did not depend on the expected tax rate, the ruler,
if he could commit himself to a preannounced tax rate, would set the tax rate
at the peak of the Laffer curve.
Diminishing returns to scale in the variable factors means that 1 -Z is
larger than B. Thus, if 4 equals zero, then x’ is larger than 2 and,
consequently, eq. (9) implies that g’ is smaller than g. The political-rent-
maximizing policy involves a higher tax rate and a smaller amount of public
services than would maximize welfare.’ 2
If, alternatively, 4 is positive, then eq. (16) requires ar/dx positive.
Accordingly, x’ is less than 1 --cI. Also, from eq. (9) g’ is larger and the
amount of political rent is smaller than if q equals zero. Moreover, x’ is
lower and g’ is larger the larger is q. In other words, with an irrevocable tax-
rate commitment, the self-interested ruler’s policy would be closer to the
welfare-maximizing policy the more that the survival probability depends on
the expected tax rate.

5. Credibility

Because he exercises sovereign power, the ruler in fact cannot irrevocably

commit himself to a preannounced tax rate. Moreover, at date t + 1, because
marketable output y,, , is predetermined, being the result of the producers’
choice at date t of C,, the ruler would maximize current political rents by
setting the tax rate, x,+ i, equal to unity. If, however, producers at date t had
expected that the tax rate at date t + 1 would be unity - that is, that the ruler
would confiscate all marketable output - then they would have set the
fraction of their time devoted to the production of marketable output equal
to zero. Accordingly, for marketable output to be positive and, hence, for
political rents to be positive, producers at date t must expect that the ruler
will resist the temptation to set x(+i opportunistically equal to unity.’ 3
This requirement implies that for political rents to be positive the
preannounced tax rate, ,x, + i, must be less than unity and credible. With
credibility, xF+1, the tax rate that producers expect, equals ,x, + 1, even though
this preannounced tax rate is not an irrevocable commitment. Credibility in
turn requires time consistency - that is, the sum of current and expected

“Given the simplifying assumption of a linear utility function, diminishing returns to scale are
essential for the result that x’> f and g’<a. If, however, the utility function were concave, this
result would obtain even with constant returns to scale in production.
’ W, as suggested above,. p, + , depended on x, + , rather than on x:+, , the ruler would be
tempted to set xl+, to maxtmtze P,+~(x,+~~,+, -g,) rather than to maxtmtze xc + ,yr +, -g,. The
implied tax rate, although higher than x’, would be less than unity if 4 is positive. Moreover,
although the present model focuses on a simple proportionate income tax, a similar time-
consistency requirement would apply to any tax that the ruler would be tempted to impose at a
higher rate than expected. Grossman and Van Huyck (1986) analyze a time-consistent
reputational equilibrium for seigniorage, in which case inflation is the tax.
 H.1. Grossman and S.J. Noh, Proprietary public finance and economic welfare 199

future political rents must be at least as large if the ruler honors this
preannouncement as it would be if the tax rate were set equal to unity.
To analyze the determination of the set of credible preannounced tax rates,
we use a simplified version of a theory of credibility developed in previous
analyses of reputational equilibria for monetary and fiscal policy - see, for
example, Grossman and Van Huyck (1988) and Grossman (1990). The key
implication of this theory is that if the incumbent ruler were ever to behave
opportunistically, then the expected tax rate in the future would be unity,
and future marketable output, and hence potential tax revenues, would be
zero.r4 Accordingly, this theory implies that, given the stationary structure of
the model, the set of credible tax rates satisfies the time-invariant condition

(18)

The LHS of condition (18) gives the present value of current and expected
future political rents if at all current and future dates public services are
provided in the amount g, and the tax rate x is announced and this
announcement is subsequently honored. The RHS of condition (18) gives the
value of political rents if public services were provided in the amount g and
the tax rate x was announced and a tax rate of unity is opportunistically
imposed. This policy would yield current political rent equal to y-g, but
would mean that at all future dates political rents would be zero.
Taking account of his credibility, a rational ruler’s problem at date t is to
choose a constant announced and actual tax rate, denoted by x*, and an
associated constant amount of productive public services, denoted by g*, to
solve the problem discussed above of maximizing expected future political
rents, ER = [p/( 1 -p)]r, subject to the additional credibility constraint given
by condition (18). To determine how condition (18) restricts x* and g*,
define X and g to be the tax rate and amount of public services that
maximize ER, subject to the constraint given by condition (18) being satisfied
as an equality. Thus, X and 2 satisfy the first-order conditions

and

r4Although this particular implication seems plausible, the qualitative results derived below
require only that the ruler’s current actions provide information that influences expectations
about his future actions. For example, it is easy to extend this analysis to allow producers to
ignore an isolated instance of opportunistic behavior or to forget distant past behavior. In
Grossman and Van Huyck (1988), memory is a stochastic process.
200 H.I. Grossman and S.J. Noh, Proprietary public finance and economic

1
ar
__L+!?P-r_-+)_ ar--!_+aS__r_ A+1 =o,
(20)
ag1-p aghv [ ag1-p agu-p)2 ag
where

ay _ ___
a ~__~_
Y ay-fi y ag
2ix= l-a l-x’ l-ag’

and where &-/ax, +/ax, &lag, and apJag are as in eqs. (16) and (17) above,
and where ,? is a positive Lagrange multiplier.
Eqs. (19) and (20) together imply that 2 and X also satisfy eqs. (6), (8) and
(9). [To confirm this result note that with g=py, eq. (20) becomes identical
to eq. (19).] Thus, even if the time-consistency constraint is binding, the self-
interested ruler provides productive public services in the quantity that, given
the tax rate, maximizes the net contribution of public services to marketable
output.
Substituting eq. (6) into eq. (18) we get

1-x
(21)
p = T-7’

and substituting eq. (8) into eq. (13) we get

(22)

Solving eqs. (21) and (22) for X we find that a credible tax rate satisfies

xrx=pe+w-q)
- (23)
l-q .

Condition (23) implies that X is larger than /I, which is the welfare-
maximizing tax rate, but less than unity. Hence, from eq. (9), g is positive,
but smaller than S. Also, J? is higher and g is lower the smaller is 0 and the
larger is q. Either a smaller 0 or a larger q implies a higher value of X and a
lower value of 2 because both smaller 8 and larger q imply, for a given value
of x, a lower survival probability and, hence, a lower valuation of expected
future political rents to current political rents.

6. Equilibrium
The analysis in section 3 derived the tax rate x’ that would produce the
highest value of ER given that the ruler honors this preannounced tax rate.
If x’ is equal to or larger than X, then condition (23) is not a binding
 H.I. Grossman and S.J. Noh, Proprietary public finance and economic werfare 201

constraint on the choice of x*. In this case, x* equals x’. Alternatively, if x’ is

smaller than 2, then condition (23) is a binding constraint on the choice of
x*. In that case, x* satisfies condition (23) as an equality - that is, x* equals
c?. In sum, the equilibrium is

x* = max(.x’, 2) (24)
and
g* = min(g’, g), (25)

where g’ and x’ , and g and X, are inversely related according to eq. (9).
Eq. (24) has the following qualitative implications for the equilibrium tax
rate: first, if and only if both x’ and 2 are less than 1 --a, which is the
revenue-maximizing tax rate, then x* is less than 1 --a. Recall that x’ equals
1 -a if q equals zero and that x’ is less than 1 -a if q is positive. Thus, with
q>O, the critical question is whether X, as given by eq. (23) is less than 1 -a.
Second, if and only if the larger of x’ and X equals 1 -u, then x* equals
1 -a. Equivalently, if and only if either X equals 1 -a or X is less than 1 -a
while q equals zero, then x* equals 1 -a.
Third, if and only if 2 is larger than 1 -a, then x* is larger than 1 -a. In
this case tax revenues would be larger if the ruler were able to create the
expectation of a lower tax rate and were to validate this expectation. The
announcement of a lower tax rate, however, would not be credible because a
lower tax rate would not be time consistent. In this case, the ruler is trapped
on the wrong side of the Laffer curve.
How do x* and g* depend on the value of q, which measures the effect of
the ruler’s policies on his survival probability? Because x’ is decreasing in q
and g’ is increasing in q, whereas X is increasing in q and g is decreasing in q,
eqs. (24) and (25) imply that x* is decreasing in q and g* is increasing in q if
x’ is larger than X, whereas x* is increasing in q and g* is decreasing in q if ?c
is larger than x’. Furthermore, for a given value of 8, x* is minimized and,
hence, is closest to R, and g* is maximized and, hence, is closest to S, if x’
equals X.
Eqs. (16), (17) and (23) together imply that, for x’ equal to X, q must
satisfy

q=l-
J (1-Wl-8)
._~___
1-a-p . (26)

Given that q is non-negative, this value of q exists if and only if 13is at least
as large as a/( 1 -j?). If, alternatively, 9 is less than a/( 1 -a), then X is larger
than x’ for all non-negative values of q. In this case, x* is minimized and g*
is maximized at q equal to zero.
202 H.1. Grossman and S.J. Noh, Proprietary public finance and economic welfare

In sum, the value of 9, denoted by q”, that maximizes the welfare of the
representative producer is

(27)

Eq. (27) implies that, in the limit as 0 approaches unity, q” also approaches
unity. Moreover, if both 8 > a/( 1-p) and q = q”, then combining eqs. (23) and
(27) we get

x*I (28)

Eq. implies that, with equal q”, approaches and approaches

in limit 0 unity. other if political
were that 8 q close unity, a ruler
choose almost policy. critical of a
structure, we see eq. is a benevolent
and policy both and for high
probability.
generally, larger of implies lower tax
and higher amount productive services and if
8 cz/(l and is enough the require-
is a constraint. the of q decreasing
and g* limited. 8 smaller cc/(1 fl) if is
enough the constraint binding, larger perversely
x* decreases

7. Summary and normative implications

We have developed a positive theory of public finance in which the
objective of a tax and spending policy is to extract rents for the incumbent
ruler, the proprietor of the governmental enterprise and of sovereign power.
The ruler in this theory is not after political power per se, nor is he merely
an agent of some subset of the citizenry. Instead, the theory treats pursuit of
political power and service to constituents as a means by which the ruler
enhances his own material well-being.
This self-interested ruler typically sets a higher tax rate and spends less on
productive public services than would maximize the welfare of the represen-
tative producer. But, the self-interested ruler’s criterion for expanding pro-
ductive public services turns out to be the same as the welfare-maximizing
criterion - namely, to set the marginal product of public services equal to
unity. The resolution of this apparent paradox is that the higher tax rate set
 H.I. Grossman and S.J. Noh, Proprietary public finance and economic welfare 203

by the self-interested ruler reduces the quantity supplied of cooperating

private inputs and, hence, reduces the marginal product of public services.
The main objective of the analysis has been to explore how dependence of
the incumbent ruler’s survival probability on the expected utility of his
subjects can induce him to pursue a more benevolent tax and spending
policy. Most importantly, we have seen that the ruler’s concern about his
survival probability can lower the equilibrium tax rate and increase the
equilibrium amount of spending on productive public services, but only until
the credibility requirement becomes a binding constraint. Given the linkage
between current policy and expectations about future policy, the minimum
time-consistent tax rate is lower the more that the ruler values future
political rents. But, the value of prospective future political rents itself
depends on the incumbent ruler’s survival probability, which depends, in
turn, on his current tax and spending policy.
The central result of the analysis of this system of interdependencies is
that, if a relatively benevolent tax and spending policy is both necessary and
sufficient for a high survival probability, then the ruler’s equilibrium policy is
relatively benevolent. As a corollary, greater dependence of the ruler’s
survival probability on current policy implies a lower equilibrium tax rate and
a higher equilibrium amount of productive public services if and only if both
this dependence is not too great and the ruler’s maximum survival prob-
ability exceeds a minimum value. Otherwise, this dependence, by reducing
the ruler’s survival probability, undermines the ruler’s credibility and makes
equilibrium policy less benevolent. In pathological cases, regardless of the
dependence of survival probability on policy, a sufficient low maximum
survival probability can cause the ruler to be trapped on the wrong side of
the Laffer curve and to provide little in the way of productive public services.
What are the implictions of this analysis for the design of a political
system - that is, if it were possible, for setting either directly or indirectly the
parameters 0 and 4 that govern the survival probability of the incumbent
ruler? One impliations is that if the maximum survival probability, 0, were
given, but we could pick the effect, as measured by q, of current policy on
the actual survival probability, then we would want to be careful not to
make q so large that the credibility constraint would bind. The larger is 0,
however, the larger is the value of q that we would choose. A second
implication is that, if we could pick both 8 and q, then we would make 8 as
large as we could, and we would make q correspondingly large. If our
choices were unconstrained, except by O_Iq < 0-c 1, then we could induce our
self-interested ruler to adopt an almost benevolent tax and spending policy.
The question of what choices are available for the design of a political
system and how the feasible set relates to the history, culture, and technology
of a society remains to be answered, but is beyond the scope of the present
inquiry.
204 H.I. Grossman and S.J. Noh, Proprietary public finance and economic werfnre

References
Alesina, Alberto, 1988, Credibility and policy convergence in a two-party system with rational
voters, American Economic Review 78, 796805.
Alesina, Albert0 and Alex Cukierman, 1990, The politics of ambiguity, Quarterly Journal of
Economics 105, 829-849.
Bardhan, Pranab, 1990, Symposium on the state and economic development, Journal of
Economic Perspectives 4, 3-7.
Brennan, Geoffrey and James M. Buchanan, 1980, The power to tax: Analytical foundations of a
liscal constitution (Cambridge University Press, New York).
Buchanan, James M. and Roger L. Faith, 1987, Secession and the limits of taxation: Toward a
theory of internal exit, American Economic Review 77, 1023-1031.
Downs, Anthony, 1957, An economic theory of democracy (Harper and Row, New York).
Findlay, Ronald, 1990, The new political economy: Its explanatory power for LDC’s, Economics
and Politics 2, 193-221.
Friedman, David, 1977, A theory of the size and shape of nations, Journal of Political Economy
85, 59-77.
Grossman, Herschel I., 1990, Inflation and reputation with generic policy preferences, Journal of
Money, Credit and Banking 22, 165-177.
Grossman, Herschel I., 1991, A general equilibrium model of insurrection, American Economic
Review 81,912-921.
Grossman, Herschel I. and Suk Jae Noh, 1990, A theory of kleptocracy with probabilistic
survival and reputation, Economics and Politics 2, 157-171.
Grossman, Herschel I, and John B. Van Huyck, 1986, Seigniorage, inflation and reputation,
Journal of Monetary Economics 18, 21-31.
Grossman, Herschel I. and John B. Van Huyck, 1988, Sovereign debt as a contingent claim:
Excusable default, repudiation, and reputation, American Economic Review 78, 1088-1097.
North, Douglas C., 1981, A neoclassical theory of the state, in: Douglas C. North, Structure
and change in economic history (Norton, New York).
Roemer, John E., 1985, Rationalizing revolutionary ideology, Econometrica 53, 855108.
Rogoff, Kenneth, 1985, The optimal degree of commitment to an intermediate monetary target,
Quarterly Journal of Economics 100, 1169-l 190.
Tiebout, Charles, 1956, A pure theory of local expenditures, Journal of Political Economy 64,
416424.
Tollison, Robert D., 1989, Chicago political economy, Public Choice 63, 293-297.