(Author’s note: This is a revised version of a post I wrote in July 2009, one of the earliest posts for this blog. I revised it in the light of current market volatility and related concerns re governance and economic stability under President Noynoy Aquino.)
The notion that mobile capital is a powerful corrective to bad governance has a noble lineage from Adam Smith, David Hume, and Charles de Montesquieu. In recent years, the idea was resurrected by globalists and like-minded entities such as ratings agencies, like Moody’s, and multilateral financial institutions such as the World Bank.
Adam Smith of “The Wealth of Nations” fame
To Smith’s mind, bad governance is excessive taxation of capital and property. Not taxation per se, as he recognized the need for public goods and the role of the state in the provision of such goods. Bad governance discourages investment and owners of transportable assets can readily change domiciles to jurisdictions with acceptable tax burdens. Smith argued that a tax burden is acceptable to businessmen if the state can provide an acceptable bundle of public goods. To businessmen, therefore, tax payments are like capital outlays for durable goods. The key public goods include internal order and political stability, a reliable system of property rights protection, contract enforcement, and dispute settlement, and public infrastructure.
Neoclassical economics assert that rational businessmen will pay taxes to the extent that the monetary value of the marginal public good, or MPG (reckoned as a valuable collective product), is equal to the marginal tax cost MTC).
Given the distinct possibility of free riding, taxes are paid starting from the point where MPG > MTC and stops when MPG = MTC. Free-riding requires that tax collection is best done through an entity imbued with legitimacy and a monopoly of means of violence–that is, the state. The payment of taxes is never voluntary and it takes a
Ratings agencies
coercive agency to collect taxes. This is not to say that non-state actors cannot collect taxes or provide public goods. States and non-states must have arms to collect taxes. However, only states can collect taxes legitimately. When non-state actors, such as insurgent armies do so, this activity is rightfully called extortion (albeit revolutionary).
New People’s Army (NPA) fighters
By default, states are considered legitimate both by its constituents and the international community. However, like all political goods, legitimacy is exhaustible. A state’s legitimacy is directly related to the magnitude and the sign of the difference between MPG and MTC, a quantity we designate as net public good (NPG). The greater the value of NPG, the greater the amount of legitimacy a state enjoys. As NPG decreases, state legitimacy similarly goes down. Should NPG take on a negative value, then the collecting state is considered illegitimate and engaged in plunder. If L was the state’s legitimacy, then L is a function of net public goods (NPG) or the difference between marginal public good (MPG) and marginal tax cost (MTC). The L function could be written as L = f(NPG) = f(MPG-MTC) or L = k NPG = k (MPG-MTC), where k is some constant between 1 and zero.
These points are crucial since the time gap between tax payment and provision of public goods is quite substantial. Notwithstanding the innate legitimacy of the state, rulers and bureaucrats may choose to use public tax revenues to provide private goods for themselves and their supporters. When they do, the state loses legitimacy and anti-state actors (that could provide the equivalent of public goods) gain traction and could eventually replace the illegitimate state in power. When economic agents pay taxes, there’s no guarantee they will get anything in return. They cannot use the tax receipt to demand a refund should the public goods they expect fail to materialize. This lack of certainty of getting something in return is another reason why economic agents do not readily pay taxes.
David Hume
Montesquieu
Among the classical political economists like Smith, Hume and Montesquieu, there was no discussion about state succession. That will come later with John Locke and Jean Jacques Rousseau. Smith and company believed that capital mobility can check excessive taxation, aka bad governance. If a capitalist faces onerous taxes, he has just to transfer to another place with lighter taxes. Of course, his assets must be fluid so he can move easily.
In recent years, a country’s ability to attract mobile capital is considered a sign that it is well governed. How then shall we interpret the massive flight of capital from the same country? Did it change to being poorly governed overnight? Or, was it a matter of governance at all?
How potent is capital mobility against bad governance? In my opinion, its potency is limited since bad governance seems to be the norm instead of the exception in the contemporary world. Why is this the case?
For one, capital mobility is not perfect. The state is not helpless and has ways to reduce capital’s mobility.
Secondly, not all capital is fluid; some capital are tied down in fixed and other assets and capital owners must sustain prohibitive transactions costs before they could be transported. This explains the popularity of stock market placements–portable capital, in short.
Philippine Stock Exchange (PSE) trading floor during a lull
Lastly and most importantly, there may be substantial interests (domestic and foreign) who are rather impervious to capital’s mobility. Some of them welcome the outflow of capital if it results in a less-competitive situation where they will have greater control over market prices. Others may not need to interact with mobile foreign capital and will therefore remain unaffected by their exit. Still some others may be satisfied with a feckless state that allows their illicit businesses to operate and prosper. In truth, there exists a politico-economic constituency that profits from state weakness and is impervious to the disciplinary strictures of mobile capital.
There is a fourth reason for mobile capital’s relative impotence. Differences in time horizons require decomposition of mobile capital.
Ford Motor Corporation Philippines (and its fixed assets)
Direct investors have greater concerns about governance since they have longer time horizons compared to owners and managers of ‘hot money’. Of greater concern to the latter is a country’s capital account regime. That is, if the host state has a liberal regime that allows for the unimpeded movement of foreign exchange. Provided comparatively better margins could be made in the short run, and provided earnings can be repatriated, portfolio capital may still be attracted to jurisdictions with poor governance. To some extent, the institutional weakness of the host state can offer windfall profit opportunities for extremely mobile capital. Occasional crises may lower asset prices and offer portfolio managers more attractive buys.
Board of Investments (BOI)
In addition, bureaucracies in weak states will offer all sorts of incentives to offset institutional infirmities and enhance returns on investments. To be sure, better governance may bring higher returns to portfolio investments. But ‘hot money’ managers may not have the patience or the inclination to wait for better institutions to evolve. They may in fact be penalized by their bosses if they did not respond to better profit opportunities elsewhere.
Notwithstanding the points above, it does not readily follow that direct investors have a natural predisposition for good governance. When and where rents are offered by corrupt bureaucrats, these will not be refused. Thus, direct investors will differ with each other regarding their political connections and acumen. To the extent that rent-seekers have captured the state or a substantial amount of the economic space, the disciplinary power of mobile capital is consequently reduced.
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