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«Nathan M. Jensen Edmund J. Malesky George Washington University Duke University natemjensen ejm5 Phone: 202-994-0820 (919) 660-4340 ...»

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Chapter 6

Pandering Upward: Tax Incentives and Credit Claiming in Authoritarian Countries

Nathan M. Jensen Edmund J. Malesky

George Washington University Duke University

natemjensen@gwu.edu ejm5@duke.edu

Phone: 202-994-0820 (919) 660-4340

Abstract: Both countries and subnational governments commonly engage in competition for mobile

capital, offering generous incentives to attract investment. Previous work has suggested that the competition for capital can be politically beneficial to incumbent politicians in democratic societies.

Building off theories of electoral pandering, this work argues that such incentives allow politicians in democracies to take credit for firms’ investment decisions or escape blame if firms do not come. For these reasons, empirical work has found that politicians facing greater electoral competition are more likely to offer tax incentives to investors. Critically, however, all of the credit claiming analysis has been performed in democratic countries. An important anomaly for the pandering story is the strong empirical finding that authoritarian countries offer greater tax incentives to foreign investors than their democratic counterparts, both in terms of variety and size of the reductions. In this piece, we explore the reasons for this puzzle, arguing that the authoritarian anomaly is conditioned by whether the authoritarian country has strong mechanisms and guarantees of meritocratic promotion for subnational leaders. In these countries, the upward accountability generated by the promotion mechanism substitutes for the downward accountability to voters. By contrast, regimes characterized by personalism, where promotion is based more on loyalty than performance, use less. To explore these insights more deeply, we employ rigorous causal inference designs and precise micro-level data to test the logic of our pandering upward argument in Vietnam, an archetype of the single-party system, and Putin’s Russia, an example of increasing personalism.

1 In July 2005, Vietnam’s Ministry of Finance cited thirty-three provinces which had provided super incentives, tax incentives beyond those permitted under central law (Burke and Nguyen 2005, Vu Long 2005). Such incentives include tax holidays as long as twenty years, free land rental for foreign invested projects, and lower profits taxes (Thai Press Reports 2006). These policies tended to be one-off gifts to new investors. As an official from the province of Binh Duong’s Department of Planning and Investment (DPI) noted, “Incentives are merely cosmetic and are thus unsustainable,” - a bit like putting lipstick on a pig (MPDF 2004). Eventually, these incentives were declared invalid by the General Department of Taxation (GTD) and the Vietnamese government moved to terminate all of the fencebreaking incentives. 1 Contrasting the super incentives with the experience in Binh Duong, a hotbed of foreign investment activity that accounts for over a quarter of Vietnam’s FDI attraction and output and did not offer targeted incentives, the official continued “What's most important is to create a transparent and enabling business environment,” (MPDF 2004, 2). The official’s anecdotal analysis of the incentives is consistent with more rigorous empirical analysis, which found that the use of these “fence-breaking” incentives was uncorrelated with investment attraction and implementation. In short, investors did not appear to consider super incentives in their long-term decisions (Vu 2007, Malesky 2008a). More surprisingly, super incentives did not even appear to lead to higher profitability among foreign firms, the disproportionate recipient of most incentives in Vietnam. Despite the significant discounts on taxes and land fees registered to investors over the time period, the average foreign investors was over four times more profitable in provinces without super-incentives (23.8 Billion VND per year) than with them (5.5 Billion VND per year) (Malesky 2008a).

The story of the thirty-three fencebreakers presents an important puzzle for the larger theoretical argument we have made thus far in the book. In almost every way, the story mirrors the general pattern 1 Although they maintained national incentives and continued to allow provinces a great deal of discretion in offering a range of fiscal incentives for investors locating in industrial zones or areas designated as underdeveloped areas. We exploit the variation in these targeted policies in our tests below.

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competition to lure investment between subnational governments contributed to the allocation of a variety of targeted incentives to fiscal investors. And as in Chapter 4, these incentives appear to be highly ineffective. There were not correlated with actual investment attraction or performance, which was predominantly explained by infrastructure, human capital, proximity to markets, and the general regulatory environment (Vu 2007).

The key difference, however, is that Vietnam is an authoritarian single-party regime with the top leadership selected internally by elite party members in the Central Committee and the elections to the Vietnamese legislature are highly manipulated, far from the democratic elections we observed in our analysis of gubernatorial and city elections in the United States (Malesky and Schuler 2010). In this sense, the presence of fiscal incentives offers a sharp challenge to the electoral competition story articulated thus far in the book.





To see the conundrum, it might be helpful to briefly review the logic of our argument. In Chapter 2, we argued that incentives were a form of political pandering with politicians using the incentives to identify themselves in voters’ minds with large and important investment projects, allowing them to take credit for attracting the investment, or escape blame if the investor ultimately chose a different locality.

Even though politicians are aware that the direct effects of incentives are highly uncertain and can even be costly, they can rely on the fact that rationally ignorant voters (Tullock 2005, Downs 1957) deem incentives to be effective. Politicians take advantage of this asymmetric information advantage to claim credit or deflect blame in the competition for investment projects. In survey experiments, we showed that voters do indeed reward politicians who offer incentives, whether or not the company actually came to locate in the locality. Then, in Chapter 6, we demonstrated that U.S. mayors, who were subject to direct elections, offered more lucrative incentives to firms then city managers, who only were connected to voters indirectly through the oversight of the elected city council. Thus, we concluded that electoral competition is a key driver of the proliferation of fiscal incentives in the U.S. and throughout the world.

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Vietnam? Indeed, the story of Vietnam is actually reflective of a larger, global pattern. Scholars, who have looked closely at incentives have concluded that that authoritarian countries offer greater tax incentives to foreign investors than their democratic counterparts, both in terms of variety and size of the reductions (Li 2006, 2009, Klem et al. 2012).

In this chapter, we explore the reasons for this puzzle. Using cross national data, we demonstrate that the authoritarian anomaly is conditioned by whether the authoritarian country has strong mechanisms of meritocratic promotion for subnational leaders. In these countries, the upward accountability generated by the promotion mechanism substitutes for the downward accountability to voters. In other words, the higher incentives observed in authoritarian countries is resulting from the pandering of subnational leaders to their central benefactors. By contrast, regimes characterized by personalism, where promotion is based more on loyalty performance, use less. To explore these insights more deeply, we employ rigorous causal inference designs and precise micro-level data to test the logic of our pandering upward argument in Vietnam, an archetype of the single-party system, and Putin’s Russia, a prime example of growing personalism.

6.1. Pandering Upward in Single-Party Regimes To begin to answer the puzzle of authoritarian incentives, it is helpful to engage in a bit of brush clearing. A dynamic and growing literature has begun to demonstrate that the residual category of “nondemocracy” obscures more than clarifies. In this section, we explore the wide variety of authoritarian regime types and they very different relationships they imply between state and citizens. Next, we drill down deeper into arguably the most successful form of authoritarianism, measured by political stability, regime duration, and economic performance – the single-party system, which includes both single-party states and hegemonic regimes.

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feature of many of these regimes – within party promotion of leadership positions based on concreate indicators of performance, including in many countries, FDI attraction targets. Daniel Bell (2014) has called this feature, political meritocracy, in his analysis of Singapore and China. While scholars have provided evidence that promotion in some single-party regimes is based on economic performance, serious concerns have been raised about the quality of the data used in promotions and the distortionary activity that is often employed to meet targets. We suggest that this imperfect meritocracy creates an analogous asymmetric information problem to the one we observed in democracies. In this case, however, the principals are central elites and the agent are subnational officials who want to claim credit for meeting FDI attraction targets, but who, like their counterparts in democratic systems, recognize that incentives may be superfluous and inefficient. In other words, single-party systems generate opportunities for pandering upwards, which is why they overuse incentives and solely account for the anomalous relationship between authoritarianism and fiscal incentives pointed out by other scholars.

Varieties of Authoritarianism Included in the catch-all grouping of non-democracies are constitutional monarchies ruled by kings or sultan where succession is determined by family lineage (e.g. Brunei, Jordan); military juntas, where rule is monopolized by a small collective of military leaders (e.g. Thailand, Egypt); single-party states where opposition parties are outlawed and a vanguard party rules in the name of the citizens (e.g.

Vietnam, China); and hegemonic/dominant parties where multi-party elections are allowed but manipulation, patronage, and fear conspire to keep the opposition from taking offices (e.g. Malaysia, Singapore) (Geddes 1999, Brooker 2000).

Within each of these categories, we also see variation in the level of personalism, defined as power consolidation by a single individual (Svolik 2012), where political decisions are dominated by a small group around the top leader and loyalty to him/her determines ascent to the top ranks (Weeks 2014, Geddes et al. 2015). While the elite leader could have a military background or may have formed a party

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authority. The discretion of the top leader is the paramount decision-making mechanism (Bratton and van de Walle 1997, Geddes 1999, Hadenious and Teorell 2007). North Korea is an excellent example of a personalist single-party system, while Russia under Putin today provides an excellent example of a hegemonic party system with strong personalist tendencies (Isacs and Whimore 2013). We return to the role that personalism plays in the use of incentives below.

The Success of Single-Party States Among various forms of autocracies, single-party regimes stand out for their performance across a number of key metrics. Single-party states are more durable than juntas and personlist regimes with lower failure rates and longer terms in office (Geddes 1999, Magaloni and Kricheli 2010, Geddes et al.

2015). They are more resilient in the face destabilizing threats, such economic crises and rise of popular opposition (Smith 2005, Brownlee 2007, Magaloni and Kricheli 2010). They generate higher levels of economic growth (Gandhi 2008; Keefer 2007) and private investment attraction (Wright 2008, Gelbach and Keefer 2011) and even score better in quality of governance (Charron and Lapuente 2011). Political leaders in one-party regimes are less likely to experience coups (Boix and Svolik 2013; Svolik 2012), and consequently stay longer in office (Gandhi and Przeworski 2007, Geddes 2008, Magloni and Kricheli 2010).

Two competing theories have been offered to explain the relative success of single-party systems (Magloni and Kricheli 2010). First, scholars argue that authoritarian ruling parties serve as a cooptation or distributive device; the rulers are able to co-opt opposition elites, distribute shares of spoils to key constituents, reward supporters, or arguably, provide a forum for collective action for other elites to hold a top leader accountable (Diaz-Cayeros et al. 2001, Lazarev 2005, Brownlee 2007, Magaloni 2008 Blaydes 2010, Gandhi 2008, Gehlbach and Keefer 2011). A second branch of the literature focuses on the benefits of party organization, including the hierarchical committee system, manipulability of cadres (i.e. the party controls groups of deployable personnel with largely interchangeable skills), and top

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especially important on this point by illustrating how successful regime parties selectively recruit the ideologically close elements at grassroots level, and repress the ideologically distant ones. Because authoritarian parties control political appointments and maintain hierarchies of services and benefits, they are able to attract the ideologically proximate segments of population as long as old cadres retire at a sufficiently high rate. Retirement is obligated through mandatory retirement ages, which open up space at the top and thereby convince new recruits that their loyalty will be reward.2 Authoritarian parties also deter defection by encouraging sunk investment among grassroots members.



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