Revisiting the democracy-private investment nexus: Does inequality matter?

Abstract

Contrary to the predictions of a large theoretical literature, recent cross-country evidence suggests autocracies can generate statistically indistinguishable levels of private investment compared to democracies. We argue that the previous exclusion of inequality explains part of this puzzle. We model current investment as a function of investors’ beliefs about future tax rates, which are conditioned by the constraints on the Executive in setting tax rates and expropriating tax revenues. In democracies, where tax rates reflect the preferences of the median voter, investment declines with rising inequality. In autocracies, investor beliefs about future tax rates reflect the relative power of Elites compared to the Executive. As inequality rises, the increased resources available to Elites constrains the Executive’s ability to expropriate more tax revenues. The heterogeneous determinants of investor beliefs can explain the observed pattern of investment across regime types. We first test our predictions at the macro-level with cross-country data. We then test the behavioral underpinnings of our model with a novel laboratory experiment showing how inequality affects individual-level investment behavior dependent upon regime type. Results from both types of analyses show that when inequality is taken into account autocracies can generate similar levels of investment to democracies.