A Collective-Action Theory of Fiscal-Military State Building

Abstract

Prior to the emergence of the fiscal-military state, many monarchs depended on economic and local elites for the collection of tax revenue and defense. Why did these powerful elites allow the ruler to increase fiscal centralization and build-up militarily? Building on historical accounts of colonial Mexico and 17th century England, this chapter develops a game-theoretic analysis that explains why increases in fiscal centralization are more likely when the probability of a threat of internal unrest or external invasion increases. Elites free ride on fiscal contributions under fragmented fiscal capacity. Centralized fiscal collection and enforcement serves as an institutional devise for the elites to overcome free riding and ensure the provision of military protection. The analysis shows that an increase in the probability of a threat is more likely to result in centralization when the alignment between the elites’ and the ruler’s vulnerability to the threat is high, and in the presence of economic growth. The analysis also suggests that institutions that allow rulers to commit, such as representative assemblies, may not be necessary for fiscal centralization to transpire. Examples from European and colonial history provide support for the implications of the theoretical analysis.

Where benefits are not earmarked, ‘somebody else should pay’ is always a powerful motivation in tax policy. Alt (1983, p. 194)

I am grateful to an anonymous referee, David Baron, B. Douglas Bernheim, Paul David, Alberto Díaz-Cayeros, Marc Dincecco, Rafael Dobado, Avner Greif, Luis Jáuregui, Yadira Gonzalez de Lara, Steve Haber, Margaret Levi, Carlos Marichal, Romans Pancs, Alvin Rabushka, Gavin Wright, and the participants at the II International Conference on Political Economy and Institutions in Baiona, the Social Science and History Workshop at Stanford University, and the Workshop on Endogenous Institutions and Political Conflict at UC Berkeley’s Center on Institutions and Governance. This work would have not been possible without the financial support from the Stanford Institute for Economic Policy Research, the John M. Olin Program in Law and Economics, Stanford Law School, and the Center on Democracy, Development, and the Rule of Law (CDDRL) at Stanford University.

These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

The emergence of the fiscal-military state in the eighteenth century granted the central government new and unprecedented roles. In England, fiscal collection was increasingly centralized and put in the hands of a new and efficient fiscal bureaucracy, an army was created, and the navy acquired world-renown reputation (O’Brien 1988 and Brewer 1989). Tax proceeds as a percentage of national income rose from 3.5 percent in the 1670s to over 12 percent by the end of the eighteenth century.¹ Even though parallel attempts at fiscal modernization in Spain met with limited success until the early nineteenth century, in colonial Mexico public officials succeeded at strengthening the central administration with fiscal bureaucrats and a proficient accounting system. Mean growth for the Mexico City Treasury averaged almost 60 percent in each of the decades between 1770 and 1800.² Other European states followed in the late eighteenth and early nineteenth centuries.

Prior to this transition, most monarchs depended to a large extent on economic and local elites for the collection of tax revenue and defense. Fiscal capacity was fragmented. The central ruler invested minimally in monitoring and enforcement capacities to collect taxes. Treasuries and fiscal institutions at the national level functioned primarily as recipients of the monies collected by the local elites. Provincial authorities or economic actors organized in corporations—such as aristocrats, merchants or ecclesiasts—were responsible for the collection and dispatch of taxes. Rulers negotiated monetary transfers and loans with these elites and corporations, and granted them exemptions and other privileges in return.³ For instance, in France the provincial Estates, the assembly of the clergy, and tax farmers had tax authority and transferred funds to the Crown.⁴ The Spanish crown protected the merchant guild from foreign competition in the colonies, provided them with defense in the form of convoys, and had a contract with them for the collection of the alcabala (sales) tax in colonial Mexico.⁵

The fiscal-military state, then, implied losses of fiscal and other privileges for different elites. Why did fiscally and politically powerful elites allow the ruler to increase fiscal centralization and build-up militarily? To the extent that a ruler lacked the ability to unilaterally increase revenue to provide an army or to strengthen fiscal administration, the compliance of at least a fraction of the elites was necessary. Indeed, all across early modern Europe “provinces, estates, ecclesiastical domains, privileged cities, and corporations, as well as noble families […] and city states, maintained privileges and defences against the imposition of more modern, centralized, universal, equitable, and potentially more productive systems of taxation and finance.”⁶

Explanations for fiscal centralization emphasize the need to increase military establishments as the major impetus for the growth of European states’ administrative apparatuses. There are two approaches in the literature. One approach highlights the role of military conflicts.⁷ Military conflicts facilitate fiscal reform because wars unify a diverse population (Huntington 1968; Herbst 2000; and Kiser and Kane 2001), or the benefits of taxation become more salient to citizens (Levi 1988; and Besley and Persson 2009) or capital investors (Mann 1988). Explanations in the second approach underscore the need to constrain rulers upon granting them higher fiscal revenues. The establishment of political institutions of representation, like a parliament, increases fiscal cooperation by making commitments on public expenditures credible (North and Weingast 1989; Hoffman and Norberg 1994; and Dincecco et al. 2011).⁸

Both of these approaches contribute to our understanding of the growth of the fiscal-military state. Military conflicts provide a window for monarchs and governments to negotiate fiscal centralization by making salient the benefits of taxation. The second approach highlights, however, that increases in the benefits of taxation may not translate in fiscal cooperation because of commitment problems. A ruler with more fiscal and coercive powers may have incentives to expropriate elites or renege on its debts.⁹ Some monarchs, however, succeeded at increasing fiscal centralization with no institutions of representation in place. The evidence in Dincecco (2011, 27) shows that in many European states fiscal centralization came before the formation of parliaments. Marichal (2007, 51) highlights that colonial Spanish America lacked representative assemblies yet Spanish officials successfully implementated fiscal and military reforms in some regions in the eighteenth century.

In this chapter, I underscore the collective action problem present in fragmented fiscal regimes that impeded the cooperation of the elites with the contribution of men and resources for the defense of the territory. As such, the chapter emphasizes a commitment problem among the fiscally powerful elites, rather than between the elites and the ruler, in the process of fiscal-military state formation.¹⁰ In fragmented regimes, the ruler’s fiscal income rested on earmarking benefits to elites. In the face of a threat of military conflict, fiscal fragmentation then led to a collective action problem: each elite group had incentives to free ride on the contributions of others, thereby contributing less than the socially optimal amount to military protection. The elites and the ruler were stuck in a low-contribution and low-public-good-provision equilibrium. I argue that fiscal centralization provided an institutional framework that allowed elites to commit to contribute to military protection by ensuring others were contributing as well.¹¹

That collective action problems are inherent to fiscally fragmented states has been well documented. Ertman (1999, 50) notes about the Estates in Germany that: “the structure of the assemblies, divided as they were into separate curiae of élite groups each with their own distinct privileges, tended to inhibit cooperation among the curiae and lead the nobility, clergy, and the towns to focus on the defense of their narrow group rights.” Bates and Lien (1985, 57) quote from Henneman (1971) that “fiscal jealousies led towns to make subsidy grants conditional upon similar grants from other towns” in France. Summerhill (2008, 224–225) notes that because rulers bargained separately with each group, fiscal fragmentation led to free riding and lower fiscal revenues.¹²

I provide a game-theoretic framework to analyze the conditions under which corporate and local elites gain by surrendering to a central government their power to levy taxes.¹³ The analysis shows that an increase in the probability of a threat of external invasion or internal unrest is more likely to cause fiscal centralization when the elites are more dependent on the ruler for future economic rents, and when the prospects of economic activity are higher. To the extent that the stakes from military protection are aligned between the elites and the ruler, and the elites lack alternative ways to commit to cooperate for defense, the elites acquiesce to fiscal capacity centralization.¹⁴

Historical evidence from the increases in fiscal centralization and military build up in seventeenth century England and eighteenth century colonial Mexico provides support for the implications of the theoretical argument. The evidence highlights the importance of the Civil War for England and the Seven Years’ War for colonial Mexico, and the lack of standing armies in both regions, in aligning the benefit from military protection between the elites and the ruler.

I present the formal argument in Sect. 1. Section 2 confronts the theoretical argument with evidence from English and colonial Mexican history. The final section concludes with a discussion of the implications and further avenues for research.

1 Formal Model

This section provides a theoretical framework to explain why fiscal-military state building is more likely when the probability of a threat of unrest or invasion increases. The focus is on the conditions under which corporate and local elites have incentives to surrender their power to levy taxes to a central government.

1.1 The Game

A central government, henceforth referred to as a ruler, R, interacts with n economic corporations, indexed by i=1,…,n. These corporations are composed of agents that are able to make agreements binding on all their members.¹⁵

The ruler is threatened with an invasion (or unrest) with probability θ. A public good (G)—military defense—is necessary to defeat the invaders (or the unruly). In order to provide military defense, the ruler depends on the contributions of the corporations because initially fiscal capacity is fragmented. That is, the ruler depends on the corporations for the enforcement and collection of fiscal monies. The corporations levy taxes and transfer some of the proceeds to the ruler.

The ruler is able to enforce bilateral contracts with the individual corporations, and by means of these private contracts the corporations transfer part of their fiscal proceeds to the ruler. Each bilateral contract is observed only by the parties to the contract. A contract with corporation i specifies the amount x _i ≥0 of good i that the ruler provides to corporation i in exchange for a payment τ _i ≥0.¹⁶ Let (x,τ)=((x ₁,τ ₁),…,(x _n ,τ _n )) be the profile of the ruler’s unilateral offers to each corporation.

Under fragmented capacity, the corporations make contributions to the public good, g _i ≥0, that result in a level of the public good G=f(g), where g=(g ₁,…,g _n ), f is (strictly) increasing in g and $f_{g_{i}g_{j}}>0$ for i≠j. These contributions are voluntary because the ruler is unable to enforce them under fragmented fiscal capacity.

The ruler can propose to the corporations an increase in fiscal centralization, whereby the corporations surrender to the ruler the power to levy taxes. The increase costs F to the ruler. Under centralization, the ruler publicly announces and enforces uniform tax payments t≥0 from each i.

1.1.1 Timing

There are two periods. In the first period, all players observe θ. The ruler then chooses whether to propose an increase in fiscal centralization or to keep fiscal capacity fragmented.¹⁷ If proposing an increase in fiscal centralization, the ruler proposes a policy profile {t,x,G} consisting of tax payments, a vector of private goods, and a level of the public good. If not proposing centralization, the ruler proposes a “fragmented” policy profile {τ,x,g}, which includes a vector of payments, private goods, and contributions to the public good. Each corporation accepts or rejects the policy profile proposed by the ruler.

In the second period, if the ruler proposed an increase in fiscal centralization and at least $\bar{n}\leq n$ corporations accept, the ruler invests in a fiscal-military state and implements the policy agreed to in the first period.¹⁸ If less than $\bar{n}$ corporations accept, fiscal capacity remains fragmented, the ruler proposes a “fragmented” policy profile {τ,x,g}, and the corporations accept or reject the ruler’s proposal. If the ruler did not propose an increase in fiscal centralization, the ruler implements the “fragmented” policy profile agreed to in the first period.

1.1.2 Payoffs

A corporation’s payoff depends on the amounts of the private good, x _i , and the public good, G, and on (exogenous) overall economic activity, $\bar{y}$. Some corporations benefit more from military protection than others. A corporation is vulnerable to the threat (of an invasion or unrest) to the extent that the corporation depends on the survival of the ruler for future rents and protection. Let α _i ≥0 parametrize the degree to which corporation i benefits from the public good (G). A higher α _i implies greater dependence on the ruler and therefore a higher benefit from G.¹⁹ The (expected) payoff of each corporation (when fiscal capacity is fragmented) is:

$$u^F_i(x_i,G)=v(x_i,\bar{y})+ \theta\alpha_i y\bigl(f(g_i,g_{-i}),\bar {y} \bigr)-g_i-\tau_i-e_i. $$

where v and y are the values of the private and public goods, respectively, at a given level of economic activity, θ is the probability of a threat, τ _i is corporation i’s payment to the ruler, and e _i >0 is corporation i’s cost to collect taxes.²⁰ The function v is increasing and concave in x and $\bar{y}$, $v_{x_{i}\bar{y}}>0$ for all i, and $v(0,\bar {y})=0$. Accordingly, y is increasing and concave in G and $\bar {y}$, $y_{G\bar{y}}>0$, and $y(0,\bar{y})=0$. Recall that G=f(g _i ,g _−i ), where g _i is corporation i’s contribution to G. Each corporation’s payoff is a function of its individual exchange with the ruler if θ=0. If, by contrast, θ>0, the corporation’s payoff is also a function of the public good. The more a corporation depends on the ruler for economic rents (α _i ), the higher the benefit from the public good.²¹ Finally, for any θ, an increase in economic activity increases the payoff of each corporation.

If corporation i rejects the ruler’s fragmented policy proposal, x _i =0 and corporation i receives payoff $u_{0}=v(0,\bar{y})+\theta \alpha_{i} y(f(0,g_{-i}),\bar{y})$, where g _−i denotes the contributions of all other corporations given that corporation i is not contributing. There are positive externalities on those that do not contribute to building an army because f is increasing in g _−i for all i. That is, if θ>0, all groups with α _i >0 benefit and cannot be excluded from the military protection.²²

When fiscal centralization is implemented, the (expected) payoff of each corporation is:

$$u^C_i(x_i,G)=v(x_i,\bar{y})+ \theta\alpha_i y(G,\bar{y})-t, $$

where t is corporation i’s tax payment. (Recall the ruler sets t _i =t for all i when centralizing tax collection.) Because the ruler collects and enforces taxes under fiscal centralization, e _i =0 for all i.

The ruler’s payoff is the revenue obtained from corporations’ payments. Let c(x,G) be the cost of providing private and public goods in both fiscal regimes. Assume c is increasing and convex in x and G, and $c_{x_{i}x_{j}}=0$ and $c_{x_{i}G}=0$ for all i. Then, the ruler’s payoffs under fragmented and centralized fiscal capacities are, respectively:

1.2 Equilibrium

I solve for the pure-strategy subgame-perfect Nash equilibria (SPNE) of the game preferred by the ruler.²³ By backward induction, I first study the choice of payments and private and public goods proposed by the ruler under fiscal fragmentation.

If fiscal capacity is fragmented, corporation i accepts policy profile {x _i ,τ _i ,G} if and only if:

(1)

In the SPNE, the participation constraint in (1) binds for all i. Otherwise, the ruler would be able to increase his payoff by increasing the payment for some corporations. By solving for τ _i from each i’s binding participation constraint, we obtain the equilibrium payment $\hat{\tau}_{i}$ for each corporation. Substituting each $\hat{\tau}_{i}$ in the ruler’s objective function, the ruler’s set of profit-maximizing policies is:

(2)

Solving we obtain the unique $\hat{x}$ and $\hat{g}$ the ruler proposes to the corporations under fragmented fiscal capacity. Notice that the equilibrium amount of private goods is the same for all corporations because the choice of x is independent from α _i and g. The proposal $\hat{x}$ is also equal to the socially optimal amount x ^∗ such that $x^{*} \in\arg\max_{x\in\mathbb{R}^{n}} \sum_{i=1}^{n} v(x_{i},\bar {y})-c(x,G)$.

Lemma 1

The equilibrium level of public good provision under fragmented fiscal capacity is lower than the socially optimal: $\hat{G} < G^{*}$.

Proof

The socially optimal level of public good provision solves:

$$ G^* \in\arg\max_{g\in\mathbb{R}^n} \enspace\sum _{i=1}^n \theta \alpha_i y \bigl(f(g_i,g_{-i}),\bar{y}\bigr)-c(x,G). $$

(3)

The first order conditions: θ∑ _i α _i ∂y/∂G⋅∂f/∂g _i =∂c/∂G⋅∂f/∂g _i for i=1,…,n, characterize G ^∗. From (2), the first order conditions: θ∑ _i α _i ∂y/∂G⋅∂f/∂g _i −θ∑ _j≠i α _j ∂y/∂G⋅∂f/∂g _i =∂c/∂G⋅∂f/∂g _i for i=1,…,n, characterize $\hat{G}$. The result follows because f is increasing in g. (The solution is interior because of the assumptions on y and c.) □

Under fragmented fiscal capacity, each corporation has incentives to transfer resources to the ruler only to the extent that it receives x _i . The corporations free ride on others in their contributions to the public good, and the ruler has no means of enforcing these contributions. Internalizing the lower contribution of each corporation, the ruler’s choice of G is lower than the socially optimal.

Lemma 1 allows us to define the social cost due to free riding as the increase in the aggregate value from public good provision if the corporations were able to commit to pay: $Y(G^{*},\bar {y})-Y(\hat{G},\bar{y})>0$, where $Y(G,\bar{y})= \sum_{i=1}^{n} y(G,\bar {y})=ny(G,\bar{y})$. If the groups were able to coordinate and police themselves to commit to pay, there would be no cost from the free riding problem. The difference $Y(G^{*},\bar{y})-Y(\hat{G},\bar{y})$ increases when the groups interact only with the ruler and are unable to solve the collective action problem among themselves.

1.3 Investment in fiscal centralization

First, notice that when fiscal capacity is centralized the ruler maximizes fiscal transfers by choosing the socially optimal amount G ^∗. Each corporation faces the following participation constraint when the ruler proposes centralization:

(4)

The right hand side of (4) is constant and given by the equilibrium policy profile $\{\hat{\tau},\hat{x},\hat{g}\}$. The corporations can refuse centralization and force the ruler to keep fiscal capacity fragmented. Summing over n and solving for t, we obtain $nt\leq\sum_{i} [v(x_{i},\bar{y})+\theta\alpha_{i} y(G,\bar{y})] - C$, where C is a constant. It follows that $u_{R}^{C}(x,G)\leq\sum_{i} [v(x_{i},\bar{y})+\theta\alpha_{i} y(G,\bar{y})] - C- c(x,G)-F$. Therefore, the ruler sets the maximum upper bound on net fiscal transfers by choosing G ^∗ as defined in (3).

Two conditions must hold for fiscal centralization to occur. First, the participation constraint in (4) must hold for at least $\bar {n}$ corporations. The corporations can refuse centralization and the ruler has no credible threat but to preserve fiscal fragmentation. Second, the ruler’s payoff must be higher under centralization than under fragmentation. If the ruler’s payoff given the tax payment necessary to obtain compliance from $\bar{n}$ corporations is less than the payoff from $\{\hat{\tau},\hat{x},\hat{g}\}$, the ruler does not propose centralization.

Substituting in (4) for $(\hat{\tau}_{i},\hat{x}_{i},\hat{g})$ and solving for t we obtain the maximum tax payment that each corporation is willing to pay in exchange for the optimal level of the public good:

(5)

A couple remarks about this maximum tax payment are in order. First, the ruler obtains higher maximum payments from those corporations who benefit more from the public good (α _i ). Second, the ruler can obtain compliance from corporation i at a tax payment higher than the maximum in (5) by compensating with private goods (a higher x _i ) or if the prospects of economic activity increase.

I first obtain the SPNE assuming the ruler can collect corporation-specific tax payments and provides the socially optimal amount of private goods x ^∗. The constraints in (5) bind for all i, otherwise the ruler would be able to increase his payoff by increasing the tax payment for some corporations. Let $t^{*}_{i}\equiv v(x_{i},\bar{y})+\theta\alpha_{i} [y(G^{*},\bar{y}) -y(f(0,g_{-i}),\bar {y})]$ be the binding constraint in (5) for i. The following proposition gives the condition under which policy profile {t ^∗,x ^∗,G ^∗} is an equilibrium for $\bar{n}=n$, where $t^{*}=(t^{*}_{1},\ldots, t^{*}_{n})$.

Proposition 1

At the SPNE, the ruler proposes policy profile {t ^∗,x ^∗,G ^∗}, all corporations accept and the ruler increases fiscal centralization if the probability of a threat is such that:

(6)

Proof

The ruler proposes a transition if and only if $\sum_{i} t^{*}_{i} -c(x^{*},G^{*})-F \geq u_{R}^{F}(\hat{\tau},\allowbreak\hat{x},\hat{G})$. Substituting in for $t^{*}_{i}$ and $\hat{\tau}_{i}$, and solving for θ gives condition (6). Note that by Lemma 1 and since y is increasing, $Y(G^{*},\bar{y})-Y(\hat{G},\bar{y})>0$. □

Condition (6) shows that an increase in fiscal centralization depends on the cost increase to the ruler from providing the optimal amount of public good and on the corporations’ overall gain from overcoming free riding, relative to the probability of a threat. Notice that the lower the average corporation’s dependence on the ruler (∑ _i α _i /n), the higher the probability of a threat needs to be for the ruler to propose centralization. That is, fiscal centralization occurs for smaller values of the probability of a threat, the smaller the divergence between the corporations’ and the ruler’s benefit from military protection. Also, centralization occurs for smaller values of θ if the prospects of economic activity $(\bar{y})$ increase, because the stakes of all parties increase. If condition (6) does not hold, the ruler proposes a fragmented policy profile and fiscal capacity remains fragmented.

The tax policy $t^{*}=(t^{*}_{1},\ldots, t^{*}_{n})$ is not an equilibrium strategy if $\bar{n}<n$.²⁴ For $\bar{n}<n$, the ruler optimizes by setting a tax policy such that constraint (5) binds for exactly $\bar{n}$ corporations. Under fiscal centralization, the ruler can use its monitoring and enforcing capacity to oblige the remaining $n-\bar{n}$ corporations to pay a tax rate higher than their maximum tax rate. I derive below the SPNE when the ruler sets a uniform tax payment for all corporations under centralization and $\bar{n}<n$.

Definition 1

For some t proposed by the ruler, corporation i is pivotal if $t^{*}_{i}\geq t$ and $m(i)+1=\bar{n}$, where $m(i)\equiv\#\{j | t^{*}_{j}>t^{*}_{i}\}$ is the number of corporations whose maximum payment exceeds i’s maximum payment.

When proposing centralization, the ruler maximizes his payoff and ensures compliance from $\bar{n}$ corporations by proposing the tax payment of the pivotal corporation for a given (x,G). Let corporation p, with corresponding $t^{*}_{p}$, be the pivotal corporation when the ruler proposes (x ^∗,G ^∗).²⁵ The following result gives the condition under which the policy profile $\{t^{*}_{p},x^{*},G^{*}\}$ yields centralization in equilibrium. I assume a corporation accepts if indifferent.

Proposition 2

At the SPNE, $\bar{n}$ corporations accept policy profile $\{t^{*}_{p},x^{*},G^{*}\}$ and the ruler invests in a centralized fiscal administration if the probability of a threat of invasion or unrest is such that:

(7)

Proof

The ruler proposes a transition if and only if $nt^{*}_{p}\geq u_{R}^{F}(\hat{\tau}, \hat{x},\hat{G})$. Substituting in for $t^{*}_{p}$ and $\hat{\tau}_{i}$, and solving for θ gives condition (7). □

The gain from providing the optimal amount of military protection is now weighted by the vulnerability to a threat of each corporation relative to that of the pivotal corporation. If the pivotal corporation has a degree of vulnerability higher than the average, the transition to centralization occurs for a lower probability of the threat than in Proposition 1, all else constant.²⁶ However, if the pivotal corporation has a lower benefit from the public good than the average corporation, the condition in Proposition 2 does not hold and the ruler does not propose centralization even though it is socially optimal. This occurs because the ruler endures a loss in fiscal revenue from requesting a uniform transfer rather than discriminating across corporations according to their benefit from the public good.

1.4 Implications

Both Propositions 1 and 2 highlight the main implication from the analysis. An increase in the probability of a threat is more likely to cause an increase in fiscal centralization and military build-up, the higher the corporations’ stakes on the survival of the ruler for their economic future. The higher the corporations’ dependence on the ruler for future rents, the higher is the benefit from the provision of the optimal military protection, and the more that the corporations are willing to transfer under centralization. Also, all else equal, a higher level of economic activity facilitates centralization by increasing the maximum a corporation is willing to pay under centralization and by increasing the social gain from overcoming free riding. A fiscal regime may therefore remain fragmented because the alignment between the benefits to the ruler and the corporate elites from military protection is small, or the ruler’s cost of investing in centralization is too high.

Proposition 2 shows in addition that if the ruler is unable to collect corporation-specific payments (and is thus unable to extract all the corporations’ benefits from the public good), an increase in fiscal centralization depends on the size of the ‘accepting’ coalition ($\bar{n}$). In particular, we may not observe centralization when it is socially optimal, if the pivotal corporation has a lower benefit from the public good than the average corporation.

Finally, a couple remarks about the theoretical framework are in order. First, the analysis emphasizes that unless the ruler has the support of some of the corporations, the increase in fiscal centralization and military build up are not feasible. The corporations can refuse centralization and the ruler has no credible threat except to preserve fiscal fragmentation. If, however, the ruler has alternative or external sources of revenue to finance an army or impose centralization, negotiation with the corporations may not play such an important role.

Second, the setup implicitly assumes the ruler has the authority and the ability to propose and implement centralization. For the results to hold, the ruler must have legal authority and the corporations must believe the ruler can credibly monitor and enforce tax collection. Lacking a central actor with legal authority or the credible ability to monitor and sanction, an increase in the probability of internal or external threat will not lead to an increase in fiscal centralization.

2 Historical Evidence

To provide support for the theoretical argument, this section discusses historical evidence from the transition to a fiscal-military state in seventeenth-century England and eighteenth-century colonial Mexico.²⁷ I organize the evidence around the two main factors highlighted by the theoretical analysis leading to a fiscal-military reform: (1) military vulnerability and the alignment between the corporate elites’ and the ruler’s benefit from military protection, and (2) the need for rulers to negotiate with the corporate elites to obtain their compliance. Section 2.1 presents evidence for England while Sect. 2.2 discusses the evidence for colonial Mexico.

The cases of England and Mexico are pertinent because they allow us to isolate the public good nature of military protection. When an army is created with predatory goals and the spoils of war exclusively assigned to specific groups, military protection confounds both a private and a public good nature. The objectives (at least initially) of the build up of a fiscal-military state in seventeenth-century England and eighteenth-century Mexico were defensive. The historical evidence below shows that they both lacked armies and had enjoyed relatively long periods of no military involvement prior to the increase in the probability of a threat.

Also, the cases of England and colonial Mexico corroborate the importance of a ruler or central government with the credible authority and ability to implement the fiscal-military reforms. Brewer (1989) notes the importance of the British crown’s recognized authority and infrastructure in the administration of justice for their success in building a fiscal-military state. In colonial Mexico, the wars of independence (1810–1821) and resulting political instability provide an example of the importance of legal authority. The internal and external threats faced by the elites in different regions in the aftermath of independence from Spain did not lead to centralization. It took almost fifty years for the region to stabilize its newly minted state. Centeno (2002) argues that this was a result of the authority void left by the Spanish crown: no group was superior to the rest.

2.1 England

In contrast to other European nations, England lacked a standing army from the late fifteenth to the late seventeenth centuries. Its landed aristocrats were also effectively demilitarized; by the 1640s “four out of five aristocrats had no military experience at all” (Brewer 1989, 12). This was partly a result of England’s non-involvement with major international conflicts during that time-period. According to Brewer (1989, 12), “England was sheltered not just by her insular position but by the scale of war in early modern Europe.” The large increase in army sizes and number of troops deployed made an invasion of England complicated, and an English invasion of the continent difficult. English naval power only began to be established in the second half of the seventeenth century. Castilian and French fleets managed to seize and sack various English ports during the Hundred Years war. Further, prior to the seventeenth century, the navy depended heavily on private support and armed merchantmen ships.²⁸

The Civil War (1642–1651) marked a turning point for the need to secure the state against domestic rivalries. An interregnum of civil warfare and challenges to hierarchy created the conditions for a watershed in England’s fiscal and military history. Importantly, the succession of events “forged a political consensus among England’s wealthy elites for an altogether stronger and more centralized state, above all to maintain order and political stability, but also to afford greater protection for the economy’s growing commercial interests overseas” (O’Brien 2011, 426). The threat of internal political stability together with the lack of military protection provided the conditions for an alignment of the executive’s and the elite’s benefit from creating a standing army and strengthening the navy.

The important role played by Parliament in fiscal matters gives evidence of the need to negotiate and obtain cooperation from the wealthy elites. Parliament decided on the selection of the levels and types of taxes, the rules for their assessment and collection, and had control over the state departments in charge of implementing those rules.²⁹ In fact, the landed elites set the terms for cooperation by initially avoiding direct taxes on land. It was not until 1799 that Pitt managed to introduce Britain’s first income tax.³⁰ “Only the armies of Revolutionary France and the probable collapse of public credit prompted the political classes to accept [direct taxation]” (O’Brien 1988, 22).

In sum, English fiscal history shows the importance of a threat of internal unrest (evident after the Civil war) in increasing fiscal centralization. By aligning the benefit from military protection for a majority of the wealthy elites and monarch, a transition out of a low-contribution and low-public-good-provision was possible. Also, the role played by parliament attests to the need to negotiate with the elites and to the importance of centralized and public fiscal policies to ensure every elite group that others were cooperating and contributing with the forging of a fiscal-military state.

2.2 Colonial Mexico

The Spanish crown faced practically no internal or external challenges in its American territories during its first 200 years of colonial rule.³¹ The crown did not need to incur in major expenses to defend its colonial territory and relied only on minimal forces at the ports and borders for the protection of the Spanish American empire.³² The vulnerable position of colonial Mexico is evidenced by the efforts to garner a field army in 1762 in the port of Veracruz, on the coast of the Gulf of Mexico.³³ This port was the point of entry and exit for all European trade with New Spain, and therefore one of the most guarded locations in colonial Mexico. In 1760, the port and fortress were guarded by around 1,000 men.³⁴ The port of Veracruz was vulnerable to attack just before the end of the Seven Years’ War. The Viceroy Marqués de Cruillas spent 3,398,471 pesos of extraordinary funds to ready the fortifications and mobilize a force of 8,500 men in and around Veracruz.³⁵ This was a force eight times the size of the previous force. Notwithstanding, according to the Viceroy, a much larger force was necessary to ensure the security of the kingdom.³⁶

The lack of military protection in conjunction with the Seven Years’ War (1756–1763) identify a watershed in colonial Mexican history. The Seven Years’ War changed the balance of power within colonial territory among the European powers.³⁷ In 1756, France declared war on Great Britain. This was the beginning of the French-Indian War, as the conflict was known to the colonists. The war was a struggle for primacy between Britain and France. For the first time in European history, battles occurred in colonial territory.³⁸ There were battles in India, North America, the Caribbean isles, the Philippines, and coastal Africa, and Europe. By the autumn of 1760, all French territory in mainland America was in British hands. An agreement made in August 1761 between the Bourbon kings of Spain and France, the Family Compact, brought Spain into the war. In August of 1762, the British Royal Navy captured Havana, Cuba, and Manila in the Philippines. The war ended following the Treaty of Paris on February 10, 1763, with a victory for Great Britain, who emerged as the dominant European power.

The military defeats suffered by Spain during the Seven Years’ War highlighted the need to secure Spanish colonial possessions against British attack. Also, because of the demographic recovery of the Indian population in the first half of the eighteenth century, many provinces in colonial Mexico saw internal unrest increase to new levels.³⁹ The Seven Years’ War, together with the increased Indian unrest, marked the fiscal centralization and military reorganization undertaken by royal officials in the second half of the eighteenth century.

A growing body of scholarship demonstrates that centralization was pursued through bargaining, compromise, and political contestation between crown officials and the main elites and local authorities.⁴⁰ There were few military or police forces in the Spanish colonies that the crown could rely upon for a top-down imposition, at least in the initial stages of reform. Furthermore, because net transfers were always positive from the Americas to Spain, the fiscal-military transition could not have been financed with continental monies.⁴¹

Reform was more successful in the regions where the elites’ network of privilege and patronage relied on the existence of the Spanish monarch and were more affected by the British threat. In the imperial capitals Mexico and Peru, and in Veracruz, Cuba and coastal regions of Panama and Colombia the crown’s officials transformed the state administration into a more highly structured apparatus, increased fiscal revenues by means of a larger and more efficient fiscal bureaucracy, and renovated military establishments to a larger extent than in other regions.⁴²

Failed attempts to implement fiscal reform earlier in the colonial period also attest to the importance of the Seven Years’ War. In 1626 the Count-Duke of Olivares attempted a fiscal reform through the creation of the Union of Arms with the goal of sharing the burdens of defense in mainland Europe between the Spanish kingdoms and the Spanish American colonies. A fixed annual contribution was demanded from every part of the empire. Colonial territory, however, was not subject to territorial threats and the colonial elites resisted the fiscal reforms. Only temporary increases to trade tax rates took effect.⁴³

The evidence of negotiation with the elites, and earlier failed attempts to increase fiscal centralization, provide evidence for the inability to implement reform in colonial Mexico lacking an alignment between the fate of the crown and that of the local and corporate elites regarding the provision of military protection.

3 Conclusion

This chapter contributes to the literature by providing a complementary mechanism for why threats of external invasion or internal unrest can lead to increases in fiscal centralization. Fragmented fiscal capacity leads to free riding in the face of a threat. Fiscal centralization provides an institutional framework that allows elites to commit to contribute to military protection by ensuring others also contribute. The analysis shows that, even if there is agreement on the need to provide military protection, it is not until a majority of the fiscally powerful have stakes on the survival of the ruler for their economic future (and so their benefit from military protection aligns with that of the ruler) that they can agree to the centralization of fiscal capacity.

The analysis here highlights two issues that suggest avenues for future research. First, the theoretical argument assumes the ruler can commit to implement the policy profile agreed to before the increase in centralization. Once a ruler invests in fiscal centralization, the ruler could renege on the policy agreement and unilaterally increase future taxes or default on its debts.⁴⁴ Reputation, however, limits the ruler’s incentives to renege on his agreements. If the future is sufficiently important, the ruler has a reputation to maintain. Scholars have argued, however, that in some cases reputation may not be enough to limit rulers, and that more elaborate institutional arrangements may be required (e.g. institutions of representation).⁴⁵

My analysis complements this literature on the need to constrain the ruler by emphasizing another commitment problem—that between the elites resulting from free riding under fragmented fiscal capacity. The results suggest that guaranteeing credibility from the ruler may not be enough. If the benefit from overcoming free riding is not sufficiently large, both the ruler and the corporations prefer fragmented capacity. The results also suggests that institutions of representation are not necessary, at least in the initial stages of fiscal centralization, to the extent that the corporate elites’ and the ruler’s benefits from military protection are aligned in response to a threat. The case of colonial Mexico corroborates that institutions of representation are not necessary for the elites to agree to fiscal centralization. Future research needs to study more carefully the timing between centralization and representation and the links between the two commitment problems mentioned.

Second, the theoretical argument does not incorporate dynamics to explain whether the investments in fiscal capacity are irreversible. Why should we not observe a reduction in fiscal centralization once the threat disappears? Incorporating the complementarity between the creation of a standing army and a fiscal administration with monitoring and enforcement capabilities, could make an increase in fiscal centralization difficult to reverse. In addition, the sunk-cost nature of the investment in fiscal centralization can lead to irreversibility after the threat disappears, all else constant.

Both the theoretical argument and the evidence from England and colonial Mexico emphasize the defensive, public-good aspect of military protection in leading to an increase in fiscal centralization. In so doing, the analysis here may tell us something about the evolution of fiscal capacity at other times and places. For a state relying on fragmented fiscal capacity to increase fiscal centralization, a sufficiently large shock jointly affecting the income of both the central government and the relevant fiscal actors is necessary. Two conditions are key: that the shock creates a collective action problem among the key actors, and that those actors believe the ruler can credibly monitor and enforce tax collection. The new fiscal regime allows for the coordination of policies and the enforcement of contributions.