By Shanta Devarajan

Resource-rich countries have weaker governance (Figure 1). This widely documented finding has led to the suggestion that the people in these countries may be better off if the government transferred the oil revenues directly to the citizens (see here, here, and here.) But this raises the question: Why would the elites in government, who are clearly benefiting from these resource rents give them up as cash transfers to the people?

Figure 1. Resource-rich countries have weaker governance

In a recently published paper, Quy-Toan Do and I provide a partial answer to this question. We start by noting that, in addition to weak governance, resource-rich countries also have lower levels of taxation (Figure 2).

Figure 2. Resource-rich countries also have lower levels of taxation

By definition, resource-rich countries do not need to rely on fiscal revenues because they have resource revenues. But this also may be why these countries have weak governance. Taxation has traditionally been a way for citizens to hold governments accountable for public spending. In resource-rich countries, where the oil revenues (say) go directly from the oil company to the government without passing through the hands of the citizens, the government officials have more control in spending the money, including on their own family and friends.

We formalize this intuition in a game-theoretic model where the choice of good governance is costly:  government can choose to be accountable (so that public projects are successful, but it earns little as kickbacks) or corrupt (where projects are less successful but the government gets greater “private” benefits from the projects). In addition to resource revenues, the government can earn fiscal revenues by taxing the citizens. Citizens can choose to pay taxes (if they believe the government will be accountable) or not (if they think the government will be corrupt). Therefore, good governance is a necessary condition for citizens to comply with their tax obligations.

With this simple framework, we derive four possible scenarios, each of which is a unique equilibrium, depending on certain parameters.

1. The resource curse: The resource revenues are so large that the government does not need tax revenues to finance public projects. In this case, the government chooses to be corrupt and build poor-quality public projects but ones with private benefits. Knowing this, citizens refuse to pay taxes. The result is an equilibrium with low taxation and weak governance—not unlike many of the resource-rich countries at the bottom of the two figures above.
2. Credibility trap: Either because of decreased revenues from lower prices or declining reserves or because of increased expenditures due to a growing and aging population, the government can no longer rely exclusively on resource revenues to finance public projects. It needs to raise taxes. But the citizens will only pay taxes if they are confident that the government will not embezzle the money. Given its reputation for corruption, the government cannot credibly commit to being accountable. Once the citizens pay the taxes, the government, having promised to be accountable, has an incentive to steal the money. So taxation remains low and governance weak, even though everybody will be better off with high taxes and accountable government.
3. Cash transfers: Caught in the credibility trap, the government transfers some of the resource revenues as cash transfers to citizens. Now the government’s incentives have changed. If it is corrupt, citizens will withhold future tax payments, and the government would have forgone both the tax revenue and the cash transfers. This makes the cost to the government of being corrupt too high, and it decides it will be accountable. Realizing this, citizens pay their taxes, and the economy achieves the high tax/strong governance combination. This is the situation where even a corrupt government will find it in its interest to give cash transfers to citizens as a way of increasing the costs to itself of being corrupt. This signal has the effect of inducing citizens to pay their taxes.
4. Poverty trap: If, while in the credibility trap, the government does not transfer cash to citizens, it will remain in the trap, with less productive projects. The result could be that resource revenues continue to decline (because of unproductive investments) and the economy reaches a point when, even if the government wanted to, there are not enough revenues to transfer to citizens to build credibility. In this case, the economy is destined to remain in a poverty trap.

Transferring resource revenues to citizens always made good economic sense, but it was not clear whether it made good political sense. When governments need tax revenue and cannot credibly commit to being accountable (especially given their track record when resource revenues were plentiful), then cash transfers can provide the government with incentives not to be corrupt—and citizens with a signal that, in fact, the government will now be accountable. As fossil fuel prices decline because of carbon taxation, and government expenditure needs rise from population growth or the desire to build a new capital city (to take an example), the credibility trap scenario is likely to become common among resource-rich countries. Cash transfers are an economically and politically feasible way of escaping the trap.