This paper explores these issues formally, presenting four variations on a model featuring a
ruler and a firm. (Reducing “society” to a single economic actor is an analytical convenience:
we are interested in what the model says about the incentive to provide differential support
to firms or sectors which differ in their taxability, which we parameterize in the model.) The
former has the ability to provide support to the latter, but will do so only to the extent that
she expects a return on her “investment.” Since support enhances economic productivity,
that return may come in the form of revenues collected following production. However, only
revenues unhidden may be collected, so both the taxability of economic activity and the
extent to which the ruler is able to commit to leaving the firm with a portion of unhidden
production will affect the provision of support.
As will be seen, in all but the most limiting scenario the ruler will have an incentive to
provide more support to firms which are more taxable. Economic actors have an incentive
to hide production from the state when the ruler is unable to commit to leaving behind a
portion of unhidden production, and need to be compensated for forgoing that option when
the ruler can commit. Given that some actors will find it easier to hide revenues than others,
revenue-maximizing rulers will typically favor economic activity which is more taxable, i.e.
favor those firms which find it harder to hide production from the state.
When the ruler
cannot commit, she anticipates that the amount of revenues she can seize after production
takes place will be greater with more taxable firms.
Consequently, she will provide more
support to firms which are more taxable.
When the ruler can commit, firms may avoid
5
Convention