Economists generally assume that the state has sufficient institutional capacity to support markets and levy taxes. This paper develops a framework where \"policy choices\" in market regulation and taxation are constrained by past investments in legal and fiscal capacity. It studies the economic and political determinants of such investments, demonstrating that legal and fiscal capacity are typically complements. The results show that, among other things, common interest public goods, such as fighting external wars, as well as political stability and inclusive political institutions, are conducive to building state capacity. Some correlations in cross-country data are consistent with the theory.
American Economic Review (2009) 99 (4): 1218–44. [doi: 10.1257/aer.99.4.1218]