Growing Pains: Transactions Costs and the Development of Fiscal Capacity

Scholarship has perceived state modernisation as a process through which transaction costs faced by economic actors were decreasing, this was to be particularly the case with trade (North, 1985; Greif, 2000). Yet although modernising states were able to mitigate the type of costs identified by North (1985, 1990) and Greif (2000) through contract enforcement and provision of the rule of law and system of litigation, at the same time new transaction costs arose from the development of the state itself. Since states needed revenues to pay for these increased capacities, they imposed taxes on economic actors and with them also new transaction costs. This aspect has been underappreciated. 

Our paper explores the case of the building of the fiscal state in Britain in the seventeenth and eighteenth centuries and the transaction costs that were imposed on merchants in the process. We document the complexity of the taxation regime arising from earmarking debt and debt servicing to specific taxes in the period between the 1660 and the reforms of William Pitt the Younger in 1780s. We show that although earmarking was an effective way for the state to showcase fiscal credibility, in the case of trade this instrument resulted in convoluted tax code. The tax administration lacked the administrative capacity that the extraordinary complexity of an earmarks-based system required. The solution to this problem was twofold; first, substantial transaction costs needed to be absorbed within the state and paid for by merchants. Second, the state eased the strain on its administrative capacity by relying on the East India Company for the administration and collection of customs on goods from the East Indies. 


Karolina Hutková is a post-doctoral researcher at University of Oxford. The paper is co-authored with Ernesto Dal Bó, Lukas Leucht, Ayman Moazzam, Noam Yuchtman. 

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