Fiscal Capacity, Tax Composition and the (in)Stability of Government Revenues in the Interwar Period∗

Large changes in government revenues can have disruptive effects on the action of states and increase uncertainty in the economy. In the interwar period, and during the Great Depression years in particular, many countries experienced such events. This paper investigates how the composition of taxes and countries’ fiscal capacity interacted with economic conditions to determine the evolution of government financing. The results highlight an important role for fiscal capacity in reducing its cyclical volatility. The evidence also indicates that this mitigating effect worked mainly by providing an easier access to borrowing, whereas there is no conclusive evidence for a dampening in the volatility of tax revenues. These findings have significant bearing on the debate regarding policy responses to the Great Depression, indicating that governments were constrained in their actions by past investments aimed at building up fiscal systems. They also lend support to the hypothesis that institutionally-based borrowing constraints can play an important role in fiscal policy procyclicality. This paper also contributes to recent research highlighting the importance of fiscal development by demonstrating the impact of fiscal capacity on cyclical variables. By presenting a novel dataset on the composition of tax revenues at the central and local level, the paper also contributes to a better understanding of the fiscal history of a period, which, in many countries, marked the beginning of far-reaching changes in the role of governments in the economy and in the structure of taxation. JEL: N10, N40, E32, E62, H11, H72