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For politicians in office, reforming public sector institutions is an investment; they must spend resources now in order to achieve future gains. There are no property rights attached to these institutions. Therefore, politicians need to remain in control if they are to reap the full benefits of reform. When the probability of re-election is unaffected by the reform choice, political polarisation between incumbent and challenger results in a lower critical value for the cost of investment by reducing the benefits of reform compared to a benchmark of no uncertainty. The reduction in the cut-off rate is increasing in the degree of polarisation. However, if undertaking reforms increases this probability, the likelihood of investment might increase, the more so the greater the polarisation in preferences.

Public sector institutions matter for economic performance. This intuitive proposition has recently received strong empirical support. For example, Hall and Jones (1998) find that differences in institutional quality explain much of the variation in production per worker between countries, Knack and Keefer (1995) show that investment and growth is higher in countries where property and contract rights are better protected, and Knack (1996) and Keefer and Knack (1997) demonstrate that the extent to which poor countries catch up with rich ones is a function of the quality of their public institutions.1 Why some countries adopt more efficient institutions than others and why countries with inefficient institutions do not reform them are thus important questions. In this paper, I develop a model of institutional reform in the context of political instability and polarisation. Other researchers have found that political instability and polarisation have a negative impact on savings, investment, and growth.2 Explanations of these results usually focus on the actions of private investors. For example, political instability in combination with polarisation implies uncertainty about future economic policies. Such uncertainty could reduce private investment in irreversible capital. I demonstrate that political instability and polarisation might also affect aggregate economic performance through a different channel, namely, the efficiency of public sector institutions. From the point of view of a politician holding office today, creating or reorganising public sector institutions is an investment; in order to realise future gains, he must spend resources at his disposal now. These resources could have been utilised for current purposes, thus creating an opportunity cost of institutional change.3 An important feature of public sector institutions is that there are no property rights attached to them. Often, therefore, a politician can only reap the fruits of his efforts in building institutions as long as he retains control over them. It follows that his expected tenure is an important determinant of the expected benefits from such activities. In democracies, the expected tenure of a politician is usually closely linked to elections.4 I show that as the probability of retaining office increases, the likelihood of reforms being undertaken increases too. The intuition is that a higher probability of reelection implies that a greater share of the benefits of reform are appropriated by the person making the investment decision.5 For politicians who are policy-motivated, political polarisation strengthens the effect of political instability on reform incentives. When an office-holder is purely motivated by policy concerns, he is indifferent between continuing in office and being replaced by another politician with identical preferences. Thus, while political instability affects the likelihood of “good” or “bad” states occurring, political polarisation determines how much worse the “bad” state is than the “good”. The greater the differences between an incumbent and his challenger(s), the weaker are the incentives to reform public sector institutions for a given probability of remaining in office. There might also be a third effect in operation: if investing in public sector institutions affects the probability of retaining office, the calculus of the incumbent is changed. Obviously, if sacrificing current resources for future gains reduces this probability, he will be less likely to do so. But if investing in the institutions he controls today improves his chances of staying put, there are benefits from doing so over and above those relating to increases in future output or the production of new goods and services. Therefore, the effect on the desirability of reforms in the eyes on an incumbent politician can depend crucially on whether such acts affect the reelection probability and if they do, in what direction. And in sum, political polarisation combines with political instability to determine the net incentives for changing the institutional structure of the public sector.

In this paper, I have demonstrated the potentially adverse effects of political instability and polarisation on public sector institutional development. If the probability of staying in office is unaffected by the incumbent's investment decision, political instability increases the hurdle that has to be surpassed for such resource-use to be optimal. The adverse effects are aggravated by political polarisation, and the disincentive generated by polarisation is larger the greater the disagreement between incumbent and challenger. Only if the relationship between political uncertainty and reforms is such that investment significantly raises the probability of staying in power will such uncertainty be conducive to reforms. The reason is that the gain from an increase in the probability of retaining office then outweighs the direct negative effect of the presence of political uncertainty. If this is the case, political polarisation will actually spur investment. While the model is simple, I believe that the issue discussed here is important because uncertainty is an integral part of every political environment no matter its formal characteristics. Furthermore, recent research emphasises the empirical importance of public sector institutions for economic performance. Moreover, Svensson (1998) has tested the predictions of his model of public sector institutional reform and political instability. As noted in Section 2, this model is similar to mine with two major exceptions: (i) he models judicial reforms which have a direct impact on private investment and (ii) political instability is exogenous. In the empirical analysis, however, he takes into account the possibility of reverse causality from economic performance to political stability. He finds that political instability and polarisation has a negative impact on public sector institutional quality and total investment in his sample. That risk-averse investors respond negatively to uncertainty about the returns to investment is well-known. In this paper I have pointed out that such effects are present in the public sector as well even though politicians do not enjoy property rights over those institutions. Uncertainty about control rights generates the same kind of consequences. Moreover, it interacts with political disagreement between politicians who compete for the same office, a factor not present in the calculus of private investors. The model presented here also demonstrates the possibility of reversing the impact of insecure returns to investment, a less obvious result. This can happen when investment influences the probability distribution of its “returns”. It is difficult to come up with examples of a similar effect in the context of private investment decisions.35 The word reform has positive connotations. Furthermore, in this paper I have spoken about the disincentives to reform generated by political uncertainty while noting that in some cases we might see “over-investment” compared to the yardstick of complete security of tenure. Therefore, by way of conclusion, let me emphasise that the results obtained here should not be interpreted in a normative manner. For instance, while my model predicts that in conditions of political uncertainty and conflict there might be comparatively fewer reforms of public sector institutions relative to more stable environments, in and of itself this need not be a bad thing. Reforms do not have to constitute an improvement compared to some status quo when evaluated according to a normative theory such as welfare economics. For example, when reforms are sought for purely partisan purposes, say to benefit some constituency of the politicians in power, overall welfare need not improve. Polarisation of preferences might then result in public sector institutions serving purposes at odds with the goals of a large part of the citizenry. If power does change hands rapidly, a sizeable share of the resources commanded by the public sector might be wasted on undoing the administrative reforms of the previous governments and putting up structures and procedures to serve the current office-holders. By reducing the gains from reforms and thus the incentives to engage in the restructuring of institutions created by past decision-makers, political uncertainty might actually be welfare-improving. It goes without saying that the conclusion would be the opposite if inefficient institutions prevail because would-be reformers are not certain that the benefits they see will be realised in the future. Hence, the merits of (non-)reform must be judged in the context of concrete cases.