- January 2015
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- This paper presents a theory explaining how trade policy is contingent on the development of fiscal capacity. The paper investigates the conditions under which mercantilism is adopted as a substitute for taxation when fiscal capacity is weak, when mercantilist revenue is reinvested in developing fiscal capacity, and when economies endogenously abandon mercantilist practices and embrace free trade. If mercantilism is pursued when the stock of fiscal capacity is too low, the economy eventually falls into a protectionist trap, characterized by low income and low taxes. If mercantilism is adopted when the initial stock is large enough, then mercantilist revenue is invested in the expansion of the fiscal bureaucracy of the state. Eventually, the economy moves from the mercantilist-equilibrium to the free trade-equilibrium, where both income and taxes are high. The empirical implications of the model are examined against historical European data from 1820 to 1950.