State capacity, redistributive compensation and the political economy of economic policy reform

If governments can compensate “losers” from large-scale economic reform, such as trade liberalization, by redistributing some of the “winners'” gains, then any potentially Pareto-improving reform should be implemented. However, in many economies, the state's capacity to identify and tax winners is limited. How do such limitations impact the adoption of reforms? We show that for reforms where the distribution of winners and losers is exogenously given, higher state capacity unambiguously helps the adoption of Pareto-improving reforms. However, for reforms which require individual investment decisions by potential winners, better state capacity may not always translate into higher political support for reform.