State Capacity and Economic Development: A Network Approach. NBER Working Paper 19813

We study the direct and spillover effects of local state capacity using the network of Colombian municipalities. We model the determination of local and national state capacity as a network game in which each municipality, anticipating the choices and spillovers created by other municipalities and the decisions of the national government, invests in local state capacity and the national government chooses the presence of the national state across municipalities to maximize its own payoff. We then estimate the parameters of this model using reduced-form instrumental variables techniques and structurally (using GMM, simulated GMM or maximum likelihood). To do so we exploit both the structure of the network of municipalities, which determines which municipalities create spillovers on others, and the historical roots of local state capacity as the source of exogenous variation. These historical instruments are related to the presence of colonial royal roads and local presence of the colonial state in the 18th century, factors which we argue are unrelated to current provision of public goods and prosperity except through their impact on their own and neighbors ’ local state capacity. Our estimates of the effects of state presence on prosperity are large and also indicate that state capacity decisions are strategic complements across municipalities. As a result, we find that bringing