Policymakers considering state governance reform face two main challenges. First, in many cases improvements in state governance are intangible or are not immediately verifiable by the citizenry. Second, having been deceived by their totalitarian regimes for decades and left unsatisfied by the unfulfilled promises put forward by recent reform programs, citizens in transition economies are skeptical about the intentions of any state-initiated programs. The government thus has to make credible commitments in order to convince the citizenry that establishing the rule of law is desirable for the government itself.

Consider an economy consisting of a firm, a politician (representing the government), and an entrepreneur (representing the private sector). The politician has a limited tenure of two periods. Initially, the government owns the firm, but it delegates its management to the entrepreneur, who receives a fixed wage. The entrepreneur derives utility only from his income; the politician derives utility from government income (now the profit of the firm) and the number of his or her subordinates (that is, the size of the government, which gives the politician a sense of power). A large government, however, entails deadweight loss to the firm’s output. In addition, the entrepreneur, who is paid a fixed wage, puts limited efforts into management, so the firm loses money.

In the first period, the politician decides whether to privatize the firm and whether to reform state governance. If it succeeds, privatization shifts ownership to the entrepreneur, who then puts all his efforts into managing the firm, causing the firm’s output to rise for the same size of the government. Government income comes from a tax levied on the firm’s output. In effect, the tax includes regular taxes, unwarranted fees, extra transaction costs, and any other kinds of cost borne by the entrepreneur as a result of poor state governance.

Privatization is a dominant strategy for the politician because government income becomes positive after privatization while the politician is able to enjoy the same level of power. The state governance reform is defined as a less predatory government, one that exacts a smaller tax on the firm. The reform is necessary to induce the entrepreneur to invest in or even buy the firm. The politician, however, may be of two types, the "L type," which is more predatory in tax collection and has more desire for power, or the "H type," which is less predatory in tax collection and has less desire for power. Reform of state governance occurs when the politician chooses to be an H type.