Historically, rulers have resorted to mercantilist practices when they were short of revenue and the fiscal capacity of the state was limited. This paper evaluates the conditions under which mercantilist practices become a temporary solution in a long-term path to a free-trade, high fiscal capacity equilibrium instead of a steady equilibrium. To this end, I evaluate the inter-temporal dilemmas of institutional investment in fiscal capacity as a function of policy capture, the stock of fiscal capacity and the technology distance between the protected firms and superior competitors. An endogenous switch from a mercantilist equilibrium to a free-entry equilibrium characterized by high-fiscal capacity and competitive industry is possible only if the initial stock of fiscal capacity is sufficiently large. On the contrary, early adoption of mercantilist policy might guide an economy into a long-term poverty trap. The paper suggests that fiscal capacity drives industrial productivity and, in turn, economic growth. Altogether, I propose a theory of endogenous fiscal institutions in which optimal trade policy (protection vs. free-entry) is driven by the stock of fiscal capacity. The model predictions are illustrated with a cross-national analysis of fiscal capacity building and technology adoption in eight European states.