Federal Politics and Budget Deficits: Evidence from the states of India Stuti Khemani Development Research Group, The World Bank Macro Seminar, September 12, 2002

Common Pool Problem of Fiscal Federalism Decoupling of tax and spending decisions -- Higher spending: classic theory of distributive politics (Weingast, Shepsle, Johnsen, 1981) -- Higher debt (Persson and Tabellini, 2000) Commitment issues of central government (Inman, 2001; Rodden, 2002)  Intergovernmental transfers positively correlated with spending/deficits  Partisanship negatively correlated with spending/deficits Evidence from Latin America (Jones, Sanguinetti, Tommasi, 2000; Dillinger and Webb, 1999); Germany (Rodden, 2000); Cross-country (Rodden, 2002)

Evidence from the Indian states Vertical fiscal imbalance—Indian states undertake between percent of total government spending; percent of state spending financed by central transfers 3 instruments of intergovernmental transfers: -- Tax sharing determined by a statutory body -- Specific purpose transfers/matching grants determined by central ministries -- Grants and loans supporting state “plans” Extensive central restrictions on state borrowing: 65% of new borrowing directly from the center; market borrowing from nationalized financial institutions Perverse incentives created by “gap-filling” transfers (Rao and Chelliah, 1991; Rao and Singh, 2000) Partisan effect: positive or negative? Depends on federal political relations Test using data from 15 major states, over the period

The Province-Center Game ● ● ● CENTRAL GOVERNMENT PROVINCIAL GOVERNMENT

Modeling Federal Politics Electoral competition between political parties that compete for representation in both national and regional legislatures Political objective—maximize representation in legislatures Voters vote along party lines: Good (bad) performance of provincial and national governments leads to positive (negative) spillovers for political parties in every election (d, l): Greater resource transfers by center to politically affiliated states (Khemani, 2002) d a > d u l a > l u

Modeling Federal Politics (cont.) Strategic bargaining: Condition 1 -- Affiliated states:  a >  -- Unaffiliated states:  u >  where  i is the loss in seats for the national political party due to provincial fiscal retrenchment, and  is the loss in seats due to sub- optimal borrowing  i ? => depends on voting behavior If voters distinguish between functions of regional and central governments they are not likely to punish the center for regional fiscal mismanagement -- Then,  u < 0  that is, the center benefits from the discomfiture of its rival political party -- Condition 1 does not hold for unaffiliated states

Modeling Federal Politics (cont.)  a depends upon the extent of negative spillovers across national and provincial elections for a political party Large spillovers should be correlated with greater control of central party leadership, and thereby lower likelihood of strategic bargaining by affiliated provinces However, difficult to distinguish whether d a > d u because of opportunistic resource allocation by the center or sub-national bargaining Hence, electoral competition + party-specific spillovers + accountability of provincial governments for local conditions => greater resource allocation to affiliated provinces

Modeling Federal Politics (cont.) Legislative bargaining model of federal politics? Coincidence of rising sub-national deficits and unstable coalitions of regional political parties in the national legislature in India, 1990 to present Increase in bargaining power of regional coalition partners Impact of coalition politics: OECD countries (Kontopoulos and Perotti, 1997, 1999), Evidence from Brazil (Dillinger and Webb, 1999) Test for strength of state ruling party in the national legislature, and additional effects after 1990 Lessons from coalition politics in state legislatures

Summary/Conclusions Partisanship has a significant and positive effect on state deficits Deficits of affiliated states in India are higher by about 10 percent of the sample average Affiliated states whose ruling parties control less than half the proportion of seats have deficits that are more than 17 percent higher than the sample average Higher deficits of affiliated states are entirely financed by more loans from the central government Intergovernmental fiscal transfers have a negative effect on deficits (though not always significant)

Indirect and Ambitious Conclusions Effect of institutions of fiscal federalism is sensitive to underlying political incentives Impact of formal rules will be limited by the extent to which they can be politically circumvented—addressed further in a study of formula- driven intergovernmental grants in India (Khemani, 2002) Better understanding of political incentives may help in designing the “right” institutional rules Unanswered question of increasing importance: off-budget borrowing– debt of state-owned-enterprises?