Federal Politics and Budget Deficits: Evidence from the states of India

Transcription

1 Federal Politics and Budget Deficits: Evidence from the states of India Stuti Khemani * Development Research Group The World Bank, 1818 H Street, NW, Washington DC20433 Second Draft March 14, 2001 Abstract There has been tremendous concern in policy circles that developing countries that are rapidly decentralizing are exposed to the risk of macroeconomic instability due to growing fiscal deficits and soft budget constraints at the sub-national level. The center is perceived as being vulnerable to sub-national fiscal profligacy and manipulation. This paper studies the effect of political affiliation on fiscal deficits in 15 major states of India, over , and finds evidence of an opportunistic center that distributes deficits amongst states in much the same way as other federal transfers in order to gain electoral advantage. Specifically, when state governments belong to the same political party as that of the central government they have higher deficits that is entirely financed by higher loans from the central government. The distinction between the vulnerable versus opportunistic views of the center is worthwhile because while the first suggests greater focus on institutions of inter-government fiscal transfers in a federation, the other suggests at least as important a role for general constitutional institutions such as electoral rules and political regimes. We argue that the evidence underscores the importance of overall political institutions in determining the consolidated government deficit, relative to specific rules of inter-government transfers. * The findings, interpretations, and conclusions expressed in this paper are entirely those of the author, and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. Correspondence may be sent via to skhemani@worldbank.org. Support from the World Bank s Research Committee is gratefully acknowledged. I also thank Gunnar Eskeland, Jonathan Rodden, Edgardo Favaro and Manuela Ferro for helpful comments.

2 I. Introduction There has been tremendous concern in policy circles that developing countries that are rapidly decentralizing are exposed to the risk of macroeconomic instability due to growing fiscal deficits and soft budget constraints at sub-national levels. While similar concerns exist for developed countries as well, the risk is perceived as exacerbated for developing countries because of lower potential revenue bases at local levels, higher dependence on federal transfers, and poor quality of legal institutions. The concern gains credence largely from individual case studies of sizable and persistent sub-national deficits in federal countries like Argentina, Brazil, and India (Rodden, Eskeland, and Litvack, 2001; The World Bank, 1999), and the theoretical and intuitive link between fiscal deficits and decentralization. This link lies in a political economy perspective of fiscal federalism in which the geographical distribution of costs, benefits, and decision-making power over public expenditures leads to a common pool problem akin to the classic theory of distributive politics (Weingast, Shepsle, and Johnsen, 1981; Inman and Fitts, 1990; Aizenman, 1998). If sub-national governments take spending decisions, and are financed by transfers from the national government, which raises taxes, then the resulting amount of total government spending will be inefficient, because local authorities do not fully internalize the effects of their spending decisions on the consolidated government budget. Within this framework, variations in political and institutional relations between the national and different sub-national governments will have differential effects on the common pool problem, and hence on individual sub-national fiscal policies (Jones, Sanguinetti, and Tommasi, 2000). This paper estimates the effect of political and institutional relations between the national and state governments in India on state fiscal deficits to examine whether the logic of the common pool problem holds, or whether an alternate model of political relations in a federation is needed to explain any impact on state deficits. Jones, Sanguinetti, and Tommasi (2000) develop two hypotheses based on the common pool game for the impact of federal-provincial relations on spending by provincial governments in Argentina one, provinces with higher federal transfers will have higher spending; and two, provinces where the governor is from the same party as the President will have lower spending. The first hypothesis is argued to result from the 2

3 greater de-coupling of tax and spending decisions in provinces that are more favored by federal transfers. The second hypothesis follows the argument that the provincial governor who is politically affiliated with the national President will be more likely to internalize the effect of spending an additional unit of national resources due to internal party discipline. The empirical evidence from the Argentine provinces is consistent with both hypotheses. Ter-Minassian (1997), Rodden, Eskeland, and Litvack (2001) and Inman (2001) study the mechanisms and institutions that support fiscal discipline, or indiscipline, at the sub-national level. The underlying story is essentially one of errant local governments yielding to the temptation of shifting their own budgetary costs onto the central government. Fiscal profligacy by sub-national governments is (unwillingly) rewarded by the national government as it is unable to commit in advance to a policy of no bailouts when a local jurisdiction is in trouble. Specific deficit bailouts and general federal transfers both soften the local government s budget constraint and lead to inefficient resource allocation (Inman, 2001). The national government is thus vulnerable to strategic manipulation by local governments because of its inability to commit to a nobailout policy. The above story of a vulnerable center is based upon a model of electoral competition where the national government is elected from a national constituency and evaluated on the basis of macroeconomic outcomes. Thus, the national government has more powerful incentives for fiscal conservatism than each sub-national government. In this model, greater fiscal decentralization would be associated with higher deficits, other things being equal (Weingast, Shepsle, and Johnsen, 1981). An implication of this model tested by Jones, Sanguinetti, and Tomassi (2000), as indicated above, is that sub-national governments that are politically affiliated with the center will be less likely to engage in opportunistic behavior, and should have lower deficits. In this paper we use variation in party affiliation across 15 major states of India over a 24 year period from to test the above implication, and in fact find the opposite relation in periods when a state government belongs to the same party as that at the center, the state has higher than average fiscal deficits. This partisan effect is huge, with deficits in affiliated states being 36 percent higher on average than deficits in non- 3

4 affiliated states. The results may point to an alternate story to that of a vulnerable center in contrast, one of an opportunistic center that favors additional resource transfers to politically affiliated sub-national governments to further its own political objectives. The center opportunistically distributes deficits across sub-national governments in much the same way as other federal transfers. 1 We find that the higher deficits of affiliated states is entirely financed by greater loans from the central government, as opposed to other forms of market debt. It could be argued that this model of an opportunistic center is not really different from that of the vulnerable center, because affiliated state governments may have greater bargaining power and greater benefits to offer the central government if allowed to run higher deficits, and any attempt to make a distinction may be viewed as unduly nitpicky and largely rhetorical. However, we argue that the Indian evidence shows that this distinction is needed to somewhat dissociate the problem of sub-national fiscal deficits from the institutions of fiscal decentralization, and renew focus on general political determinants of deficits. One policy implication of making this distinction could be that general electoral rules and political regimes are at least as much, if not more relevant for influencing government deficits than rules of inter-government fiscal transfers in a federation. In fact, the results for the Indian states show very small effects of federal transfers (and in the opposite direction than expected) that so far have been assumed to have large perverse effects on deficits (Rao, 1998; McCarten 2001); the single largest effect on state deficits is that of political affiliation, even after controlling for the effect of other federal transfers. The effect of politics on state deficits in India seems to be better explained by a large literature on the effect of electoral competition on regional distribution of national resources (Dixit and Londregan, 1996; Lindbeck and Weibull, 1987; Cox and McCubbins, 1986), where the model applies to any type of government unitary or federal, centralized or decentralized. The regional distribution is instead sensitive to processes of electoral competition, particularly to the nature of the electoral objective function (Case, 1998). The key distinction of this opportunistic view of the center is that 1 Political determinants of systematic channels of federal transfers to the states in India have been recently examined by Dasgupta, Dhillon, and Dutta (2001), Khemani (2001), and Rao and Singh (2000). 4

5 in this view the center is the principal decision-maker in control of consolidated government finances. Hence, this paper provides a cautionary note to interpretations of large sub-national deficits as the result of soft budget constraints in a federation, because the distribution of the sub-national deficit may imply overall central control of the national budget constraint. The national budget and individual state budgets may be prone to unsustainable deficits, a problem in its own right, but to understand which it would be important to focus on the nature of electoral competition electoral rules, and institutions of interest group politics in developing countries. The Indian evidence therefore shows that the correlation between decentralization and deficits may arise because some underlying political institutions simultaneously affect the size of deficits and the degree of decentralization. There exists a substantial macroeconomic literature on the political and institutional determinants of fiscal deficits of the national government (see Alesina and Perotti, 1995, 1996 for excellent surveys; von Hagen, 1992). Some of this political and institutional analysis carries over to the case of sub-national governments, with a political game played within sub-national governments between different agents, in addition to any federal game. Poterba (1994) and Alt and Lowry (1994) examine the effect of divided governments on fiscal policy in the American states, and find that adjustment to fiscal shocks is slower in states with different parties controlling the state legislature and executive. Poterba (1996) provides a survey of the impact of legislated budgetary institutions on state fiscal policy states with balanced budget rules adjust faster to fiscal shocks. However, this strand of literature on budget deficits did not focus on broader constitutional institutions like electoral rules and government regimes. The empirical evidence reported here provides additional motivation for delving deeper into the effect of political institutions on public finances, and for the development of an economic approach to comparative politics (as in Persson and Tabellini, 2000). In the next section we describe the nature of political competition and federal fiscal arrangements in India that motivates the hypothesis that opportunistic political manipulation by the center leads to higher fiscal deficits when states are politically affiliated with the center. Section III describes the empirical methodology, the data, and the basic results. Section IV explores alternate interpretations of the results, and presents 5

6 further evidence that argues in favor of the opportunistic center model. Section V concludes, with some discussion of related policy implications for fiscal relations in the Indian federation in the post-1995 era of coalition politics at the center. II. Political Parties, Electoral Competition, and State Finances in India Political parties and electoral competition India is a parliamentary democracy since the adoption of its constitution in 1950, with direct elections based on universal adult suffrage to the Lok Sabha, or the House of the People, the lower house at the national level, and to the Vidhan Sabhas, the individual legislative assemblies at the state level. The political party with majority seats in the national legislature forms the cabinet of ministers and appoints the Prime Minister to lead the executive branch of the national government. Analogous to the national executive, the state executive consists of a cabinet of ministers headed by a Chief Minister and appointed by the majority party in the Vidhan Sabha. India has had regular elections to both the national and state legislatures, with high levels of voter participation, amounting to an average of 56.6 percent in national elections and even higher in state elections (Butler, Lahiri, and Roy, 1995). 2 We focus on two aspects of electoral institutions in India that are relevant for the argument made here of opportunistic policy manipulation by the center one, party-based electoral competition between multiple political parties with regional power bases; and two, majoritarian representation from single-member constituencies where victory is determined by a first-past-the-post simple plurality electoral law. Political parties are at the center of Indian democracy opinion polls have repeatedly shown that voters are influenced more by their image of the party rather than the specific candidate (Butler, Lahiri, and Roy, 1995). The number of political parties competing in elections at both the national and state levels is large and varied, ranging from truly national parties born out of the country s struggle for independence in the first half of the 20 th century, to ephemeral and loose coalition parties with regional power bases. In an extensive compilation of research on state electoral politics in India, Weiner 2 The election schedule was temporarily interrupted by Prime Minister Indira Gandhi when she invoked emergency powers in But this decision was revoked in 1977, new elections held, and Mrs. Gandhi s party routed, ostensibly as an angry reaction to the authoritarian tactics of her government. 6

7 and Field (1974) conclude that the Indian political system is characterized by various cleavages social, ethnic, and regional that form the raw material for political conflicts and alignments. There are limited ideological differences between parties along the lines of economic policy. Instead, electoral competition between parties revolves around access to the instruments of government and appropriation of public resources by different groups (Chhibber, 1995) 3. Political parties are therefore more concerned with providing their supporters with access to public resources rather than competing in any ideological space for potential votes. Part of the explanation for this kind of distributive politics lies in the intense interest group politics of India along class and caste lines, but part also in the nature of the electoral laws. Both combine to create a common political constraint for all parties in power at the national level the need to mobilize political support by extending political patronage to special interest groups on a regional basis (Chhibber, 1995; Chhibber and Petrocik, 1989). India s first-past-the-post voting system is based on contests between individual candidates in single-member constituencies where the seat is won by the candidate that gets more votes than any other. The nation is divided into over 500 constituencies for elections to the national legislature, and the party that wins a majority of seats, distributed in any manner across the country (irrespective of state borders), usually gets to form the government. 4 This simple plurality electoral law in practice implies a very tenuous link between the percentage of popular votes received by a party and the probability of winning the majority of seats in the national legislature, because of fragmented electoral competition in each constituency. Butler, Lahiri, and Roy (1995) indicate that once a party crosses a particular threshold in votes, around 30 to 35 percent, it can move to a landslide victory in seats by gaining just a few percentage points in popular support. At the end of the day, it is really the number of seats in the legislature that matters for 3 Chibber (1995) in fact performs a similar exercise as that undertaken here, because he looks for patterns in central distribution of subsidies and loans to state governments that are explained by the center s political motives, as evidence in support of his claim of party-based distributive policies. However, his analysis consists of looking at one political indicator variable that is a complex (and arguably, subjective) combination of political affiliation, timing of elections, closeness of electoral race etc. So, it is difficult to interpret his results in the context motivated here. 4 In case of a clear majority, as in more than 50 percent of the seats, the party is always invited by the President (the constitutional head) to form the government. However, in recent years no single party has won even close to 50 percent of the seats, in which case coalitions are built across party lines that need to face a confidence vote in Parliament in order to form the government. 7

8 political control, so interest group politics to attain the critical number of votes from a large number of constituencies becomes the key political strategy for all parties. Hence, even if the marginal voter evaluates candidates or parties based upon their performance in office (as Khemani, 2000 finds evidence for) it is not this marginal voter s behavior that determines the object of national political interest the seat to the legislature. The central government therefore is best positioned to evaluate which constituencies in which states it should focus upon in order to maximize its probability of winning a majority of seats in the next elections. Imagine a two-stage model of a federal system where the center decides on the regional distribution of national resources (including loans to finance sub-national deficits) in the first stage, in order to maximize the chances of forming the government in the next elections, and the regional governments then decide local inter-sectoral allocations based on the total transfers received. In this game, the extent and nature of decentralization would matter for the government deficit only if it affected the process of electoral competition and the nature of the center s objective function. Hence, in this view of an opportunistic center it is important to focus on the nature of the electoral process in general rather than just the system of inter-government fiscal relations. Additionally, evidence of large or persistent sub-national deficits may not imply soft budget constraints or a lack of central control over consolidated finances, but rather systematic and opportunistic usage of fiscal instruments at the disposal of the center to benefit those states from which it gains maximum electoral advantage. The overall size of the deficit may be unaffected by the level of decentralization because the central government has similar political incentives as the sub-national governments, with limited additional incentives for fiscal conservatism. However, fiscal decentralization could be an important determinant of the process of electoral competition, and thence an important determinant of the overall deficit. Expenditure responsibilities in the Indian federation are largely decentralized to state governments who thus have access to spending instruments with direct impact on people s lives. If a party loses control of a state government it thus loses control over some public instruments to buy political support through patronage. In addition, given the regional diversity in class and caste politics in India, state-level party officials are better 8

9 situated to obtain information on local interest group configurations. Hence, it is not surprising to note that if a party comes to power in a state (by winning a majority of seats in the state legislature), then in the next national elections that party also tends to win seats to the national legislature. 5 In light of the above discussion it would seem that state-level party leaders wield an enormous amount of power within the party so that the effect of party affiliation on state deficits could also be interpreted as the center being more vulnerable to withinparty politics, than to rival party politics. Our empirical analysis is not really able to distinguish between this view and that of a strong central decision-maker that is able to discipline sub-national actors but instead chooses to opportunistically manipulate them for political advantage. Hence, in this sense, the distinction between vulnerability and opportunism becomes rhetorical, as political scientists that study Indian party politics would probably testify to enormously complicated political intrigues even within a single, stable national party. But, as long as these within-party political intrigues are not primarily determined by the nature of fiscal decentralization, but rather by the nature of regional politics in India, then it would be misleading to attribute the problem of deficits to the instruments of fiscal federalism. Instead, even from a policy point of view it would be more worthwhile to understand the nature of the political constraints and then explore whether institutional instruments are available to address the problem of fiscal profligacy. State finances why deficits? The above discussion of political parties and electoral competition indicates that national governments have political incentives to ensure that their party controls state governments, for which purpose it attempts to bias the distribution of national resources to politically affiliated states. But the question still arises why this is achieved through allowing greater state deficits? Why not through other transfer mechanisms that increase state resources but not deficits? 5 An example from the state of Andhra Pradesh is illustrative in this context. The Congress party lost control of the state government in Andhra Pradesh in the 1983 state elections to a new regional party, the Telegu Desam. In the next national elections in 1984, even though it won an overwhelming majority of seats in the national legislature, the Congress lost most seats from Andhra Pradesh to the Telegu Desam, despite the latter s novice status in national politics. 9

10 To answer the above questions requires a brief digression into the nature of state finances in India. The constitutional assignment of revenue generation powers and expenditure responsibilities, and the role of different channels of central transfers to augment state resources is discussed at length in various studies (Rao and Singh, 2000; Anand, Bagchi, and Sen, 2001; Khemani, 2001). In a nutshell, the Indian federation is characterized by vertical fiscal imbalance, where the states undertake more than 50 percent of government expenditures but generate a little over 30 percent of total revenues; 30 percent of the expenditures of state governments is financed by transfers from the central government. There are three channels of direct budgetary transfers from the center to the states: tax sharing and grants decided by a statutory body, the Finance Commission, on the basis of well-established rules; grants and loans decided by another independent body, the Planning Commission, which is also based on an established formula; and discretionary grants and loans by the central government. There is an emerging literature analyzing the effects of political affiliation on these different institutional channels of transfers (Dasgupta, Dhillon and Dutta, 2001; Khemani, 2001, Rao and Singh, 2000). The evidence is mixed and complex some institutions are more amenable to political control by the center than others, and the nature of control differs across the different categories of transfers. However, Khemani (2001) finds a similar effect of political affiliation as the one on deficits for transfers decided by the Planning Commission, thereby raising the following question. What if the political affiliation effect on deficits works through transfers? Politically affiliated states receive greater transfers, creating for greater dependence on central transfers. This dependence in its turn creates perverse incentives at the state level to run higher deficits this period in expectation of higher transfers in the next period. Many studies have expressed concern that the Indian transfers system, even though it is very rules-based, actually creates perverse incentives for state deficits through its gap-filling approach (Rao, 1998; McCarten, 2001). We test for this in our analysis by including lagged and predicted values of transfers in the basic equation estimating the affiliation effect, and find a very small effect of central transfers, and in an unexpected direction. Higher transfers appear to be associated with lower deficits, and 10

11 including the transfer variables in the equation has no effect on the size or significance of the affiliation effect. But we re once again left with the question of why political affiliation works through deficits than through these other channels of transfers? We explore whether the answer lies in additional political discretion and control over loans to state governments, since the other channels of resource transfers are more rules-based and controlled by statutory bodies. We find that the higher deficits of affiliated states is entirely financed by greater loans from the central government, as opposed to other forms of market debt. This leads to our claim in the introduction that an opportunistic central government distributes deficits across states, in the form of central loans, in much the same way as other federal transfers. This evidence also casts doubt on the vulnerable center view because if the states running higher deficits were holding the center hostage, they could finance their additional deficit through any means, without exclusive reliance on central loans, and expect a bail-out in later periods. In theory, sub-national borrowing from the market is heavily regulated by the central government. But, McCarten (2001) and Anand, Bagchi, and Sen (2001) describe, various ways in which these rules may be easy to circumvent. III. Empirical specification, data, and basic results Specification The objective of this paper is to estimate the effect of political affiliation between the center and a state government on the latter s fiscal deficit. The basic empirical model is the following: DEFICIT it = β AFFILIATION it + η Z it + α i + δ t + ε it (1) where DEFICIT it is the fiscal deficit in state i in year t; AFFILIATION it is an indicator of political affiliation that equals 1 when the governing party in state i at time t belongs to the same party as that governing at the center at time t, and 0 otherwise. Time variant economic and demographic characteristics of states (state domestic product and total population) are included in the vector Z it, while α i controls for state-level fixed effects. In addition, a time effect for each year, δ t, is included to control for various shocks to the state economy in any given year. These additional variables need to be included because they are likely to be correlated with unobservable voter tastes and other shocks that affect 11

12 both the political process of determining affiliation of the state government as well as fiscal deficits. Hence, β, the coefficient on political affiliation, is identified from variation within a state from its own average deficit when it is affiliated and not affiliated with the center. Under the hypothesis of an opportunistic center that favors resource distribution to its affiliated states, we would expect to find β > 0. The affiliation indicator is coded as equal to 1 if we are able to establish strict matching in party identity between the state and central government, that is, we ignore the role of political affiliation between loosely knit coalitions. Many would find this characterization of affiliation too restrictive, but it is necessitated by our purpose of distinguishing whether sub-national deficits are influenced by bargaining between the center and the state or by optimizing behavior on the part of the central decision-maker with arguably stronger control and common political objectives within a single political party. However, just including the affiliation indicator may not effectively distinguish between the two views of the center as opportunistic or vulnerable because what may really matter is the proportion of seats from the state that the state ruling party controls in the national legislature. The affiliation indicator may be highly correlated with a large proportion of seats in the national legislature, as an affiliated state party may piggy-back on the voters support of the national ruling party. We would thus need to distinguish the effect of non-affiliated states with a large proportion of seats in the national legislature. Under the vulnerable center view non-affiliated state governments that control a large proportion of seats to the national legislature should be more likely to hold the center hostage, and not internalize the adverse macroeconomic consequences of fiscal profligacy. On the other hand, amongst affiliated states, the proportion of seats in the legislature could matter for an opportunistic center for different reasons depending on the nature of its objective function whether it is to maximize seats in the legislature or the probability of winning a majority of seats in the legislature. 6 Depending on the parameters of the model, the center may choose to favor affiliated states that are core 6 Case (2001) shows that in a presidential system of government, depending on whether the objective is to maximize votes for the president or to maximize the probability of winning the presidency, different predictions are obtained for presidential transfers to regions with core supporters or swing voters. 12

13 supporters (with a large proportion of seats in the national legislature) or where there are more gains to be had due to a smaller proportion of seats controlled by the ruling party. We therefore augment specification (1) by including interaction terms between affiliation and the proportion of seats (allotted to the state) controlled by the state ruling party in the national legislature SEATS it. We expect that if the center is indeed vulnerable to manipulation by rival political parties, γ > 0, while the sign of φ can go either way: DEFICIT it = β AFFILIATION it + φ AFFIL*SEATS it + γ (1 AFFIL)*SEATS it + η Z it + α i + δ t + ε it (2) Data The data set for this study is compiled from diverse sources for 15 major states of India over the period The political data is compiled from Butler, Lahiri, and Roy (1995). The public finance data on revenues, expenditures, and inter-government transfers, is available from relevant volumes of the Reserve Bank of India Bulletin, a quarterly publication of the central bank of India with annual issues on details of finances of state governments. 7 State demographic and economic characteristics, and a state-level price index to convert all variables into real terms are available from an Indian data set put together at the World Bank. A detailed description of these variables is available in Ozler et al (1996). Table 1 provides summary statistics for each of the variables included in the analysis. These 15 states of India account for 95 percent of the total population. India consists of 26 states at present but many of the smaller ones have been created recently. However, 11 of the 15 states under study have existed since the organization of the federation in An additional two, were created for linguistic reasons out of a single large state Maharashtra and Gujarat in 1960; and two in 1966 Pubjab and Haryana also for ethnic and linguistic reasons. Hence, in order to avoid issues of endogenous state boundaries, and of special transfers to smaller states, we focus only on the 15 major states that have existed from the early days of the federation Basic Results 13

14 Table 2 reports the results of estimating specifications (1) and (2) using ordinary least squares with robust standard errors. State governments that belong to the same political party as the central government have significantly higher fiscal deficits. Amongst affiliated states, those that control a very low proportion of seats to the national legislature tend to have significantly higher deficits than those that control a higher proportion of seats. In fact, if an affiliated state government controls all the state s seats to the national legislature (that is, the proportion=1), then it s net benefit from affiliation becomes negative, since the coefficient on the interaction term is greater than the coefficient on the affiliation indicator. Hence, it is really those affiliated states where the center has a lot to gain in terms of seats to the national legislature that seem to be particularly favored in terms of being allowed to run higher deficits. The effect of political affiliation is substantial from specification (2) it appears that affiliated states on average have a fiscal deficit that is 36 percent higher than the average of the sample. Non-affiliated states even with larger proportions of state seats in the national legislature do not appear to bargain for higher deficits. Robustness of the affiliation effect There are several potential problems with correctly identifying the effect of political affiliation on deficits in specifications (1) and (2), some of which are directly obtained from our strict definition of affiliation. First, the affiliation indicator may be correlated with instances of coalition governments at the state level when it is difficult to establish a strict party match with the central government. Such cases of coalition regimes are usually coded as 1, that is not-affiliated, in our sample. But coalition politics is likely to have an impact on state deficits in its own right, so that the estimate of β will be confounded with the effect of coalition politics. We could argue that to some extent the state fixed-effects, α i, accounts for the proclivity of a state to have coalition governments since some Indian states have been systematically more stable than others. However, we also include an additional indicator variable COALITION it, which equals 1 when there is no clear majority in the state legislature, and the executive is formed of a coalition of various political parties. 7 I am grateful to Tim Besley of the London School of Economics and to Bhaskar Naidu of the World Bank s South Asia regional divison for providing me with some of this data that had already been compiled 14

15 Second, the timing of state elections could be correlated both with state deficits and with the affiliation indicator, and we therefore also include a specification that controls for the state election cycle. 8 Third, the equation explaining variations in state deficits may be mis-specified if it does not control for any dynamic process underlying deficits. Lagged deficits may be correlated both with current deficits and affiliation, and hence is also included to test the robustness of the affiliation effect. In Table 3 we include each of these additional variables whose omission may have potentially biased the coefficients on affiliation and its interactions in the results reported in the previous table. Coalition politics at the state level and the state election cycle are not significantly correlated with state deficits, and including them in the regression does not affect the size or significance of the coefficients of interest. This result is interesting in its own right because it seems to indicate that state-level political variables have no statistically discernable effect on deficits, although they might on the composition of spending and revenues (as reported by Khemani, 2000). Instead, it is the state s political relation with the center that accounts for large variation in its deficit. Including lagged values of the deficit (in column 2) also does not change the effect of affiliation, although the size of the coefficient is reduced by 20 percent. 9 IV. Federal transfers how is the deficit financed? What if the affiliation effect on deficits is actually driven by its effect on systematic fiscal transfers from the center to the states, and it is really the design of these transfers that creates perverse incentives at the state level for higher fiscal deficits? Several scholars of inter-government fiscal relations in India have long argued that states that receive higher federal transfers run higher deficits because of a purported gapfilling approach to transfers where greater federal assistance is provided to states in their research groups. 8 Although, Khemani (2000) finds no effect of elections on state debt. 9 Including lagged values of the dependent variable in a panel data setting potentially creates for inconsistently estimated coefficients on all the variables. Arellano and Bond (1991), Arellano and Bover (1995), and Blundell and Bond (1998) develop a Generalized Method of Moments (GMM) estimator that produces consistent estimates in dynamic panel data settings, using lagged values as instruments. However, at this time, we have not applied the GMM estimator to ensure that the affiliation effect is robust to that as well. 15

16 whose expenditure requirements are perceived to far exceed their revenue potential (Rao, 1998; McCarten, 2001). However, we know of no study that actually tests this hypothesis with rigorous statistics the link is made by simply describing the design of transfers and citing low revenue generation and high deficits at sub-national levels. 10 One reason why no one has actually estimated the effect of central transfers on state deficits may be because of the inherent simultaneity problem deficits and transfers are determined in equilibrium and it is difficult to tease out a causal relation. Unfortunately, we are also not able to address this endogeneity in a satisfactory manner, but make a first attempt to do so, by estimating the effect of transfers using lagged values of transfers as instruments and in reduced form. These results are reported in Table 4. The first column reports the reduced form with lagged values of Finance Commission transfers (share in taxes and statutory grants) and lagged values of Planning Commission grants, and the second column with predicted values using the lagged values as instruments. We find that contrary to the wide-spread opinion that the design of inter-government transfers in India provides states with perverse incentives for fiscal management, greater transfers are actually correlated with lower deficits. The effect of affiliation is unchanged even after controlling for these transfers. 11 It is also important to analyze how the higher deficit of affiliated states is financed. Perhaps affiliated state governments have higher credit worth and are more likely to raise and repay debt? This seems hardly credible since most of the financing of the deficit of state governments is through loans from the central government itself, with heavy regulation of market borrowing. However, it is widely believed that these regulations are easy to circumvent (Anand, Bagchi, and Sen, 2001); McCarten, 2001) and at least in theory the Indian federation is susceptible to the risk of soft budget constraints at sub-national levels. In fact, if the affiliation effect is driven by influential state leaders 10 Rajaraman (1999) is an exception, but she tests for the effect of grants to village governments on their own revenue generation in one state of India. But her specification does not really control for the endogenous determination of both transfers and local fiscal policies. 11 We also estimate the effect of transfers on own revenue generation and do find a significant negative effect, but the effect is very small with the elasticity being less than 1 at the sample average. These results are available upon request. 16

17 holding the central government hostage, we should probably expect to see the higher deficit financed by market loans that circumvent the center. In fact, as we report in Table 5, the higher deficit of affiliated states seems to be entirely financed by higher loans from the central government. Hence our interpretation of these results as the central government opportunistically distributing deficits across states in much the same way as other federal transfers. Political bargaining through extra-budgetary transactions? The analysis undertaken here is based on budgetary transactions of state governments for which detailed data is compiled by government agencies on a regular basis. There is concern amongst policy circles that political factors may in fact have a more powerful influence on extra-budgetary transactions that are not subjected to legislative scrutiny. One channel of particular concern is the debt of state-owned public sector enterprises (PSEs) that is guaranteed by the state government and owed to a nationalized banking sector. It is therefore possible that non-affiliated states are able to extract greater resources from the central government through the borrowings of their public enterprises that are, in effect, never paid back. We do not have data available on public sector enterprises to check this alternate story of political bargaining between the center and the states. However, one variable we do have data for that would perhaps approximate the borrowing of PSEs is that of loans and advances by the state government which are reported to consist largely of loans to publicly owned enterprises. We find that the effect of political affiliation on such loans and advances by the state government is of the same sign and magnitude as the effect on overall fiscal deficit. Net loans by affiliated state governments is about 54 percent higher than that by non-affiliated state governments, as reported in Table 6. This evidence, and the fact that we do not find any effect of political affiliation on the market debt for which data is available through state budgets, and that we do indeed find substantial political effects on other budgetary transactions (thereby suggesting that legislative scrutiny does not prevent political manipulations from taking place), leads us to speculate that any effect of political affiliation on the finances of state owned enterprises would be similar to the effects described here. 17

18 What is the underlying structural model that leads to greater deficits for affiliated states? Following Alt and Lowry (1994) and Jones et al (2000) we estimate structural equations for state revenues and expenditure using three stage least squares: REVENUE it = η 1 INCOME it + η 2 POPU it + η 3 REVENUE it-1 + η 4 TRANSFER it-1 + η 5 DEFICIT it-1 + β r AFFILIATION it + φ r AFFIL*SEATS it + γ r (1 AFFIL)*SEATS it + λ r COALITION it + α r i + δ r t + ε r it (3) SPENDING it = µ 1 REVENUE it + µ 2 POPU it + µ 3 GROWTH it + µ 4 TRANSFER it-1 + µ 5 DEFICIT it-1 + β S AFFILIATION it + φ S AFFIL*SEATS it + γ S (1 AFFIL)*SEATS it + λ S COALITION it + α S i + δ S t + ε S it (4) where REVENUE it is the total per capita revenues of state i in year t, and SPENDING it is total spending undertaken by state i in year t (net of interest payments). The estimated parameters for the equations above are reported in Table 7. The pattern of coefficients is consistent with those in the deficit regressions in previous tables. Spending by affiliated state governments is 5 percent higher on average, although those affiliated governments that control a higher proportion of the state s seats in the national legislature have lower spending. Interestingly, states ruled by coalition governments lower spending by 4 percent. Grants from the central government have a negative effect on state spending, again contrary to the widely hypothesized view that the structure of inter-government grants creates perverse incentives for greater spending and higher deficits. The relative size of the affiliation effect on spending (as reported in Table 7), and on loans and advances by the state government (as reported in Table 6) suggests that the higher deficits of affiliated states is largely explained by higher loans made by affiliated states. This pattern of evidence leads us to speculate that political parties controlling the central government in India provide greater resources to affiliated state governments perhaps to finance public employment and subsidies provided by state owned enterprises in order to further their electoral objectives. 18

19 V. Conclusion This paper conducts a simple test of the common-pool game in a federation where sub-national governments are more likely to have higher deficits because they do not internalize the macroeconomic effects of fiscal profligacy. Specifically, we test a prediction implied by this model that sub-national governments that belong to the same political party as the central government should have lower fiscal deficits because they are more likely to internalize the effect of increasing deficits. We find that in 15 major states of India over the period , states in fact have substantially higher deficits (about 36 percent of the sample average) when their government belongs to the same party as that governing at the center. The additional deficit of affiliated states is financed almost entirely by additional loans from the central government (as opposed to the market) leading to our interpretation that the central government in India opportunistically distributes deficits across states in a similar manner to other fiscal transfers in order to gain political advantage. We claim that it is instructive to make this distinction between an opportunistic center that is a party to, and perhaps encouraging of, fiscal profligacy in states where it stands to gain electoral advantage, versus a vulnerable center that is liable to be held hostage by sub-national governments because of commitment problems. The main reason for this distinction lies in our belief that the results reported here indicate that general political institutions such as electoral laws and the nature of electoral competition are more important determinants of both national and sub-national deficits, rather than the institutional design of fiscal decentralization or instruments of fiscal transfers. In order to explicitly test for the relative importance of the design of transfers versus political variables, we estimate (for the first time in the literature, to the best of our knowledge) the effect of different categories of transfers on state deficits in India. We find no evidence for the widely held view that the design of inter-government transfers in India provides perverse incentives to state governments to run higher deficits. There is no substantial effect of transfers on deficits (in fact a small and counter-intuitive negative effect), and a robust effect of political affiliation on deficits that holds for a range of specifications. 19

20 The nature of distributive politics at both the national and individual state levels described in some detail in Section II may imply that all levels of government in India run high and perhaps unsustainable deficits, which is a problem in its own right. But the solutions to this problem may not be found in altering rules of inter-government transfers or the nature or extent of fiscal decentralization. In the model implied in this paper there is no immediate implication for the impact on deficits of further decentralization within a stable federal system, that is one that increases responsibilities and powers of subnational governments within the federal political arrangement. The evidence provided here shows that sub-national deficits are determined by the nature of electoral competition between political parties, and as long as the rules of fiscal federalism do not change the nature of party competition in the federation, it may have no effect on overall consolidated government deficit. This evidence feeds the growing concern within the country and in international policy circles that the new era of coalition politics at the center will lead to substantial fiscal pressures. Political affiliation in this era is much more broadly defined because the central government now consists of a loose coalition of several regional political parties. The type of analysis undertaken here for the period cannot be directly extended to the post-1995 period because of the emergence of substantially different coalition politics at the national level which will not allow identification of political affiliation between the central and state governments based on single party identity. In this post period it may very well make sense to describe the center as vulnerable to political intrigues within its own coalition. This analysis of the relatively stable period before 1996 therefore highlights the significant fiscal risks of the changed political circumstances if substantial evidence for political opportunism by the center is available even before 1996, we may expect far greater political pressures on fiscal policies in the years after. The changing electoral incentives due to the changing nature of competition between political parties may thus have huge implications for fiscal policies which are as yet little understood. We therefore hazard to recommend that the Indian government would do well in further investigating the economic impacts of the rules of electoral competition in India, and exploring institutional solutions to potentially wasteful processes of political 20