comparative political studies 2007 khemani 691 712

7/28/2019 Comparative Political Studies 2007 Khemani 691 712

1/23

http://cps.sagepub.com/Comparative Political Studies

http://cps.sagepub.com/content/40/6/691The online version of this article can be found at:

DOI: 10.1177/0010414006290110

2007 40: 691Comparative Political StudiesStuti Khemani

the States of IndiaParty Politics and Fiscal Discipline in a Federation : Evidence from

Published by:

http://www.sagepublications.com

can be found at:Comparative Political StudiesAdditional services and information for

http://cps.sagepub.com/cgi/alertsEmail Alerts:

http://cps.sagepub.com/subscriptionsSubscriptions:

http://www.sagepub.com/journalsReprints.navReprints:

http://www.sagepub.com/journalsPermissions.navPermissions:

http://cps.sagepub.com/content/40/6/691.refs.htmlCitations:

What is This?

- May 9, 2007Version of Record>>

at The University of Melbourne Libraries on March 1, 2013cps.sagepub.comDownloaded from
http://cps.sagepub.com/http://cps.sagepub.com/http://cps.sagepub.com/content/40/6/691http://cps.sagepub.com/content/40/6/691http://cps.sagepub.com/content/40/6/691http://www.sagepublications.com/http://cps.sagepub.com/cgi/alertshttp://cps.sagepub.com/cgi/alertshttp://cps.sagepub.com/subscriptionshttp://cps.sagepub.com/subscriptionshttp://www.sagepub.com/journalsReprints.navhttp://www.sagepub.com/journalsReprints.navhttp://www.sagepub.com/journalsPermissions.navhttp://cps.sagepub.com/content/40/6/691.refs.htmlhttp://online.sagepub.com/site/sphelp/vorhelp.xhtmlhttp://online.sagepub.com/site/sphelp/vorhelp.xhtmlhttp://online.sagepub.com/site/sphelp/vorhelp.xhtmlhttp://cps.sagepub.com/content/40/6/691.full.pdfhttp://cps.sagepub.com/content/40/6/691.full.pdfhttp://cps.sagepub.com/http://cps.sagepub.com/http://cps.sagepub.com/http://online.sagepub.com/site/sphelp/vorhelp.xhtmlhttp://cps.sagepub.com/content/40/6/691.full.pdfhttp://cps.sagepub.com/content/40/6/691.refs.htmlhttp://www.sagepub.com/journalsPermissions.navhttp://www.sagepub.com/journalsReprints.navhttp://cps.sagepub.com/subscriptionshttp://cps.sagepub.com/cgi/alertshttp://www.sagepublications.com/http://cps.sagepub.com/content/40/6/691http://cps.sagepub.com/


2/23

Party Politics and FiscalDiscipline in a Federation

Evidence from the States of India

Stuti KhemaniThe World Bank, Washington, D.C.

Theoretical and empirical analysis suggests that federations are prone to fis-cal indiscipline, because of intergovernmental bargaining over the allocation

of national resources. What role do political parties play in mediating this

bargain? If the national government is dominated by a single political party,

does the party discipline those states where its affiliates are in power? If the

national government consists of a coalition of political parties, do states ruled

by coalition partners bargain for higher deficits? This article provides evi-

dence on these questions from India, a large federation in the developing

world that serves as a valuable laboratory for this purpose. The authors find

that those state governments that belong to the same party as that leading thenational government run higher than average deficits; correspondingly, states

governed by rival political parties have lower deficits, even if these parties are

members of a coalition government at the center.

Keywords: political parties; fiscal deficit; federalism

One of the more prominent issues in recent development policy is the

risk of fiscal indiscipline and macroeconomic instability in developingcountries that are rapidly decentralizing fiscal powers to subnational gov-

ernments. The concern lies explicitly in the domain of political economy

a classic common pool problem of distributive politicswhen spending

decisions taken at local levels are financed by transfers from the national

government, which raises taxes. Bargaining between the center and various

subnational jurisdictions for a greater share of national resources under the

Comparative Political Studies

Volume 40 Number 6

June 2007 691-712

2007 Sage Publications

10.1177/0010414006290110

http://cps.sagepub.comhosted at

http://online.sagepub.com

691

Authors Note: The author is grateful to Edgardo Favaro, Stephen Howes, Jonathan Rodden,

David Strmberg, and three anonymous referees for very helpful comments. Support from the

World Banks Research Committee is thankfully acknowledged. The findings, interpretations,

and conclusions expressed in this article 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.

http://cps.sagepub.com/http://cps.sagepub.com/http://cps.sagepub.com/http://cps.sagepub.com/


3/23

threat of regional secession or withdrawal of political support (Riker, 1964;

Treisman, 1999) can lead to overfishing of the common property of national

resources. Rodden (2002) finds that fiscal deficits are greater in nationswhere subnationals are more dependent on national transfers for their spend-

ing and where they are free to borrow from capital markets. Wibbels (2000)

finds larger fiscal deficits in federal compared to unitary nations in the

developing world.

At least in two regions of the worldLatin America and Russiasubna-

tional fiscal profligacy has been credited with contributing to macroeconomic

crises, by many scholars and policy makers, among them Blanchard and

Shleifer (2001), Dillinger and Webb (1999), Ordeshook (1996), Samuels(2000), Stepan (2000), and Treisman (2000). This body of research commonly

assumes that the national political executive is the only agency concerned

with overall fiscal stability. In accordance with this idea, a large literature on

the role of fiscal institutions in improving fiscal performance has advocated

a particular institutional solution to the problem of fiscal indisciplinestrong

central governments with the authority to impose hard budget constraints

on subnationals via monitoring and regulation of subnational debt (Poterba &

von Hagen, 1999; Rodden, Eskeland, & Litvack, 2003).A particular political institution has often been associated with strong cen-

tral governmentssingle-party majority governments, where national party

leaders will force subnationals to internalize the costs of their policies on

national fiscal stability (Blanchard & Shleifer, 2001; Dillinger & Webb, 1999;

Jones, Sanguinetti, & Tommasi, 2000; Ordeshook, 1996; Samuels, 2000;

Stepan, 2000). The central idea in this literature is that the national party lead-

ing the center is likely to be held accountable by voters for overall macroeco-

nomic outcomes and hence have the right incentives for fiscal discipline. Thus,

having a dominant national party leading the center and most of the states is

posited as a favorable condition for fiscal discipline in a federation.

However, a recent article by Wibbels (2003) argues that this line of

thinking is at odds with that in an earlier literature on market-preserving

federalism, in which interjurisdictional competition between governments

to attract private economic activity serves to commit them to not bail-out

agencies, projects, or enterprises that fail (Qian & Weingast, 1997, provide

a review). In this market-preserving view of federalism, there is doubt

about whether a central political authority that is strong enough to imposediscipline on subnational governments would be itself disciplined by

market considerations of efficiency. Wibbels (2003) suggests that greater

regional political competition is likely to strengthen political incentives for

fiscal prudence.

692 Comparative Political Studies



4/23

This article provides an empirical assessment of these competing ideas

on the role of multiparty political competition in a federation in hindering

or promoting fiscal discipline. The debate lends itself to the following ques-tions that are amenable to empirical testing: If the national government is

dominated by a single political party, does the party discipline those states

where its affiliates are in power? If the national government consists of a

coalition of political parties, do states ruled by coalition partners bargain for

higher deficits? Affirmative responses to both these questions would sup-

port the argument that dominant national parties promote fiscal discipline

in a federation. Negative responses to both questions, on the other hand,

would be consistent with the market-preserving view of the salutary poten-tial of greater political competition.

India provides a valuable laboratory to address these questions, because

while for much of its history as a democracy, it has seen one dominant

national political party at the helm of fiscal policy, with the authority to mon-

itor and regulate subnational borrowing; in more recent years, regional polit-

ical parties have gained greater representation in the national government and

have served as critical members in or supporters of national coalition gov-

ernments. This article uses panel data on 15 major states of India, whichaccount for 95% of the countrys population, during a period of time, 1972 to

1998, when there is considerable variation in the representation of state-based

parties in the national government, to test the hypotheses raised above and

provide evidence on the impact of party politics on fiscal discipline.

A preview of the main findings is as follows: When a state government

is controlled by the same party that controls the national government, the

state has higher than average fiscal deficit. This partisan effect is large, with

the deficit to GDP ratio in politically affiliated states being half a percent-

age point higher than that in nonaffiliated states, calculated at the sample

average. There is no evidence of higher deficits in states that are members

in or supporters of a coalition government at the center. Higher fiscal

deficits in states whose governments belong to the national ruling party are

driven by higher spending. Higher deficit spending of these states appears

to be financed by their access to subsidized credit from financial markets

that are controlled by the center, as evidenced by their lower interest pay-

ments on debt, when compared to states governed by rival political parties.

This pattern of evidence does not support the view that a dominantnational party is likely to promote fiscal discipline in a federation; instead,

it is consistent with the notion that greater regional political competi-

tion can create market-preserving conditions that strengthen incentives for

fiscal discipline.

Khemani / Party Politics in India 693



5/23


6/23

(hereafter referred to as the Congress), largely because of the historical

legacy of being the leader of the independence movement against British

colonial rule. However, sometime in the late 1960s and early 1970s (thereis some debate amongst scholars over the exact beginning), the Congress

partys dominance began to decline, especially as demonstrated in stiff

challenges from rival political parties in state assembly elections, several

of which were emerging regional parties. These regional parties began to

replace the Congress as the governing party at the state level.

The Congress lost control of the national parliament for the first time in

the national elections of 1977, when a new national-level opposition polit-

ical party was forged through alliances between political leaders previouslybelonging to disparate political groups. However, it came back to power in

an early election in 1980. It similarly lost control of the national parliament

in the 1989 elections to a new political party created for the explicit purpose

of organizing a unified opposition to the Congress, only to return quickly

to power in 1991 with early elections. In the 1989 elections and after, seat

control in the national parliament became increasingly fragmented across

different political parties, including regional parties with their power bases

at the state level. Since 1989, multiparty competition for control over thenational parliament appears firmly established, with national parties such as

the Congress and the Bharatiya Janata Party leading coalition governments

that depend on the support of regional political parties to remain in power.

The post-1989 period not only saw political transformation of represen-

tation in the national legislature and executive government but also an eco-

nomic transformation with the liberalization reforms of 1991, which several

scholars argue has substantially changed the political economy of federal-

ism in India by weakening the economic powers of the center and increas-

ing interjurisdictional competition among the states (Rudolph & Rudolph,

2001; Saez, 2002; Sinha, 2004; to name a few). Liberalization specifically

reduced central control over industrial policy and public sector investments,

increased salience of state-level regulations, and competition among states

for private investment (Sinha, 2004).

In contrast, formal fiscal institutions that govern the sharing of revenue

resources and expenditure responsibilities between the center and the states

have remained steady, although given the political and economic transfor-

mation, a reasonable hypothesis is that the de facto nature of the fiscal bar-gain might have changed, which is what this article attempts to test. The

Indian states are constitutionally assigned expenditure responsibilities for

most local public goods, such as in education, health, and infrastructure.

Between 1960 and the present, state governments have been undertaking




7/23

nearly 50% to 60% of total government expenditures in India (Rao &

Singh, 2005). Relative to their expenditure responsibilities, the revenue

generation powers of state governments are more limited, with high-yieldingtaxes assigned to the center. Between 1960 and the present state, governments

collected nearly 30% of the total revenues (Rao & Singh, 2005).

The constitutional assignment of expenditure responsibilities and rev-

enue authority between the central and the state governments in India was

intentionally imbalanced to give the central government a role in regional

redistribution and promote unity among the disparate nationalities residing

within one country. Overall fiscal control at the center, with state expendi-

tures dependent on federal fiscal transfers, was expected to rein in regionalsecessionist tendencies and promote regional equality. Detailed analysis of

the history of fiscal federalism and intergovernmental transfers in India,

with exhaustive references, can be found in Rao and Chelliah (1991) and

Rao and Singh (2005).

An independent fiscal agency was created for the explicit purpose of

curbing partisan influence on the sharing of national revenues between

national and state governmentsthe Finance Commission of India. It was

established by the Indian Constitution of 1950, which mandates the appoint-ment of new members to the Commission every 5 years, with the primary

purpose of determining the sharing of centrally collected tax proceeds between

the central and state governments and the distribution of grants in aid of

revenues across states.

An interesting and revealing finding was that soon after the provision of

this independent agency, the national government established another agency

with access to very similar instruments of resource distribution across states,

but with far fewer constraints on partisan manipulation. The Planning

Commission was set up by a Resolution of the Government of India in 1950,

as a government agency within the central executive, with the prime minister

as chairman. Its purpose is to supplement the annual budget process with a

medium and long-term planning process to determine the allocation of national

resources across competing needs. Its technical members are appointed

directly by the prime minister and serve as advisors to the government, work-

ing under the general guidance of the National Development Council, which

is chaired by the prime minister and includes all central cabinet ministers and

state chief ministers. In particular, the formula for distribution of PlanningCommission transfers across states is determined by the National Development

Council and its political representatives.3

In addition to the general-purpose transfers determined by these two

commissions in general aid of state budgets, various central ministries




8/23

make specific-purpose grants for so-called centrally sponsored schemes

and central plan schemes in health, education, poverty alleviation, and

such. In the sample of 15 major states studied here, from 1972 to 1998, taxdevolution and grants by the independent agency makes up about 24% of

state revenues, whereas grants from central government ministries and the

Planning Commission constitute about 14%.

Fiscal deficits of states are defined as the difference between total spend-

ing (on the current account, on capital project investments, on net loans to

other agencies, especially state-owned enterprises) and total revenues of a

state (including own-generated and tax devolution and grants made by all

central agencies). State deficits are financed both by direct loans from thecentral government, constituting about 60% of total borrowing by the 15

major states in the sample studied here, and by borrowing from financial

markets. However, these market sources are heavily regulated by the center,

and most market lending to states is by nationalized banks. States are also

known to borrow off budget through state-owned public enterprises,

although the burden ultimately falls on the state (Anand, Bagchi, & Sen

2004; McCarten, 2003). The center, therefore, plays a dominant role in

determining deficit financing for states, both directly through a largevolume of loans but also indirectly through regulation of market loans and

bailouts of state-owned enterprises.

The Empirical Model

As described above, there has been substantial variation with time across

Indian states in political relations with the center on one hand and in fiscal

performance on the other hand. Are these two processes linked in particu-lar ways, as hypothesized in the literature on political bargaining between

different tiers of government?

To answer the questions raised in this article, we estimate the following

model:

DEFICIT/StateGDPit = Zit + t + i + it + 1 StrictlyAffiliated it+ 2 Coalition Partnerit + Coalition Partner

State Party Seatsit + State Party Seatsit+ StrictlyAffiliated StatePartySeatsit (1)

in whichDEFICIT/StateGDPit

is fiscal deficit in state i in year t, expressed

as a percentage of the state domestic product (GDP). Time-varying economic

and demographic characteristics of states (real per capita state domestic




9/23

product and total population) are included in the vectorZit. A time effect for

each year, t, is included to control for various shocks to the economy in any

given year, and state fixed effects, i, are included. Taken together, thesevariables determine the average deficit to state GDP ratio in a state given its

economic conditions. The other variables capture the hypothesized political

impacts on deficits, and their coefficients are identified in this empirical

specification as the change in a states deficit from its own average deficit

when its political conditions change. The unobservable error term in this

specification is denoted by it.The variable Strictly Affiliated is an indicator variable which equals 1

when the political party leading the state government is the same as thatleading the national government (that is, the national prime minister and the

state chief minister belong to the same party), and 0 otherwise. If a single-

party majority government at the center has particularly strong incentives

for fiscal discipline and institutional authority over subnational borrowing,

then either political variables do not matter for state fiscal deficits as the

center would determine these solely according to economic criteria, or

states ruled by the same political party have lower deficits, if the center is

better able to discipline its own party members. That is, under this hypoth-esis, we would expect either 1 < 0 or statistically indistinguishable from 0.Conversely, if we find that 1 > 0, then this result would suggest thatnational political parties do not have strong incentives for fiscal discipline,

as state deficits are distorted by political considerations.

Jones et al. (2000), Dillinger and Webb (1999), Rodden and Wibbels

(2002), among others, hypothesize that the center is likely to have leverage

in affiliated states through internal party disciplinary mechanisms and

might be able to preempt state fiscal profligacy, leading to lower deficits for

affiliated states. Subnational governments that are politically affiliated with

the center are more likely to internalize the effect of spending an additional

unit of national resources because of internal party discipline to protect the

partys national reputation and should therefore have lower spending and

deficits. Consistent with this hypothesis, Jones et al. (2000) find empirical

evidence that provinces in Argentina, whose governors belong to the same

political party as that of the national president, have lower spending than

provinces that are not affiliated with the presidents party.

If single-party majority national governments have stronger incentivesfor fiscal discipline than do coalition governments, then when the national

government shifts from the former to the latter regime, then states that emerge

as coalition partners should have higher deficits than before, when they

were not coalition partners. The variable Coalition Partneris an indicator




10/23

variable that equals 1 when the political party leading the state is a coalition

member or supporter of the party leading the national government (that is,

the prime minister and chief minister belong to different political parties thatare allied in a coalition). A test of this hypothesis is therefore the test that

2 > 0 in Equation 1. If the bargaining power of coalition partners increaseswith the number of seats they control, then we would also have > 0.

Conversely, if we find that 2 < 0 or statistically indistinguishable from0, then this result would cast doubt on the story of coalition governments

being more susceptible to subnational fiscal indiscipline than single-party

majority governments. If this is combined with a finding of1 > 0, then the

two results would together reinforce the conclusion that even the nationalpolitical executive, captured here as the national political party leading the

government, can have weak incentives for fiscal discipline.

Irrespective of party affiliation between the central and state political

executives, a typical model of legislative bargaining, as in the classic arti-

cle by Weingast, Shepsle, and Johnsen (1981), would argue that a region

would be able to win greater resources for itself if it has greater represen-

tation in the national legislature. As described previously there is no varia-

tion with time and across the Indian states in the extent of per capitarepresentation, because national districts are allotted to states in proportion

to their population. However, there is variation in the extent to which the

state ruling party controls the national districts allotted to the stateif all

the national legislators coming from a states districts belong to the state

ruling party, the state party leadership might be in a better position to lobby

for greater resource transfer to the state. Equation 1 therefore includes the

variable State Party Seats, which is the proportion of districts allotted to a

state in the national legislature that is controlled by the state ruling party,

and we test whether > 0.Strictly applied, the hypothesis that national party leadership can disci-

pline state party leaders would imply that is statistically indistinguishablefrom 0that is, in strictly affiliated states, the extent of control of districts

in the national legislature by the party should not make a difference. However,

if state party leaders are in fact bargaining with their partys national

leaders, or if the national party is deliberately using deficit financing to tar-

get resources to particular states, then we might expect the partys control

over national districts to matter. The nature of impactthat is whether> 0 or < 0is a complex theoretical question, because several differenttypes of stories could be constructed for either direction of impact. If the

partys control over a higher proportion of districts is interpreted as a proxy

for greater popularity of the party among voters in a state, then the sign on




11/23

would capture whether the party provides greater resources to those stateswhere it is more popular.

Equation 1 gives us the reduced-form impact of politics on deficits. Ifparty politics does indeed matter for deficits, what are the direct channels

of impactlower revenues and grants or higher spending? To unpack the

impact of these political variables on deficitsthat is, to understand

whether the impact is through lower own revenue effort of states, or higher

spending, or greater bargaining for federal transfers, we simultaneously

estimate the following system of equations:

Own Revenueit = f1 (OwnRevenueit-1, all variables in [1]) (2)Grants Under Political Discretionit = f2 (Grants Under Political Discretionit-1,

all variables in [1]) (3)

Grants By Independent Agencyit = f3 (Grants By Independent Agencyit-1, allvariables in [1]) (4)

Noninterest Spendingit = f4 (Own Revenueit-1,Grants Under Political Discretionit-1,

Grants By Independent Agencyit-1,


Interest Spendingit = f5 (Own Revenueit-1,Grants Under Political Discretionit-1,

Grants By Independent Agencyit-1,


We estimate the impact of party politics separately on the three compo-

nents of state revenues in India, as given in Equations 2 through 4own

revenue generation by states, grants made by central political agenciesthat is, the Planning Commission and individual central ministries and

grants made by the independent fiscal agency, the Finance Commission (as

described previously). As the specification indicates, we use lagged values

of own revenues and the two types of grants to identify their impact on

spending, following the specification in Jones et al. (2000) and Alt and

Lowry (2004).

This system of equations allows us to test an alternate leading hypothe-

sis in the literature on fiscal federalism and fiscal disciplinethat depen-dence on federal grants creates perverse incentives for fiscal profligacy (see

Rodden, 2002, for a review). In the specific context of fiscal institutions

in India, several scholars have argued that the design of federal transfers, in

that they are supposed to be gap-filling to provide additional resources to




12/23

those states who have lower revenues and greater spending needs, induces

states to spend more and then request additional transfers (Rao, 1998; Rao

& Singh, 2005; Sinha, 2004). Do states tend to spend more (or more than adollar) out of a dollar of federal grants than they do out of own revenues?

To the best of our knowledge, this is the first time a rigorous empirical test

has been undertaken of this hypothesis.

We estimate the impact of the different sources of revenue and of the polit-

ical variables on total spending on public services and organs of state, exclud-

ing interest payments (Equation 5) and then separately on interest payments

(Equation 6). We do this to test whether those states that have higher deficits

and higher spending are partially financed through lower interest paymentsthat is, by having access to subsidized credit from financial markets. As dis-

cussed earlier, state fiscal deficits are ultimately financed by the center, either

directly through central government loans or indirectly through the centers

control of financial markets. To test the extent to which deficits are directly

financed through central loans, we estimate Equation 1 by replacing the depen-

dent variable of deficit to GDP with real per capita central loans.

Data and Results

The data set for this study is compiled from diverse sources for 15 major

states of India during the period 1972 to 1998. The political data are com-

piled from Butler, Lahiri, and Roy (1995). The public finance data on

deficits, revenues, expenditures, and intergovernmental transfers is avail-

able since 1972 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. State demographic and

economic characteristics and a state-level price index to convert all vari-

ables into real terms (constant 1992 prices) are available from an Indian

data set put together at the World Bank. A detailed description of these vari-

ables is available in Ozler, Datt, and Ravallion (1996). Table 1 provides

summary statistics for each of the variables included in the analysis.4 Of the

405 state-year observations in the sample studied here, only 2 have shown

a small fiscal surplusthat is, state finances in India are always likely to be

in deficit presumably because of the inherent vertical fiscal imbalance inIndias federal structure and the role of the center in providing loans to

states for planned economic development.

Model 1 of Table 2 reports the results of estimating Equation 1 using

ordinary least squares (OLS) with robust standard errors clustered by state.5




13/23

The coefficient estimates show that when states belong to the same politi-

cal party as the central government, they have significantly higher fiscal

deficits; accordingly, when states are not strictly affiliated they have lower

deficits, even if they are members or supporters of a coalition government

at the center. Among strictly affiliated states, those where the party controls

a small proportion of seats to the national legislature tend to have signifi-

cantly higher deficits than those that control a higher proportion of seats. In

fact, if an affiliated state government controls all the states seats to the

national legislature (that is, the proportion = 1), then its net benefit fromaffiliation can be negative, because the coefficient on the interaction term is

greater than the coefficient on the affiliation indicator in many specifica-

tions. Hence, it is really those affiliated states where the ruling party has

more scope of gaining seats in national elections that seem to be particu-

larly favored in terms of being allowed to run higher deficits.The effect of political affiliation is substantialthe deficit to GDP ratio

in affiliated states (in which the proportion of seats controlled by the ruling

party is at the sample average, which is about half) is greater by half a per-

centage point. If an affiliated state controls close to zero of the seats in the


Table 1

Summary Statistics of the Variables Used in the Analysisa

Variable M SD

Real fiscal deficitb 213.53 135.24

Real state income 5106.64 2118.04

Ratio of deficit to state income 0.04 0.02

Total population (in thousands) 48984.14 29538.4

Own revenues 580.45 362.59

Grants under political discretion 109.25 62.53

Grants by an independent agency 185.04 72.93

Total spending (excluding interest payments) 975.71 438.80Interest payments 110.38 82.84

Strictly affiliated (= 1 if central and state 0.57 0.50

governments belong to same political party)

Coalition partner (= 1 if state ruling party is 0.07 0.25

part of a central coalition government)

State ruling partys seat share (share of seats 0.61 0.29

allotted to a state in the national legislature

won by the state ruling party)

a. Fiscal variables and state domestic product are in per capita, constant 1992 Indian rupees.

b. Fiscal deficit = Total current expenditure + total capital expenditure total revenue + (loans

by state government recovery of loans).



14/23

Table2

EffectofPartyIdentityon

StateFiscalDeficit

Variable

Model1

SE

Model2

SE

Model3

SE

Strictlyaffiliated

(=1ifcentral

0.014***

0.003

0.015***

0.0

04

0.014***

0.003

andstategovernmentsbelong

tosamepolitic

alparty)

Coalitionpartner

(=1ifstaterulingparty

0.005

0.012

0.005

0.0

13

0.005

0.012

ispartofacen

tralcoalitiongovernment)

CoalitionPartner

State

0.002

0.024

0.002

0.0

25

0.002

0.025

RulingPartyS

eats

StrictlyAffiliated

StateRulingPartySeats

0.019***

0.004

0.021***

0.0

05

0.019***

0.005

State-rulingparty

seats

0.006*

0.003

0.006

0.0

04

0.006

0.004

Congressstate(=

1ifaCongress

0.002

0.0

02

Partyrulesstate)

VoteshareofCongresspartyin

0.0001

0.0

002

lastelection

Coalitiongovernment

0.0002

0.002

(=1ifrulingp

artyatstate

levelcontrolslessthan50%

ofseatsinthe

statelegislature)

Stateelectionyear(=1ifayear

0.0001

0.001

beforeastateelection)

Realstateincomepercapita

0.00001**

0.0000

02

0.00001**

0.0

00002

0.00001**

0.000002

Totalpopulation

0

0

0

Note:Population

:N=

405,

R2=

.54;dependent

variableistheratioofstatefis

caldeficittostateGDP;yeareffectsandstatefixedeffectsin

cluded;

OLSregressions

withrobuststandarderrorsclu

steredbystate.

*psignificantat10%.**psignificantat5%.**

*psignificantat1%.

703



15/23

national parliament, then its deficit to GDP ratio is greater by more than one

percentage point.6

We performed several different tests to ensure that the estimated impact ofparty affiliation is not being driven by other kinds of political effects that just

happen to be correlated with the party affiliation indicators. One of the biggest

concerns is that the variation in affiliation in the data derives largely from

whether voters in a state elect a particular party, the Congress party, or not. As

discussed in earlier, the Congress party has dominated national government in

India until the 1990s, although it has been frequently unseated from state gov-

ernments. We include the share of votes cast for the Congress party in

Equation 1 to control for voter taste for the dominant national political partyand an indicator for whether the state is ruled by the Congress party. These

results are shown in Model 2 of Table 2. The Congress variables are not sig-

nificant, and including them does not change the other coefficient estimates.

Other political and institutional determinants of deficits at the state level

that have been tested in the received literature might be correlated with

affiliation and be driving the results such as election cycles (Alesina,

Roubini, & Cohen, 1997; Khemani, 2004) and fragmented or divided leg-

islatures (Alt & Lowry, 1994; Perotti & Kontopoulos, 2002; Poterba, 1994;Roubini & Sachs, 1989). Model 3 of Table 2 includes two additional indi-

cator variables: One of these equals 1 when the state ruling party controls less

than 50% of the seats in the state legislature and therefore has to depend on

support from other parties to form a coalition government; the second

equals 1 for the year just preceding a state election.7 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 coef-

ficients of interest. These results are interesting in their own right because

they indicate that party identification between the national and state gov-

ernments in India stands out as the only significant political determinant of

variation in deficits across and within states with time, to the exclusion of

other plausible political and institutional determinants at the state level that

have been tested in the received literature.

Table 3 reports the results of estimating the system of Equations 2 through

6 using three-stage least squares. There are no significant effects of the polit-

ical variables on own revenue generation; however, federal grants deter-

mined by central ministries and the Planning Commissionthat is, agenciesunder political discretionare greater to strictly affiliated state govern-

ments. In surprising contrast, federal grants determined by the independent

fiscal agency, the Finance Commission, are lower when state governments

belong to the national ruling party. That is, the independent agency counteracts




16/23

Table3

ImpactofPoliticson

RevenuesandSpendin

g3-StageLeastSquaresEstimates

Grantsby

GrantsbyIndependent

TotalSpending

OwnRevenue

PoliticalAgencies

Agency

(excludinginterest)

InterestPayments

Model1

SE

Model2

SE

Model3

SE

Model4

SE

Model5

SE

Lagdependentvariable

0.51***

0.05

0.54***

0.05

0.62***

0.04

Ownrevenue

0

.84***

0.11

0.01

0.05

Grantsbypoliticalagencies

0

.52

0.42

0.44**

0.18

Grantsbyindepe

ndentagency

0

.59*

0.36

0.20

0.15

Realstateincomepercapita

0.05***

0.01

0.0002

0.002

0.00001

0.002

0

.003

0.01

0.01*

0.004

Totalpopulation

0.01***

0.001

0.0002

0.0003

0.0001

0.0002

0

.002*

0.001

0.002**

0.001

Strictlyaffiliated

6.63

30.74

16.57**

8.2

20.19***

7.64

148

.95***

26.99

36.68**

11.57

Coalitionpartner

33.21

58.87

7.10

18.11

8.95

14.63

49

.74

45.86

26.71

19.66

Affiliation

Seats

0.16

46.70

18.58

14.44

4.87

11.50

175

.1***

38.19

40.43***

16.41

Coalition

Seats

97.48

1

12.66

22.01

34.82

20.41

28.05

68

.37

90.72

2.14

38.80

State-rulingparty

seats

10.88

30.47

2.77

9.42

7.64

7.54

30

.12

23.52

3.03

10.10

Note:Dependent

variablesarepercapita,constant1992Rs;Statefixedeffectsandyeareffectsincluded.

*psignificantat10%.**psignificantat5%.**

*psignificantat1%.

705



17/23

the partisan influence of the political agencies. These results are entirely

consistent with those reported in an article devoted to contrasting the impactof politics on transfers by different central agencies, which reaches the same

conclusion through many more empirical tests, that the independent agency

curbs the partisan influence of the national government (Khemani, 2003).8

Spending by state governments belonging to the national ruling party is

substantially higher, and more so when the ruling party controls a smaller

proportion of districts. That is, exactly the same pattern of political impact on

spending is obtained as on overall deficits. The coefficient on own revenues

in the spending equation estimated in column 4 is significantly bigger in size

than the coefficients on grants, and the grant coefficients are estimated at

under 0.6, that is, less than 60% of every additional unit of grants is spent on

public services. Hence, the results show that states spend significantly more

out of own revenues than they do out of transfers and that they do not spend

more than a unit out of a unit of transfers in expectation of greater transfers

in the future.9 These results, therefore, do not support the hypothesis that

transfer dependence creates perverse incentives for fiscal profligacy.

Model 5 of Table 3 shows that interest payments are significantly lower

for same-party state governments, again, especially when the party controlsfewer districts. This suggests that higher deficits in these states are partially

financed out of access to subsidized credit from financial markets. Table 4

shows the results for political impact on direct central loans, net of repay-

ment. Although the pattern of coefficients signs is the same as for deficits,


Table 4

Effect of Party Identity on Central Loans

Variable Model 1 SE

Strictly affiliated (= 1 if central and state 81.39 69.76

governments belong to same political party)

Coalition partner (= 1 if state ruling party is 44.15 26.13

part of a central coalition government)

Coalition Partner State-Ruling Party Seats 74.77 69.97

Strictly Affiliated State-Ruling Party Seats 95.37 78.69

State-ruling party seats 16.08 15.56

Real state income per capita 0.02** 0.01

Note: Population:N= 405,R2 = .56); Dependent variable is per capita net loans by the center

in constant 1992Rs; Year effects and state fixed effects included; OLS regressions with robust

standard errors clustered by state.

*p significant at 10%. **p significant at 5%. ***p significant at 1%.



18/23

the point estimates are measured with a lot of error and are not statistically

significant. This suggests that the center does not systematically use any

one financing instrument to finance state deficits but rather a combinationof the various instruments available to it, as discussed earlier.

Interpretation of Results

The main result that it is those states whose governments belong to the

same party as the national ruling party suggests weak incentives of the

national ruling party for fiscal discipline. We interpret this pattern of evi-dence as suggesting that although delegating authority to the national polit-

ical executive to monitor and regulate subnational borrowing might allow it

to discipline states governed by rival political parties, it does not prevent the

national ruling party from using deficit financing to further its own political

objectives. That is, the mere existence of a single national party at the helm

of government does not guarantee subnational fiscal prudence. National

political parties themselves can have weak incentives for fiscal discipline.

Strictly affiliated states could have higher deficits, because the centeropportunistically and deliberately distributes deficit financing across states to

further the partys political objectives or because state party leaders have bar-

gaining power within the party and hold the central party leadership hostage

through their actions. We cannot conclusively distinguish between these two

interpretations using the available data, but below we present some arguments

that appeal to the latter interpretation of bargaining within political parties.

Which of the two is appropriate is likely to depend on the extent of inter-

nal party discipline or control of national party leaders over state party

leaders. There is quite a bit of political science literature on the bargaining

power of state leaders of the Congress party, which is the party most likely

to be driving the incidence of affiliation. In the late 1960s, power within the

Congress party has been described as resting in the hands of powerful state

leaders, commonly called the Syndicate (Frankel, 1978; Kochanek, 1968;

Rudolph & Rudolph, 1987). From 1971 to 1977 and again from 1980 to

1985, Prime Minister Indira Gandhi tried to bypass state leaders to forge

direct ties with local elites that helped as power brokers during elections

(Kochanek, 1976). After 1985, her son and then Prime Minister RajivGandhi have been described as unable to control the various factions within

the Congress party (Frankel, 1987; Manor, 1988; Weiner, 1987). This liter-

ature is therefore consistent with a story of bargaining by affiliated states

for bailouts from the center.




19/23

The bargaining story is also more appealing, given that federal fiscal

institutions in India do provide the center with alternate instruments of resource

transfer to statesgrants through the Planning Commission and throughvarious central ministriesand the results reported here show that these

agencies indeed provide greater grants to state governments belonging to

the national ruling party. Why then, would the center recourse to deficit

financing to deliberately target resources to its affiliated states? Why not give

more grants and eschew political distortions to financial markets? The bar-

gaining interpretation addresses this conundrum. Because the state deficit

is determined directly through actions of the state government, it is more

likely to be a preemptive move on the part of state political leaders. In polit-ically affiliated states, the center might bear relatively greater costs of no

bailout once a state has incurred additional spending, because of the damage

done to the reputation of the political party if the state government goes into

a fiscal crisis. Knowing this, affiliated states have incentives to overspend

in expectation of greater loans from the center.

Following this line of argument through to the case of unaffiliated states,

the direct costs to the center of not bailing out the state when in financial

trouble might be mitigated by costs to the rival political party controllingthe state, if voters punish the rival political party ruling the state for subse-

quent ill effects of fiscal mismanagement. That is, the central ruling party

might actually stand to gain from its rival partys discomfiture because of

fiscal retrenchment, whereas it loses by supporting additional spending on

local public goods whose political benefits would accrue to the rival party.

This explanation is consistent with our finding that states ruled by coalition

partners belonging to other political parties do not have higher deficits.

Parties that are coalition partners or supporters might bargain for other

thingsnational cabinet portfolios, for instance, or particular economic

policies that would benefit their states economic actorsbut there is no

evidence that they run higher deficits in the states as a bargaining chip. This

article does not aim to address the broader question of how parties in a

coalition government might bargain over national policies or economic

resources, being focused on the immediate purpose of analyzing fiscal bar-

gaining between different tiers of government.

Conclusion

This article provides new empirical evidence on political incentives of

national governments to impose fiscal discipline on subnationals. It finds




20/23

that those states whose governments belong to the same party as that lead-

ing the national government have higher deficitsthat is, states ruled by

rival political parties have correspondingly lower deficits, even when theyare partners in a national coalition government. This evidence of the polit-

ical vulnerability of national ruling parties to their own members, even

when they enjoy a clear majority in the national parliament, suggests that

the institutional solution of delegation of subnational debt oversight to the

national political executive that has been favored by many policy makers is

unlikely to solve the problem of fiscal indiscipline in a federation. Further

research on the more fundamental question of political determinants of

deficits at multiple tiers of government, especially in developing countrieswhere there is a knowledge gap, is likely to be fruitful in understanding how

political interests can become aligned with fiscal discipline and whether

specific institutions can help promote such alignment.

Notes

1. A party does not have win a critical number of votes in each state to win the districts

allotted to a state in the national legislature. Districts are won on an individual basis.2. In the event of a single party not winning more than 50% of Lok Sabha seats, a ruling

coalition is formed among different parties on the basis of a vote of confidence in Parliament.

3. Scholars of Indian fiscal federalism have described transfers made by the Planning

Commission as unconstitutional, because the Finance Commission was envisioned in the

Constitution as the only agency with decision-authority over regular, general-purpose transfers

to the states (Bagchi, 1977).

4. These 15 states of India account for 95% of the total population. India consists of

28 states at present, of which 3 were newly created in 2000, 2 were recently converted to state-

hood from Union Territories, and 8 are designated special states, largely because of sepa-

ratist tensions and provided extraordinary central transfers. Of the 15 states under study, 11have existed since the organization of the federation in 1956. An additional two states were

created for linguistic reasons out of a single large stateMaharashtra and Gujaratin 1960;

and two in 1966Pubjab and Haryanaalso for ethnic and linguistic reasons. Hence, to avoid

issues of endogenous state boundaries and of special transfers to some smaller states, we only

focus on the 15 major states that have existed from the early days of the federation. These 15

states are the following: Andhra Pradesh, Assam, Bihar, Gujarat, Haryana, Karnataka, Kerala,

Madhya Pradesh, Maharashtra, Orissa, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh, and

West Bengal. This analysis stops in the year 1998 because after this year, three of the states in

the sample were each split into two, leading to a discontinuity in the unit of observation.

5. This is the specification of choice in a large literature which uses panel data on theIndian states to address various research questions correlating variation in institutions with

variation in economic outcomes. Chhibber and Nooruddin (2004) and Besley and Burgess

(2003) are prominent examples and contain further references.

6. None of the main results are affected by including or excluding the control variables or

dropping individual states one at a time. The sign of the coefficient on the affiliation and seats




21/23

interaction is identical when the absolute number of national legislators belonging to the state

ruling party is used instead of as a proportion of the total seats allotted to a state.

7. There is a large literature on political budget cycles, which finds evidence of expan-sionary fiscal policies in election years in developing countries. However, Khemani (2004)

finds no effect of such cycles in overall spending and deficits in the Indian statesonly the

composition of spending and revenues changes, possibly to target special interest groups for

campaign support.

8. Khemani (2003) in fact shows that Planning Commission transfers are particularly sus-

ceptible to political influence, despite the existence of a formulathe Gadgil formulathat is

supposed to determine how much resources a state receives. That is, what seems to make a dif-

ference for political control is not whether transfers are formula driven but the identity of the

agency making the decisions. If the agency is headed by the national political executive, its

distribution of transfers is consistent with serving the executive governments political interests;if the agency is designed to be independent of political control (the Finance Commission), it

counteracts the partisan influence on resources available to states.

9. The results on transfer dependence are supported by an alternate specification when we

include vertical fiscal imbalance; that is, the proportion of intergovernmental grants in total

state revenues (total intergovernmental grants divided by total revenues) as a measure of trans-

fer dependence directly in Equation 1. We find that the coefficient on vertical fiscal imbalance

is not statistically significant. These results are available from the author by request.

References

Alesina, A., Roubini, N., & Cohen, G. (1997). Political cycles and the macroeconomy.

Cambridge, MA: MIT Press.

Alt, J., & Lowry, R. (1994). Divided government, fiscal institutions, and budget deficits:

Evidence from the state. The American Political Science Review, 88(4), 811-828.

Anand, M., Bagchi, A., & Sen, T. (2004). Fiscal discipline at the state level: Perverse incen-

tives and paths to reform. In E. Favaro & A. Lahiri (Eds.), Fiscal policies and sustainable

growth in India (pp. 80-101). New York: Oxford University Press.

Bagchi, A. (1977). Fiscal federalismProblems and possible solutions: A review article.Indian Economic Review, 12(2), 185-211.

Besley, T., & Burgess, R. (2003). The political economy of government responsiveness:

Theory and evidence from India. Quarterly Journal of Economics, 117(4), 1415-1451.

Blanchard, O., & Shleifer,A. (2001). Federalism with and without political centralization: China

versus Russia.International Monetary Fund Staff Papers, 48(Special Issue), 171-179.

Brass, P. (1990). The politics of India since independence. New York: Cambridge University Press.

Butler, D., Lahiri, A., & Roy, P. (1995). India decides: Elections 19521995. New Delhi,

India: Books and Things Publishers.

Chhibber, P., & Nooruddin, I. (2004). Do party systems count? The number of parties and gov-

ernment performance in the Indian states. Comparative Political Studies, 37(2), 152-187.Dillinger, W., & Webb, S. (1999). Fiscal management in federal democracies: Argentina and

Brazil (Policy Research Working Paper No. 2121). Washington DC: The World Bank.

Frankel, F. (1978).Indias political economy, 1947-1977: The gradual revolution. Princeton,

NJ: Princeton University Press.




22/23


23/23

Rudolph, L., & Rudolph, S. (1987).In pursuit of Lakshmi: The political economy of the Indian

state. Chicago: University of Chicago Press.

Rudolph, L., & Rudolph, S. (2001, May 5). The iconization of Chandrababu: Sharing sover-eignty in Indias federal market economy.Economic and Political Weekly, 1546-1549.

Saez, L., (2002). Federalism without a center: The impact of political and economic reform on

Indias federal system. New Delhi, India: Sage.

Samuels, D. (2000). Concurrent elections, discordant results: Presidentialism, federalism, and

governance in Brazil. Comparative Politics, 33, 1-20.

Sinha, A. (2004). The changing political economy of federalism in India: A historical institu-

tionalist approach.India Review, 3(1), 25-63.

Stepan, A. (2000). Brazils decentralized federalism: Bringing government closer to the citi-

zens?Deadalus, 129, 145-170.

Treisman, D. (1999). Political decentralization and economic reform: A game-theoretic analy-sis.American Journal of Political Science, 43, 488-517.

Treisman, D. (2000). Decentralization and inflation: Commitment, collective action, or conti-

nuity?American Political Science Review, 94, 837-858.

Weiner, M. (1987). Rajiv Gandhi: A mid-term assessment. In Marshall Bouton (Ed.), India

briefing, 1987. Boulder, CO: Westview.

Weiner, M., & Field, J. (Eds.). (1974). Studies in electoral politics in the Indian states.

New Delhi, India: Manohar Book Service.

Weingast, B., Shepsle, K., & Johnsen, C. (1981). The political economy of benefits and costs:

A neoclassical approach to distributive politics.Journal of Political Economy, 89, 642-664.

Wibbels, E. (2000). Federalism and the politics of macroeconomic policy and performance.American Journal of Political Science, 44(4), 687-702.

Wibbels, E. (2003). Bailouts, budget constraints, and Leviathans: Comparative federalism and

lessons from the early United States. Comparative Political Studies, 36(5), 475-508.

Yadav, Y. (1996). Reconfiguration in Indian politics: State assembly elections, 1993-1995.

Economic and Political Weekly, 31(1), 95-104.

Stuti Khemani is an economist in the Development Research Group of The World Bank. Her

research focuses on the political economy of public policies and institutional interventions that

strengthen political incentives for growth-promoting and human development policies. Shereceived a PhD in economics from the Massachusetts Institute of Technology in 1999.


comparative political studies 2007 khemani 691 712

Documents