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

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 1972-1995, 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 email to [email protected]. 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.