Institutions, politics and the soft budget constraint in a decentralised economy: the case of India

Abstract

This thesis tries to build a set of theoretical and empirical premises of the important issues pertaining to a decentralized government structure. While the questions that we attempt to answer in this thesis are varied, the common theme that runs through the essays is its focus on issues from a regional perspective. Our empirical outcomes are based on the Indian federal system, more specifically, the 15 major states of India, which account for over 90 per cent of the population and 95 per cent of GDP. The period under consideration is 1985 - 2000. We consider this to be a crucial period because a lot of stress in state finances emerged during this period. The research questions we broadly seek to answer are the following: 1. What are the causes of differences in developmental levels across the major Indian states? 2. What is the role of political alignment in determining the budgetary considerations of states? 3. What accounts for differences in human developmental outcomes across the states? 4. In normative terms, can it be argued that a decentralized structure need not automatically lead to the iformation of a hard budget constraint? Further, can it be claimed that under certain circumstances, particularly when dealing with State-run natural monopolies, that a soft budget constraint may lead to better outcomes? The starting point of our analysis or the first essay (Chapter 2) deals with the question as to why have Indian states had different levels of development and growth? The existing literature argues that states, which have followed better policies in terms of macroeconomic probity and identification of developmental issues, have had better outcomes, which we feel is an inherently circular argument. The existing literature does not answer the basic issue of what prompted certain states to follow better policies? We add to the burgeoning literature on growth in Indian states, by looking at institutional quality. We argue that some states in India have better institutions than others, and these have set better policies. We suggest that the level of political accountability and the quantum of 'point resources' such as minerals would have an impact on the quality of institutions. The idea being that a region can be 'cursed' with high mineral wealth and having unaccountable politicians. This can lead the politician to try to subvert institutional quality in these regions to facilitate 'rent seizing', leading to lower developmental and growth prospects for such states. We try to prove this through a theoretical model as well as an empirical exercise. The second essay (Chapter 3) is more empirical in its construct and analyses the impact of political affiliations and the quality of fiscal institutions on regional budget constraints. While we do not make any normative judgments here regarding the welfare implications of soft budgets, we argue that the correct political alignment and poor fiscal institutions might combine to lead a state to greater fiscal profligacy. This is because of the inability to have institutional checks on expenditures and due to a higher probability of an ex post bailout by the central government, through higher ad hoc transfers. The third essay (Chapter 4) considers not merely ' budgetary output' levels such as the quantum of expenditures, in isolation, but looks at the 'outcomes' of such expenditures, viz. the impact of expenditure on health on an 'outcome' indicator like Infant Mortality Rates (IMR). across the major Indian states. We argue that analyzing the budgetary allocations on any expenditure tells us merely half the story. Since the Indian states are constitutionally required to spend more on human development expenditures such as health and education as compared to the central government, the correct way to look at 'effective' expenditure would be to analyse the determinants of variation in 'outcome' indicators. We in our essay, consider variations in IMR to be our measure of 'outcomes'. We suggest that political accountability might have a major role in determining human developmental outcome levels through better utilization of expenditures. Since we argued in the second essay that the potentially harmful impact of poor fiscal institutions and political alignment, is softening of the budget constraint, our final essay (Chapter 5) is a theoretical piece of work, which looks at the micro-foundations of a 'soft budget constraint' and tries to analyse the normative issue of the welfare considerations in this regard. We try to prove two concomitant factors in the federalism and soft budget literature. First, contrary to some of the existing literature, decentralization, need not automatically increase a commitment to the hard budget and second, in normative terms, under certain circumstances, a 'soft budget' is preferable to a 'hard budget'.