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Party Politics and Fiscal Discipline in a Federation : Evidence from the States of India
Stuti Khemani Comparative Political Studies 2007 40: 691 DOI: 10.1177/0010414006290110 The online version of this article can be found at: http://cps.sagepub.com/content/40/6/691

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Party Politics and Fiscal Discipline in a Federation

Evidence from the States of India
Stuti Khemani
The World Bank, Washington, D.C.

Comparative Political Studies Volume 40 Number 6 June 2007 691-712 2007 Sage Publications 10.1177/0010414006290110 http://cps.sagepub.com hosted at http://online.sagepub.com

Theoretical and empirical analysis suggests that federations are prone to fiscal 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 evidence 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 the national 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

ne of the more prominent issues in recent development policy is the risk of fiscal indiscipline and macroeconomic instability in developing countries that are rapidly decentralizing fiscal powers to subnational governments. 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
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. 691

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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 nations where subnationals are more dependent on national transfers for their spending 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 Russiasubnational 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 central 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 leading the center is likely to be held accountable by voters for overall macroeconomic 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 impose discipline 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.

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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 questions 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 support 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 potential 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 monitor and regulate subnational borrowing; in more recent years, regional political parties have gained greater representation in the national government and have served as critical members in or supporters of national coalition governments. This article uses panel data on 15 major states of India, which account 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 percentage 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 payments on debt, when compared to states governed by rival political parties. This pattern of evidence does not support the view that a dominant national party is likely to promote fiscal discipline in a federation; instead, it is consistent with the notion that greater regional political competition can create market-preserving conditions that strengthen incentives for fiscal discipline.

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The article is organized as follows: It first provides a brief description of Indian political and fiscal institutions to set the national context for this analysis. It then presents the empirical model used to test the competing hypotheses outlined above. This is followed by a description of the data used and the results of the analysis. Finally, the article provides a discussion and interpretation of the results and conclusions for future directions.

Political and Fiscal Institutions in India

Government in India has been a Westminster-style parliamentary democracy since the adoption of a 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 country is divided into 4,061 single-member districts for state assembly elections, which are grouped together, separately within each state, to form 543 singlemember districts for the national assembly. The number of national districts allotted to a state is proportional to its population so that there is no real variation across states in per capita representation at the center. The party, which wins a majority of districts distributed in any manner across the states,1 is invited to form the government, headed by a prime minister and a cabinet of ministers.2 Analogous to the national executive, the party or coalition of parties with a majority of seats in an individual states legislative assembly forms the state-level executive government headed by a chief minister and a state cabinet of ministers. Although India has an Upper House, the Rajya Sabha or the Council of States, this chamber has no real authority over fiscal policy. Thus, states bargaining power at the center for fiscal resources is exercised, if at all, through the lower housethat is, the Lok Sabha, and/or through the selection of central cabinet ministers. Political parties compete in both state and national elections, and states are represented in the central legislature through party members elected from the national districts allotted to a state and through the selection of state party leaders in the central cabinet of ministers. There exists a large political science literature analyzing party competition in India from which we derive the following brief description (Brass, 1990; Frankel, 1978, 1987; Kochanek, 1968, 1976; Manor, 1988; Rudolph & Rudolph, 1987; Weiner, 1987; Weiner & Field, 1974; Yadav, 1996 are the major references used here). A single political party dominated electoral competition in the early years of Indias democracynamely the Indian National Congress

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(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 (there is 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 political party was forged through alliances between political leaders previously belonging 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 the national 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 representation in the national legislature and executive government but also an economic transformation with the liberalization reforms of 1991, which several scholars argue has substantially changed the political economy of federalism in India by weakening the economic powers of the center and increasing 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 transformation, a reasonable hypothesis is that the de facto nature of the fiscal bargain 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

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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-yielding taxes 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 revenue 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 expenditures dependent on federal fiscal transfers, was expected to rein in regional secessionist 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 appointment 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, working 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 Planning Commission 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

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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, tax devolution 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 spending (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 the central 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 large volume 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 particular 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 StrictlyAffiliatedit + 2 Coalition Partnerit + Coalition Partner State Party Seatsit + State Party Seatsit + StrictlyAffiliated StatePartySeatsit

(1)

in which DEFICIT/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

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product and total population) are included in the vector Zit. 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, these variables 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 that leading the national government (that is, the national prime minister and the state chief minister belong to the same party), and 0 otherwise. If a singleparty 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 hypothesis, we would expect either 1 < 0 or statistically indistinguishable from 0. Conversely, if we find that 1 > 0, then this result would suggest that national 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 incentives for 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 Partner is an indicator

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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 that are 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 increases with the number of seats they control, then we would also have > 0. Conversely, if we find that 2 < 0 or statistically indistinguishable from 0, 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 of 1 > 0, then the two results would together reinforce the conclusion that even the national political 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 article by Weingast, Shepsle, and Johnsen (1981), would argue that a region would be able to win greater resources for itself if it has greater representation in the national legislature. As described previously there is no variation with time and across the Indian states in the extent of per capita representation, 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 discipline state party leaders would imply that is statistically indistinguishable from 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 target 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 different types 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

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would capture whether the party provides greater resources to those states where it is more popular. Equation 1 gives us the reduced-form impact of politics on deficits. If party 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]) Grants Under Political Discretionit = f2 (Grants Under Political Discretionit-1, all variables in [1]) Grants By Independent Agencyit = f3 (Grants By Independent Agencyit-1, all variables in [1]) Noninterest Spendingit = f4 (Own Revenueit-1, Grants Under Political Discretionit-1, Grants By Independent Agencyit-1, all variables in [1]) Interest Spendingit = f5 (Own Revenueit-1, Grants Under Political Discretionit-1, Grants By Independent Agencyit-1, all variables in [1]) (2) (3) (4)

(5)

(6)

We estimate the impact of party politics separately on the three components of state revenues in India, as given in Equations 2 through 4own revenue generation by states, grants made by central political agencies that 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 hypothesis in the literature on fiscal federalism and fiscal disciplinethat dependence 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

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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 a dollar) 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 political variables on total spending on public services and organs of state, excluding 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 payments that is, by having access to subsidized credit from financial markets. As discussed 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 dependent 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 compiled from Butler, Lahiri, and Roy (1995). The public finance data on deficits, revenues, expenditures, and intergovernmental transfers is available 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 variables into real terms (constant 1992 prices) are available from an Indian data set put together at the World Bank. A detailed description of these variables 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 in Indias 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

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Table 1 Summary Statistics of the Variables Used in the Analysisa

Variable Real fiscal deficit Real state income Ratio of deficit to state income Total population (in thousands) Own revenues Grants under political discretion Grants by an independent agency Total spending (excluding interest payments) Interest payments Strictly affiliated (= 1 if central and state governments belong to same political party) Coalition partner (= 1 if state ruling party is part of a central coalition government) State ruling partys seat share (share of seats allotted to a state in the national legislature won by the state ruling party)
b

M 213.53 5106.64 0.04 48984.14 580.45 109.25 185.04 975.71 110.38 0.57 0.07 0.61

SD 135.24 2118.04 0.02 29538.4 362.59 62.53 72.93 438.80 82.84 0.50 0.25 0.29

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).

The coefficient estimates show that when states belong to the same political 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 significantly 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 from affiliation can be negative, because the coefficient on the interaction term is greater than the coefficient on the affiliation indicator in many specifications. Hence, it is really those affiliated states where the ruling party has more scope of gaining seats in national elections that seem to be particularly 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 percentage point. If an affiliated state controls close to zero of the seats in the

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Table 2 Effect of Party Identity on State Fiscal Deficit

Model 1 0.014*** 0.003 0.015*** 0.004 0.014*** 0.003 SE Model 2 SE Model 3 SE

Variable

0.005 0.012 0.024 0.004 0.003 0.021*** 0.006 0.002 0.005 0.004 0.002 0.0002 0.0002 0.0001 0.002 0.025 0.002 0.013 0.002 0.019*** 0.006*

0.005

0.005

0.012 0.025 0.005 0.004

0.019*** 0.006

0.002

0.0001 0.00001** 0 0.000002 0.00001** 0 0.000002 0.00001** 0

0.001 0.000002

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Strictly affiliated (= 1 if central and state governments belong to same political party) Coalition partner (= 1 if state ruling party is part of a central coalition government) Coalition Partner State Ruling Party Seats Strictly Affiliated State Ruling Party Seats State-ruling party seats Congress state (= 1 if a Congress Party rules state) Vote share of Congress party in last election Coalition government (= 1 if ruling party at state level controls less than 50% of seats in the state legislature) State election year (= 1 if a year before a state election) Real state income per capita Total population

Note: Population: N = 405, R2 = .54; dependent variable is the ratio of state fiscal deficit to state GDP; 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%.

703

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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 of party 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 governments. We include the share of votes cast for the Congress party in Equation 1 to control for voter taste for the dominant national political party and 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 significant, 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 legislatures (Alt & Lowry, 1994; Perotti & Kontopoulos, 2002; Poterba, 1994; Roubini & Sachs, 1989). Model 3 of Table 2 includes two additional indicator 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 coefficients of interest. These results are interesting in their own right because they indicate that party identification between the national and state governments 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 political variables on own revenue generation; however, federal grants determined by central ministries and the Planning Commissionthat is, agencies under political discretionare greater to strictly affiliated state governments. 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

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Table 3 Impact of Politics on Revenues and Spending3-Stage Least Squares Estimates

Grants by Political Agencies Model 2 0.54*** 0.05 0.62*** 0.04 SE Model 3 SE Model 4 SE Grants by Independent Agency Total Spending (excluding interest) Interest Payments Model 5 SE

Own Revenue SE 0.05

Model 1

Lag dependent variable Own revenue Grants by political agencies Grants by independent agency Real state income per capita Total population Strictly affiliated Coalition partner Affiliation Seats Coalition Seats State-ruling party seats 0.002 0.0003 8.2 18.11 14.44 34.82 9.42 0.00001 0.0001 20.19*** 8.95 4.87 20.41 7.64 0.84*** 0.52 0.59* 0.002 0.003 0.0002 0.002* 7.64 148.95*** 14.63 49.74 11.50 175.1*** 28.05 68.37 7.54 30.12

0.51***

0.05*** 0.01 0.0002 0.01*** 0.001 0.0002 6.63 30.74 16.57** 33.21 58.87 7.10 0.16 46.70 18.58 97.48 112.66 22.01 10.88 30.47 2.77

0.11 0.01 0.42 0.44** 0.36 0.20 0.01 0.01* 0.001 0.002** 26.99 36.68** 45.86 26.71 38.19 40.43*** 90.72 2.14 23.52 3.03

0.05 0.18 0.15 0.004 0.001 11.57 19.66 16.41 38.80 10.10

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Note: Dependent variables are per capita, constant 1992 Rs; State fixed effects and year effects included. *p significant at 10%. **p significant at 5%. ***p significant at 1%.

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Table 4 Effect of Party Identity on Central Loans

Variable Strictly affiliated (= 1 if central and state governments belong to same political party) Coalition partner (= 1 if state ruling party is part of a central coalition government) Coalition Partner State-Ruling Party Seats Strictly Affiliated State-Ruling Party Seats State-ruling party seats Real state income per capita Model 1 81.39 44.15 74.77 95.37 16.08 0.02** SE 69.76 26.13 69.97 78.69 15.56 0.01

Note: Population: N = 405, R2 = .56); Dependent variable is per capita net loans by the center in constant 1992 Rs; 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%.

the partisan influence of the political agencies. These results are entirely consistent with those reported in an article devoted to contrasting the impact of 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 controls fewer 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 repayment. Although the pattern of coefficients signs is the same as for deficits,

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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 combination of 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 evidence as suggesting that although delegating authority to the national political 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 center opportunistically and deliberately distributes deficit financing across states to further the partys political objectives or because state party leaders have bargaining 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 internal 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 Rajiv Gandhi have been described as unable to control the various factions within the Congress party (Frankel, 1987; Manor, 1988; Weiner, 1987). This literature is therefore consistent with a story of bargaining by affiliated states for bailouts from the center.

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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 through various 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 bargaining 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 politically 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 controlling the state, if voters punish the rival political party ruling the state for subsequent 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 bargaining 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

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that those states whose governments belong to the same party as that leading the national government have higher deficitsthat is, states ruled by rival political parties have correspondingly lower deficits, even when they are partners in a national coalition government. This evidence of the political 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 countries where 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 statehood from Union Territories, and 8 are designated special states, largely because of separatist tensions and provided extraordinary central transfers. Of the 15 states under study, 11 have 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 the Indian 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

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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 expansionary 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 susceptible 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 difference 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 transfer 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.

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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. She received a PhD in economics from the Massachusetts Institute of Technology in 1999.

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