Political Economy of Fiscal Reform in Indian States

Abstract

The political economy considerations for fiscal reforms in a big federal country with a multi-party political structure involve a complex process, especially at the subnational level. India, for example, is an ideal example where fiscal reforms in the states present a unique opportunity to study this complex process. There are some important political factors, with ambiguous empirical results, that will have profound effects on fiscal reforms. Fiscal populism is one such factor. It may be noted that the government is not a ‘benevolent social planner’ that maximizes the utility of the representative individual but is concerned only with winning the next election. As the ruling political party expects vote swing in its favor, it may not indulge into fiscal profligacy like providing free electricity, subsidizing power, or granting tax concessions, etc. which enables the state government to raise its own revenue as a percentage of its total expenditure. This may not necessarily be true, as, a party can become less reform oriented if there is no political uncertainty or pressure. Political alliance is another important variable. When both the federal government and the state are ruled by the same party, it is quite likely that the particular state will enjoy some fiscal benefits. As a result, own revenue as a percentage of total expenditure of the favored states might increase, and the states may be reluctant to initiate hard reforms. On the other hand, a reform-oriented federal government might influence the states with the same ruling political party to initiate bold reforms. An additional political economy impediment, namely the common-pool problem where the major interest group that benefits from the status quo (not initiating hard reforms), is well represented within the government. Practically, no serious attempt has been made so far to understand the political economy of reform process at the state level in India in a comprehensive manner. The purpose of this paper is to settle the ambiguities in the relationship between fiscal reform and the political economy determinants empirically in the context of the India states covering fourteen major states in India during the period 2001–02 and 2013–14.