Political Foundations of Market-Enhancing Federalism: Theoretical Lessons from India and China

Abstract

In recent times, decentralization and federalism have been suggested as solutions for multiple crises facing the world. Decentralization is seen to be good for democracy, for markets, and for governance.1 A powerful impetus for the idea and practice of decentralization arises from the simultaneous processes of economic globalization underway in much of the world. Economic liberalization, it is argued, is compatible with and requires decentralization of functions and authority. Economic theory has posited clear efficiency effects of decentralization.2 The second generation of research on fiscal federalism puts forward more nuanced arguments by analyzing the pattern and nature of decentralization rather than decentralization per se. Barry Weingast and his collaborators suggest that market-preserving federalism, a sub type of federalism, is crucial for positive economic performance. The theory of mar ket-preserving federalism incorporates a more realistic assumption about rulers; strong central states, it argues, hold the potential to subvert the beneficial effects of market-oriented growth. Local governments, in contrast, subject to the pressures of interjurisdictional competition, respond to citizens' functional needs as well as check arbitrary central power effectively.3 Despite these insights, the reform experience of key countries poses puzzles for theories linking decentralization and economic liberalization. Decentralization's effects on economic indicators vary significantly across countries, creating negative as well as positive effects.4 In Brazil, for example, subnational autonomy acts as a check against the central government's powers, and subnational revenues finance most of the provinces' developmental programs, yet macroeconomic performance has been extremely unstable in the 1990s. In contrast, in India, despite fiscal central ism, economic reforms have generated moderate to high economic growth in the 1990s. Recent scholarship has led many observers to be more skeptical about the posited benefits of decentralization.5 Policymakers and scholars have written about delays in federal systems, veto powers enjoyed by subnational authorities, and the ability of subnational governments to transfer locally generated deficits to different levels of the system. While these empirical discrepancies from received theory do not challenge the normative and conditional claims made by public finance and mar ket-preserving arguments, they do raise an issue that these approaches are unable to