State Finances after Fiscal Responsibility Legislation: Genuine Improvement or Illusion?

Abstract

ABSTRACTGetting subnational governments to behave in a fiscally responsible manner is a challenge in federations. Fiscal Responsibility Legislation (FRL), which binds subnational governments to fiscal prudence, has been seen as a way of meeting this challenge. We examine this issue in the context of states in the Indian federation. We seek to investigate the extent to which states have tried to improve their fiscal health in the post-FRL period.The fiscal performance of 15 Indian states, both before and after the enactment of FRLs, is examined. Initially, we compare a measure of fiscal performance (e.g., gross fiscal deficit as percentage of each state’s output) for specified number of years after enacting the FRL with the performance over the same number of years prior to enacting the FRL. We then employ GMM estimation approach to estimate a dynamic panel data model to study the impact of the FRLs. Our analysis suggests that federal transfers have likely played a much more important role in the process of restoring states’ fiscal health as compared to their own-efforts at such improvement. This paper thus signals the need to re-look at the quantum and design of intergovernmental transfer such that states are encouraged to boost their own-revenue collection efforts.