Click here for search results

Newsletter

Site Tools

In Quest of Institutions that Promote Fiscal Discipline

Research Brief narrow banner
Mar 14, 2006,
 Stuti Khemani

 

Research analyzing political constraints to fiscal discipline in large developing countries has recently produced some provocative results on how politics influences fiscal policy. This work is being synthesized to identify a potentially powerful institutional solution to the problem of politically motivated fiscal deficits.

 

Fiscal discipline continues to be a center-piece of policy discussions in development, especially in many parts of the world where lower levels of government are taking over responsibilities from national authorities. Several large developing countries in this category are concerned with budget deficits (Argentina, Brazil, China, India, and Russia [12345]).

 

 graphic stuti march 2006
The pure economic explanation for budget deficits—tax smoothing in response to shocks—has been deemed inadequate in a large literature analyzing OECD countries, which emphasizes the importance of political factors [6]. In developing countries in recent years the problem of budget deficits has been laid at the doorstep of political bargaining between different tiers of government [12345]. It is argued that fiscal decentralization de-links spending and taxing decisions, by financing expenditures of multiple sub-national governments out of a common-pool of national revenues.  This leads to over-spending and over-borrowing as each sub-national political agent bargains for a larger share of resources for her region. An institutional solution adopted in many countries is to delegate greater authority to the national political executive for monitoring and regulating sub-national finances, in the belief that national authorities have strong incentives for fiscal discipline.

 

If this belief is true, it implies several testable hypotheses: that a single-party majority national government should be better able to discipline sub-nationals, especially those governed by members of its own party; and in contrast, that national governments formed as a coalition of political parties would be susceptible to fiscal indiscipline of coalition partners governing at sub-national levels. The states of India provide a valuable laboratory to test these hypotheses.  For much of India's history as a democracy, one dominant national political party has been at the helm of fiscal policy with the authority to monitor and regulate sub-national borrowing.  In recent years, however, regional political parties have gained greater representation in the national legislature and serve as critical supporters of national coalition governments. The evidence from a panel of 15 major Indian states during 1972-98 debunks both hypotheses—states governed by members of the nationally dominant ruling party actually have higher deficits, and states governed by rival parties have lower deficits, even when they are partners in a coalition government [7].

back-to-top gif

 

The evidence from India shows that national ruling parties may have weak incentives for fiscal discipline, even when they lead a majority government. For this reason delegation of authority to the national political executive does not necessarily solve the problem of fiscal discipline in a federation.

 

Why do national political parties have weak incentives for fiscal discipline?

 

Electoral politics that emphasize direct transfers to a large number of households can create weak political incentives to provide broad public goods such as fiscal stability [8]. In particular, non-cooperative bargaining among various constituencies within political parties can lead to higher government spending and deficits, even when a single-party dominates the national government. Theoretically, such costly bargaining both within and among political parties can be averted if all parties commit to staying within an overall resource envelope, and cooperate to achieve an optimal level of government spending and borrowing. An institutional mechanism that might promote credible commitment of all parties is authorizing an independent, non-partisan agency to enforce constraints on fiscal aggregates such as the consolidated government deficit and debt levels [9].

 

Delegation to an independent fiscal agency which monitors and regulates consolidated government debt and deficit could curb political influence and promote fiscal discipline in much the same way an independent central bank promotes sound monetary policy. Similar ideas for delegating authority to an independent agency are being outlined in Latin America [10] and the role of independent agencies is being promoted even more broadly using the U.S. Federal Reserve as a model [11].

 

Why would delegation to an independent agency and not formal fiscal rules better target particular levels of debt and deficits?

 

An increasing number of countries in both developed and developing regions have adopted various balanced-budget requirements and debt limits, with the primary objective of conferring credibility on their fiscal policies. The efficacy of these rules has by and large shown to make a difference for fiscal performance, although there is an acknowledged tradeoff between effectiveness and flexibility [12]. An independent agency can serve as a non-partisan determinant of contingency conditions under which rules should be flexible, and as a monitor to ensure transparent compliance with the rules.

 

back-to-top gif

If this seems rather obvious, the question becomes why independent fiscal agencies have not been implemented given that similar steps have been taken for monetary policy through the creation of independent central banks for the same objective, namely promoting macroeconomic stability? The likely answer is that such an agency can be viewed as an inappropriate side-stepping of democratic decision-making processes that typically governs fiscal policy. Fiscal policy, after all, has enormous implications for income distribution and public goods, and should therefore be determined only by legitimate representatives of the people, not by technocratic bodies over which citizens might exercise limited control. However, although democratic control may be essential for decision-making over the size of government, the distribution of spending, and the structure of taxation, it should not be considered crucial for fiscal aggregates such as debt and deficit [13]. Once this distinction is accepted by policymakers, a legitimate role for independent fiscal agencies may follow.

 

Is it possible to create non-partisan, independent fiscal agencies that can effectively curb political influence, and hence be credible to rival political groups?

 

Several countries have experimented with creating such agencies for a particular policy instrument—intergovernmental fiscal transfers. The Commonwealth Grants Commission in Australia is the best example among the older federations of the world. However, it is in the newer federations in Asia and Africa that decisionmaking over intergovernmental transfers are increasingly being delegated to an independent agency, such as the National Finance Council in Malaysia, the Revenue Mobilization Allocation and Fiscal Commission in Nigeria, and the Finance Commission in India. Evidence from India shows that transfers made by the independent agency indeed constrains political influence on resources available to state governments [14]. It therefore has the potential to do the same for fiscal deficits.

 

The conditions under which independent fiscal agencies can be created and delegated authority to monitor and regulate consolidated government debt and deficit is a fruitful policy agenda to explore, again, in the spirit of the earlier agenda pursuing independent central banks.

back-to-top gif

 

The findings, interpretations, and conclusions expressed in this brief are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent.


STUTI KHEMANI is an Economist in the Development Research Group (Human Development and Public Services Team). Her research focuses on the political economy of public policies and institutional interventions that strengthen political incentives for growth-promoting and human development policies. Email c/o:research@worldbank.org

 

Related Resources 

References

 

[ 1] Blanchard, O., and A. Shleifer, “Federalism with and without political centralization: China versus Russia,” IMF Staff Papers 48(Special Issue): 171-179, 2001.

[ 2] Dillinger, W., and S. Webb, “Fiscal management in federal democracies: Argentina and Brazil,”  Policy Research Working Paper 2121, World Bank, Washington, D.C., 1999.

[ 3] Jones, M., P. Sanguinetti, and M. Tommasi, “Politics, institutions, and fiscal performance in a federal system: an analysis of the Argentine provinces,” Journal of Development Economics 61: 305–33, 2000.

[ 4] Rodden, J., G. Eskeland, and J. Litvack, eds., Decentralization and Hard Budget Constraints. MIT Press, 2003.

[ 5] Rodden, J., “The dilemma of fiscal federalism: intergovernmental grants and fiscal performance around the world,” American Journal of Political Science 46(3): 670-687, 2002.

[ 6] For a review see Alesina, A., and R. Perotti, “The political economy of budget deficits,” IMF Staff Papers (March): 1–31, 1995.

[ 7] Khemani, S., “Party Politics and Fiscal Discipline in a Federation: Evidence from the states of India,” Comparative Political Studies, Forthcoming, 2007.

[ 8] Keefer, P., and S. Khemani, “Democracy, Public Expenditures, and the Poor,” World Bank Research Observer 20 (Spring):1-27, 2005.

[ 9] Khemani, S., “Can Delegation to an Independent Agency Promote Fiscal Discipline?” Development Research Group, World Bank, processed, 2006.

[ 10] Eichengreen, B., R. Hausmann, and J. Von Hagen, “Reforming budgetary institutions in Latin America: the case for a National Fiscal Council,” Open Economies Review 10: 415-442, 1999.

[ 11] Blinder, A., “Is government too political?” Foreign Affairs 76(6): 115-126, 1997.

[ 12] Poterba, J., and J. von Hagen, Fiscal Institutions and Fiscal Performance, University of Chicago Press, 1999.

[ 13] Wyplosz, C., “Fiscal discipline in emerging market countries: how to go about it?” Paper prepared for conference on “Financial Stability and Development in Emerging Economies: Steps Forward for Bankers and Financial Authorities,” organized by the Forum on Debt and Development (FONDAD) in Amsterdam, June 3-4, 2002.

[ 14] Khemani, S., “Partisan Politics and Intergovernmental Transfers in India,”  Policy Research Working Paper 3016, World Bank, Washington, D.C., 2003.

back-to-top gif




Permanent URL for this page: http://go.worldbank.org/D9IUU8X9F0