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Political Incentives Driving Fiscal Policy

research brief
February 26, 2009   Stuti Khemani and Waly Wane

New results on the political determinants of fiscal policy overturn conventional wisdom, and lend themselves to innovative institutional approaches to reform.

A new analysis of populist demands for greater government spending shows that countries tax and spend more when governed by a single party than by a coalition of multiple political parties.[1]
The driving force behind this result is the need to woo “swing” voters, who are both unattached to political parties and unlikely to be successfully targeted through party machines.

When such swing voters are numerous or demanding, no single party can attract a majority of votes by targeting its core voters. Parties that try to form a government on their own strength, without coalition partners, have to raise taxes and spend more universally to win the support of a larger number of swing voters.

At some point, when swing votes become too costly to win, it then becomes politically advantageous for multiple parties to come together to govern and win elections as a coalition, on the basis of targeting the core supporters of coalition members with government spending. In this new model single-party governments pursue populist fiscal policy, using higher taxation and universal spending, compared to coalition governments that keep taxes low and spending targeted to core interest groups.

States spend less when they are governed by coalitions of multiple political parties

The evidence for a negative correlation between coalition governments and fiscal policy is obtained from cross-country data and cross-state data within one country, India, where the participation of swing voters has been increasing.

Khemani Brief Figure 

Note: Government Fragmentation is a continuous variable measuring the probability that two randomly chosen assembly members would belong to different parties. Regressions control for economic, demographic and institutional characteristics, and include regional and decade fixed effects.

The cross-country evidence from 70 countries over four decades, 1970-2006, shows that switching from a country-decade with a single-party government, where the executive head controls a majority in all law-making houses, to a country-decade with divided government, correlates with a reduction in taxes and spending of 3-4 percentage points of GDP (Figure).

Political changes over time within the states of India provide a valuable laboratory to test the new theory using improved econometric specifications that are not feasible with cross-country data. Examination of the fiscal impact of ruling party changes in the 15 major states of India over the period 1972-1995 finds that states spend less when they move from being governed by a single dominant party, the Congress party, to being governed by coalitions of multiple political parties.

Populist pressure in India

Voting data and voter surveys in India are suggestive of the weakening attachment of voters to political parties [2] and the waning influence of local landlords and caste leaders which constrains political parties in mobilizing votes through targeted spending. [3]

In anecdotal evidence, political parties of all hues in India have expressed the pressure upon them to create fiscal space to expand broad-based spending, especially in the form of price subsidies and workfare programs. [4]

Implications for electoral rules

Populist fiscal policy in this model cannot be averted by changing electoral rules because it arises due to variation in the demands of swing voters while keeping electoral rules fixed. In the cross-country data the fiscal impact is driven by changes in type of government across countries that share proportional electoral systems; in India it is driven by political changes within states that have the same majoritarian electoral system.

Independent fiscal agencies may be better at enforcing fiscal responsibility laws

When fiscal waste arises because voters are too demanding, hierarchical procedures that concentrate budgetary authority within single party governments are unlikely to be an effective restraint on expansionary fiscal policies, especially when there is increasing participation by swing voters.

An independent bureaucracy might allow politicians to shift the blame for unpopular spending contractions or tax increases on to the technocratic advice of bureaucrats.

For such delegation to work, however, the bureaucracy must be credibly non-partisan. All political parties must trust that it will blow the whistle for fiscal adjustment and set budget constraints without regard to the party that controls the executive government who would bear the blame for fiscal retrenchment.

This view is supported by previous work showing that it is possible to create independent bureaucracies that correct the distortions induced by partisan politics in distributing intergovernmental transfers. [5]


STUTI KHEMANI is a Senior Economist in the Development Research Group of the World Bank. Her research interests include the political economy of public policy choices, and institutional reforms for development.

WALY WANE is an Economist in the Development Research Group of the World Bank. His research interests include the analysis of incentives at the frontline provider-level and their impact on the quality and quantity of supplied public services.


Notes

1. Khemani, Stuti, and Waly Wane. 2008. “Populist Fiscal Policy.” Policy Research Working Paper 4762, Development Research Group, World Bank, Washington, DC. (Updated version Feb 2009)

2. Chhibber, Pradeep, and Ken Kollman. 2004. The Formation of National Party Systems: Federalism and Party Competition in Canada, Great Britain, India and the United States. Princeton, NJ: Princeton University Press.

Yadav, Yogendra. 2000. “Understanding the Second Democratic Upsurge.” In Transforming India: Social and Political Dynamics of Democracy, ed. Francine Frankel, 120–145, Delhi: Oxford University Press.

Yadav, Yogendra. 1999. “Electoral Politics in the Time of Change: India’s Third Electoral System, 1989-99.” Economic and Political Weekly August 21-28: 2393–99.

 3. Krishna, Anirudh. 2003. “What is Happening to Caste? A View from Some North Indian Villages.” Journal of Asian Studies 62(4): 1171–93.

Oldenburg, Philip. 1999. “The Thirteenth Election of India’s Lok Sabha (House of the People).” Asian Update Series, The Asia Society, New York, New York.

4. Nooruddin, Irfan, and Pradeep K. Chhibber. 2008. “Unstable Politics: Fiscal Space and Electoral Volatility in the Indian States.”  Comparative Political Studies 41(8): 1069–91.

Chhibber, Pradeep K. 1995. “Political Parties, Electoral Competition, Government Expenditures and Economic Reform in India.” The Journal of Development Studies 32(1): 74–96.

5. Khemani, Stuti. 2007. “Does Delegation of Fiscal Policy to an Independent Agency Make a Difference? Evidence from Intergovernmental Transfers in India.” Journal of Development Economics 82(2): 464–84.




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