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Beyond the Fiction of Federalism: Macroeconomic Management in Multitiered Systems

Published online by Cambridge University Press:  13 June 2011

Jonathan Rodden  and
Erik Wibbels
Erik Wibbels
Affiliation:
University of Washington
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Recent research on federalism is extremely divided. While some tout the benefits of “market-preserving” federalism, others point to the fragmentation and incoherence of policy in federal states. This research bridges the divide by analyzing the political andfiscalstructures that are likely to account for the highly divergent economic experiences of federal systems around die world. To test these propositions, the authors use an original data set to conduct analyses of budget balance and inflation infifteenfederationsaround the world from 1978 through 1996. The empirical research suggests that the level of fiscal decentralization, the nature of intergovernmental finance, and vertical partisan relations all influence macroeconomic outcomes. The find- ings have broad implications for the widespread move toward greater decentralization and for the theoretical literatures on federalism and macroeconomics.

Type
Research Article
Information
World Politics , Volume 54 , Issue 4 , July 2002 , pp. 494 - 531
Copyright
Copyright © Trustees of Princeton University 2002

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References

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24 Rodden(fn.5).

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28 An exception is Canada, where the Senate is weak and appointed, and regional bargaining takes place primarily in other forums: within the cabinet, directly between Ottawa and provincial governments, and in the premiers' conferences.

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32 Relatively low values for the United States and Switzerland may be surprising—this is because local and municipal governments are not included in either the numerator or the denominator. Local data were unavailable for several countries, and furthermore our arguments are focused on constituent units in federations.

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37 Given data shortcomings, we are unable to differentiate between provincial spending for which allocation decisions are made solely by provincial officials and that which is controlled indirectly by federal fiat (unfunded mandates, for instance). H1 makes the plausible assumption that a shift from central to provincial spending implies some loss of direct central control over the consolidated public sector budget.

38 For an overview of concepts and measurements of fiscal illusion and a literature review, see Oates, Wallace, “On the Nature and Measurement of Fiscal Illusion: A Survey,” in Oates, ed., Studies in Fiscal Federalism (Brookfield, Vt: Edward Elgar, 1991)Google Scholar. For a theoretical application to intergovernmental grants in particular, see Oates, “Lump-Sum Intergovernmental Grants Have Price Effects,” in Peter Mieszkowski and William Oakland, eds., Fiscal Federalism and Grants-in-Aid (Washington, D.C.: Urban Institute, 1979).

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41 Rodden(fn.5).

42 Dillinger and Webb (fn. 22) make a plausible argument to the contrary: they suggest that transfer dependence sometimes provides the central government with valuable leverage that can be used to impose reforms and tighter fiscal discipline on the subnational units. However, such strong conditionality is the exception rather than the rule in most intergovernmental transfer schemes in federations, and even if central governments make such proclamations, they may not be credible in the long run.

43 See, e.g., Kiichiro Fukasaku and Luiz de Mello, “Fiscal Decentralization and Macroeconomic Stability: The Experience of Large Developing and Transition Economies,” in Fukasaku and Hausmann (fn. 40).

44 For cases without certain kinds of revenue-sharing programs, the GFS data and government data are identical, since the GFS is based on country sources.

45 For example, Brennan and Buchanan (fn. 3).

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49 Jonathan Rodden, “Creating a More Perfect Union: Political Parties and the Reform of Federal Systems” (Manuscript, Department of Political Science, MIT, 2001).

50 Jones, Mark, Sanguinetti, Pablo, and Tommasi, Mariano, “Politics, Institutions and Fiscal Performance in a Federal System: An Analysis of the Argentine Provinces,” Journal of Development Economics 61 (April 2000)CrossRefGoogle Scholar.

51 An interesting contrary hypothesis in the Indian context is presented in Stuti Khemani, who argues that since the deficits of the Indian states are funded primarily by loans over which the central government has discretion, state deficits are essentially pork manipulated by the central government. As a result, deficits are higher in the states controlled by the center, though it is unclear whether this would have any effect on overall public sector deficits. See Khemani, “Partisan Politics and Subnational Fiscal Deficits in India: What Does It Imply for the National Budget Constraint?” (Manuscript, World Bank, 2001).

52 Coalition governments at the center complicate the collection of this data for Switzerland, Brazil, and Austria. In fact, we are unable to calculate a sensible measure for Switzerland, where the federal executive is a collegial body that represents (by convention) all of the major parties. In Brazil, where the party system is highly fractionalized, national executives must rely on unstable legislative coalitions. It is plausible that members of such coalitions would be able to discipline their copartisans at the state level in a manner consistent with the theoretical propositions outlined above. Nevertheless, the variable presented in Figure 1 (and used in subsequent regressions) counts only those states run by the same party as the chief executive, for the simple reason that where coalition governments are prevalent, chief executives have had little success at disciplining states governed by other coalition members. To deal with the concern, we have also constructed a variable that codes states controlled byjunior members of the federal coalition as controlled by the center. This variable is different for a small number of years only in Brazil and Austria and does not affect the results reported below. In the case of subnational coalition governments (prevalent in Austria, Germany, and India), we code based on the senior member of the coalition that occupies the office of chief minister, prime minister, president, and so on.

53 Note that for country-years characterized by authoritarianism we have coded this variable as 1, indicating that the central government controlled all state governments.

54 David Wildasin, “Externalities and Bailouts: Hard and Soft Budget Constraints in Intergovernmental Fiscal Relations” (Manuscript, Washington, D.C., World Bank, 1997).

55 See May, R. J., Federalism and Fiscal Adjustment (Oxford: Oxford University Press, 1969)Google Scholar. With reference to defense, a similar argument was made by Alexander Hamilton about the Dutch Confederation: “In this confederacy, one large province, by its superior wealth and influence, is commonly a match for all the rest; and when they to not comply, the province of Holland is obliged to compel them”; cited in Frisch, Morton J., ed., Selected Writings and Speeches of Alexander Hamilton (Washington, D.C.: American Enterprise Institute, 1985), 200Google Scholar.

56 GDP share would perhaps be preferable to expenditure share as a measure of ajurisdiction's ability to impose negative fiscal externalities on others, but we are unable to obtain provincial-level GDP data for the full sample. Given our interest in fiscal policy, expenditure concentration is preferable to a measure of population concentration.

57 Wildasin (fn. 54).

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60 It is important to avoid double counting grants that are included in the center's expenditures and the provinces' revenues. In the numerator the two cancel out when calculating the combined central-provincial surplus. However, to accurately measure the denominator—total expenditures—it is necessary to subtract grants to avoid double-counting the grants when they are “spent” at the central level and then again at the local level.

61 Treisman (fn. 5); Wibbels (fn. 5).

62 We use the log, as the inflation data are skewed.

63 These data are from the World Bank, World Development Indicators (information available at www.worldbank.org).

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67 Data taken from World Bank (fn. 65). As described below, we have experimented with several ather measures of horizontal political fragmentation as well.

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69 Data taken from the Polity 98 data set (www.cidcm.umd.ed/inser/polity/indev.htm).

70 We have also experimented with a range of additional demographic control variables: area, population, population/number of states, urbanization, population density, ethnic fractionalization, and percentage of the population above and below the working age. None of these attained statistical significance, and none affected the substance or significance of the results reported herein.

71 Data taken from World Bank (fn. 63).

72 Data taken from World Bank (fn. 63). We have also estimated models that address these possibilities by differentiating between expected GDP and shocks, but this estimation technique does not affect the results presented below.

73 Data taken from World Bank (fn. 63).

74 For recent overviews of tradeoffs, see Maddala, G. S., “Recent Developments in Dynamic Econometric Modelling: A Personal Viewpoint,” in Mebane, Walter, ed., Political Analysis, vol. 7 (Ann Arbor: University of Michigan Press, 1998)Google Scholar; Judson, Ruth and Owen, Ann, “Estimating Dynamic Panel Data Models: A Guide for Macroeconomists,” Economic Letters 65 (October 1999)CrossRefGoogle Scholar; Baltagi, Badi, Econometric Analysis of Panel Data (New York: Wiley, 2001)Google Scholar; Bernhard Kittel and Hannes Winner, “How Reliable Is Pooled Analysis in Political Economy? The Globalization-Welfare State Nexus Revisited,” Discussion Paper 2–3 (Cologne: Max-Plank-Institut für Gesellschaftsforschung, May 2002).

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76 The bias also increases with the magnitude of the autoregressive coefficient. See Judson and Kven (fn. 74).

77 See Robert Franzese, Cindy Kam, and Amaney Jamal, “Modeling and Interpreting Interactive Hypotheses in Regression Analysis” (Manuscript, University of Michigan, 1999).

78 In models withoutfixedeffects, the interaction term and its components are jointly significant at the 1 percent level in thefiscalperformance equation (model 5) but do not reach significance in the inflation equation (model 6).

79 The arguments presented above suggest not only that deficits and inflation might be higher in the absence of vertical copartisanship but also that central and provincial governments might attempt to shift theirfiscalburdens onto one another in a “vertical war of attrition” instead of taking painful adjustment measures. To examine this possibility, we have also estimated a dynamic model in which the copartisanship variable is interacted with the lagged dependent variable in order to test whether high levels of copartisanship are associated with faster adjustment to large deficits. The results suggest that, indeed, high levels of copartisanship are associated with faster adjustment.

80 See Garrett, Geoffrey and Rodden, Jonathan, “Globalization and Decentralization,” in Kahler, Miles and Lake, David, eds., Globalizing Authority (Princeton: Princeton University Press, forthcoming)Google Scholar.

81 It is difficult to know how to interpret the effect of fractionalization in the central legislature on combined central-provincial budget balance. We have estimated models using other measures of political fractionalization suggested by Roubini and Sachs (fn. 31) and by Tsebelis, George, “Decision-Making in Political Systems: Veto Players in Presidentialism, Parliamentarism, Multicameralism and Multjpartism,” British Journal of Political Science 25 (July 1995)CrossRefGoogle Scholar. We also estimated dynamic models that interact these measures with the lagged dependent variable to capture delayed adjustment, but none of these variables attains significance or affects the main results.

82 Specifically, we used Im-Pesaran-Shin and Levin-Lin tests. See Maddala, G. S. and Kim, In-Moo, Unit Roots, Cointegration, and Structural Change (Cambridge: Cambridge University Press, 1998)Google Scholar; Baltagi (fn. 74).

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85 Note that the results reported above do not include Switzerland because of our inability to calculate the copartisanship variable. When Switzerland is included and the copartisanship variable is dropped, the substance and the significance of all other variables are unchanged.

86 All of the results are available from the authors upon request.

87 Jones, Mark, Sanguinetti, Pablo, and Tommasi, Mariano, “Politics, Institutions and Fiscal Performance in a Federal System: An Analysis of the Argentine Provinces,” Journal of Development Economics 61 (April 2000)CrossRefGoogle Scholar.

88 Khemani (fn. 51).