The Negative Impact of Federalism on Economic Performances

Introduction

A federal state is one in which sovereignty is constitutionally split between at least two territorial levels so that independent governmental units at each level have final authority in at least one policy realm. While federalism is considered a successful political tool to enhance democracy, good governance, citizen proximity and management of diversity in practice, it is under the scrutiny of much criticism. Most often, the system is blamed for creating unnecessary duplication of government and overlapping of potentially contradictory policies. More specifically, it is often accused of being at the root of many collective action problems in the formulation and implementation of economic and other politics. A collective action problem occurs in a situation where a group would benefit from cooperating but certain members of that group have little incentive to contribute to the collective effort. This can occur in federalism when a central government is interested in pursuing long-term politics, improving macroeconomic indicators, achieving monetary stability and avoiding crises to attract international investments and promote economic growth on a national scale. While on the other hand, the constituent units may be more inclined to follow short-term local goals that will make their electors happy and will increase the probability of being re-elected. Additionally, these collective action problems aggravate through the degree of importance that veto players play. A veto player is an individual or collective actor whose agreement is necessary for a change in the political status quo.

From a societal standpoint, the federal political system is a well-established and recognized governance that has been adopted by many developed and developing countries. Over half of the members of the Group of Twenty, including some states encompassing the largest population proportions in the world, such as India, Brazil and the United States are governed by federations. An increasing amount of non-federal states have in the past years proposed or taken steps to decentralize functions to their regions to obtain some of the competitive advantages of federalism. There is a vast range of statistical data regarding the impact of federalism on economic indicators and so many series of indicators can be studied. Survey also exists on the perceived impact of federal governance adding another set of data for the researcher. Hence the study is scientifically relevant as it allows to draw robust conclusions and address the inefficiency in the design of federal states today.

The pursuit of clashing economic policies between the central government and its constituent units is a collective action problem that can cause economic mismanagement. Economic mismanagement is observable through a multitude of indicators, such as a country displaying falling rates of economic growth in contrast to peer countries, high rates of corruption and inefficient policy implementations.

In this essay I will discuss the main empirical findings on the causal relationship using three academic studies. To begin with, all three academic studies in this paper recognize that numerous variations exist in the form of federal institutions across the developed and developing world. Differences in the degree of fiscal decentralization, differences in characteristics and the way federalism is operated will influence the economic outcome of the country. Wibbels states that political representation of subnational political units and the number and size of provinces can all be expected to influence macroeconomic policies. Intergovernmental fiscal systems and hierarchical rules are among the important building blocks in a more nuanced approach to the varieties of federalism.

Empirical Studies

The three studies that incorporate a vast range of perspectives and test the outcomes of federalism under different measures conclude a negative impact on economic indicators and support the existence of a causal relationship with economic mismanagement. Wibbes analyses the impact of federalism on 46 large federal and unitary countries between 1979 and 1995 by measuring units of national economic adjustment, volatility level, and crisis frequency. His findings confirm the predictions that macroeconomic performance and reform implementation is negatively affected in the 10 countries where federalism operates. Basing his study on a survey, Treisman observes that federal states were perceived to be more corrupt by populations. He suggested that the division of power that the different levels of government entail seemingly poses a burden on enterprises and entices higher rates of venality and bribery. In the last study, Rodden investigates 43 OECD countries and notices that large and persistent aggregate deficits occur when subnational governments are simultaneously dependent on intergovernmental transfers and also free to borrow. On the other hand, he stressed that long-term balanced budgets among subnational governments are found when either a central government imposes borrowing restrictions or when subnational governments have both wide-ranging taxing and borrowing autonomy.

All three studies imply the greater responsibility of fiscal decentralisation for these negative economic outcomes. Decentralisation in terms of political and administrative policies was also studied but the results are weaker and less conclusive. In fact, the more fiscal powers are decentralised the stronger the causal relationship appears to be. The decentralisation of expenditure, taxation policies or the capacity to borrow seems to have the strongest negative impact on the economic indicators.

When sub-governments are dependent on transfer from the national government or when the center cautions their credit, the negative impact tends to be worse. This outcome is to be expected when the constituent units are reliant on the central government for funds and certain that credit accountability will be supported unconditionally. It acts as an incentive for sub-governments to be less careful in terms of expenditure and deficit levels. Wibbles argues that the macroeconomic and fiscal imbalances are in part structurally determined by the devolved political and fiscal institutions that create incentives for subnational governments to avoid the political costs of fiscal adjustment. Rodden explained that when constitutionally or politically constrained central governments take on heavy co-financing obligations towards subnational units. This implies that central government to take up responsibility in case of fiscal issues in lower level governments. Treisman attributes corruption to subnational officials deciding how much bribes to extract from businesses so that both levels have the power to regulate.

Finally, Wibbels, Rodden and Treisman all agree on the dangers of adopting federal systems in developing countries. These countries have more difficulty to borrow as credit access will be much more limited for the sub-national entities, generating inefficiencies. Additionally, sub-entities of developing countries commonly have poor institutional structure and lack of human capital to implement policies. At last, developing countries could be more exposed to corruption not because their population tends towards it but because the preventing mechanisms of checks in balances are not in place. These statements also apply to sub-governments in smaller developed countries who do not benefit from the economies of scale of larger states, have less access to credit and possibly more corruption as fewer checks in balances exist.

Strengths and Weaknesses

Rodden’s main strengths in his research are the three mathematical models he uses and adjusts to capture the pure effect of federalism and validate or reject his hypothesis. Multiple hypotheses are tested then validated, rejected or adjusted to reach the models. Rodden employs a robust multi-model approach and tests for the control variable in his findings. Rodden combines the use of time series and cross-section analysis in his approach and also attempts to compensate for data difference and countries disparity in the equations. One could argue weakness in the initially low comparability of the data as high variability between the federal system characteristics studied exists in terms of size or centralisation. Additionally, the small amount of data for some series and the relatively short period of ten years analysed can be considered a weakness too. Finally, the R² coefficient that evaluates the models’ proportion of variance is relatively low and the disparity of findings makes the conclusion more mixed.

Treisman’s study includes more context around what can influence corruption and result in mismanagement besides federalism as the impact of federalism on corruption is only one of the six factors this study analyses to explain corruption. This study has the merit to broaden the investigation and show other factors that impact economic indicators while demonstrating the same negative impact of federalism with a strong correlation. The study cautions around giving too much importance on the result of endogenous variables and makes sure to not double count their effects. It is inclusive in terms of diversity of geographies and countries covered and tests twelve hypotheses such as corruption will be lower in federal states and corruption will be higher in federal states so to consider the impact in both directions. Nevertheless, Treisman bases his results on a perception survey and not real statistical data on corruption. The study also only focuses on corruption which is not the only driver for mismanagement. While the causal relation between federalism and corruption is only one of the six theories studied, it is done over a short period of time so the study could be considered too superficial to draw conclusions on the specific impact of federalism.

Wibbels focuses on macro-economic impacts and the success of reforms in large countries while considering both federal and unitary governments. The strength of the study is to distinguish between the effects of macroeconomic reforms, fiscal and political federalism. Wibbels argues that theories often take the isolated case of the United States to demonstrate the non-negative impact of federalism on economic performance. He proceeds to compare theoretical literature that supports or rejects this claim to his empirical findings. The study is robust due to the extensive time period studied and the comparability of the countries studied in size because Wibbels narrows down the analysis to large and developed nations with GDP rates exceeding ten billion US dollars. In this manner, Wibbels restricts the study frame to capture only the impact of federalism and obtain stronger models. As a result of the strong operationalisation, he achieves more robust statistical results of the effect measured. One can argue that Wibbels builds hypothesis only in the direction of the negative impact of federalism. He also only tests three hypotheses; the success of macroeconomic adjustment, volatility levels and crisis frequency. Furthermore, he limits the characteristics of federalism to two provinces that are represented at a national level and have elected legislature on their own, which significantly simplifies the reality and reduces federalism disparity.

Conclusion

This analytical essay has shown a negative relationship of certain design of federalism on economic performances. The empirical studies used were relevant in the investigation of the causal relationship as they attempt to describe a political and economic phenomenon not under a general federal system but in terms of specific unaddressed collective action problems. Although the studies vary greatly in terms of variables considered, ranging from macroeconomic indicators to perceived corruption levels, their empirical data confirms a negative causal relationship between federalist systems and economic mismanagement measured. While this causal relationship is not present in all federations, it becomes prominent in those states that allow too great of a fiscal autonomy to their subnational governments and fail to regulate their decentralization proportionally. In other words, federalist systems fail to address their collective action problems when central governments grant too much independence to their constituents units which creates too great a space for fiscal imbalances and lack of accountability. As a learning, one could conclude that the move to federalism should be done with caution especially in the case of emerging nations where the design of the system should limit fiscal decentralisation and control the autonomy granted to the sub-units to avoid the predicted negative economic impact.

Bibliography

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