A successful transition to a market economy requires creating the appropriate incentives for governments at all levels to foster rather than to control markets. Economists have long agreed that getting "prices right" through appropriately structured markets is essential to giving economic agents appropriate incentives. What they typically neglect is the parallel problem for government: that political institutions must be appropriately structured so that the governments have incentives to pursue policies that foster growth rather than service to interest groups, market intervention, and corruption. Put another way, economists have a mature theory of economic development but lack the parallel theory of political development.
A critical aspect of political development concerns how to structure the political game so that all the players have incentives consistent with improving social welfare. These players include not only economic agents, such as enterprise managers, but also elected officials and consumers/voters.
We investigate this general question in the context of federalism, with a focus on the Russian Federation. To this end, we develop a theory of comparative federal economic performance based on how the structure of federalism provides incentives for political officials at all levels of government.
Why Are Some federal Nations Rich and Others Poor?
For the last four centuries, the richest nation in the world has been federal, namely, the Dutch Republic from the late sixteenth through the mid–seventeenth century; England from the late seventeenth or early eighteenth and the mid–nineteenth century (a de facto federal state); and the United States from the late nineteenth century to the present. Similarly, modern China, a de facto federal state, has also experienced sustained growth for more than 20 years. In contrast, many federal states have fared much more poorly, including India, the large Latin America federal states of Argentina, Brazil, and Mexico, and modern Russia. How do we account for such large differences in economic performance?
Our first observation is that federalism is not a single system with a single tendency. Federal states instead comprise a category of systems whose political and economic properties vary widely. Federal systems differ across a range of dimensions, depending in large part on the types of policies that are assigned the various levels of government and the types of incentive created for government policymaking. The comparative theory of federalism shows how different types of federal systems yield systematic differences in economic performance. The theory shows why some federal systems experience sustained growth, including the richest economy in the world, whereas others remain poor and exhibit low growth.
The way taxation and policymaking authority have been delegated makes no economic sense. The central government’s wide-ranging attempts to control regional government forces a ‘one-size-fits-all’ set of policies on diverse economies with dramatically different needs.
We distinguish four dimensions that differentiate federal systems. All federal systems delegate authority to lower governments, but they differ systematically in the types of policies delegated and in the types of incentives created for subnational officials. First, do subnational governments have primary authority over their economy, or does the national government? In particular, are policies assigned to levels of government consistent with the assignment principle in economics, which holds that policies should be assigned to the level of government that can most efficiently deliver them? Second, does the national government have the authority to police a common market across all regions, or do the states have the power to erect trade barriers to products and resources from other states? Third, do the states face a hard budget constraint; that is, do they bear the financial consequences of their decisions, or will the federal government bail them out of financial problems? And, finally, is there a set of institutions that protects the rights and powers of the subnational governments, or is the division of authority at the discretion of the national government?
The four dimensions of political power allow us to predict a federal system’s economic performance. As we show, a critical feature of successful federal systems is that they provide various levels of government with incentives to foster economic prosperity instead of corruption, service to interest groups, and obstructive market intervention, such as creating monopolies, protected markets, and unjustified subsidies to favored producers.
The Ideal System
We begin with an ideal type of a federal system called market-preserving federalism—a federation that satisfies all four conditions. A market-preserving federal system is one in which subnational governments have primary regulatory authority over their economies, in which they face a common market and hard budget constraint, and in which there is institutional protection for the federal arrangement.
Market-preserving federalism provides a range of incentives for government officials to foster economic prosperity. First, fiscal incentives imply that a subnational government prospers in parallel with its local economy: as its local economy grows, so too does its revenue. Second, the common-market condition fosters factor and product mobility. By preventing subnational governments from using internal trade barriers to insulate local firms from market competition, this condition helps level the economic playing field. The common market also limits the ability of subnational governments to impose costly market distortions to benefit interest groups. The reason is that these distortions put local firms at a market disadvantage relative to firms from other jurisdictions. Finally, the hard budget constraint makes fiscal imprudence very costly.
In contrast, federations that fail to satisfy various conditions fail to provide government officials with incentives to foster growth and thus exhibit what we call federal pathologies. A soft budget constraint, for example, encourages subnational governments to engage in rent-seeking and corruption because they do not bear the full costs of fiscal shortfalls. A subnational government without any policy authority is simply unable to tailor policy to local conditions, thus failing the economists’ assignment principle. Similarly, federations that fail the common-market condition allow subnational governments to erect trade barriers. These federations fail the well-known Tiebout principle, which holds that competition among subnational governments gives them incentives to serve their constituents and helps foster local economic growth.
Federalism, Russian Style
We apply our approach to federalism, Russian style. Federalism in Russia exhibits a range of pathologies. Most important, Russia’s federal structure fails to give subnational government officials the incentive to foster local economic prosperity. First, subnational governments have too little policymaking authority with which to tailor local policies to local conditions. Second, significant welfare losses arise because the informal policy authority they have wrested from the center does not conform to the assignment principle whereby policies are assigned to that level of government that can most efficiently deliver them. Third, a soft budget constraint increases opportunities for subnational government corruption, rent-seeking, and market intervention. Finally, the form of informal autonomy allows subnational governments to force profitable enterprises to accept burdensome taxes, regulations, and nonremunerative expenditures. Because subnational governments can extract more rents from more-profitable enterprises, the Russian political system markedly decreases the economic incentives for new investment. In striking contrast to the Chinese system, the structure of Russia’s fiscal federalism provides few fiscal incentives for subnational governments to foster local economic prosperity.
The Russian government lacks consistent, credible, and financially sensible lines of authority between Moscow and the regions. The result is a misallocation of resources and a substantial impediment to Russia’s transition to a market economy.
Federalism, Russian style, fails to conform to the assignment principle, the Tiebout principle, or those associated with market-preserving federalism. The assignment of policies to different levels of government has been based on political expediency rather than on a logical design conforming to standard principles. As the economist Christine Wallich has observed, Russia’s assignment of taxation and policymaking authority makes no economic sense. The center’s wide-ranging attempts to control regional government behavior force a "one-size-fits-all" set of policies on a diverse economy with dramatically different needs. These attempts violate the three classic principles of fiscal federalism. First, central control fails to allow local jurisdictions the political freedom to adjust policy to fit local conditions. Economist Friedrich von Hayek observed long ago that central control can never know enough to adjust policies to local circumstances. Second, it violates the assignment principle, granting policy authority to the appropriate level of government. Finally, these controls prevent the Tiebout mechanism allowing policy flexibility to reflect local demand conditions and hence the political competition among local jurisdictions that is important for their behavior.
Economist Friedrich von Hayek observed long ago that central planners can never know enough to adjust policies to local circumstances. Someone needs to explain that to Moscow.
The center’s attempts to force conformity among subnational governments produce another bad feature of federalism in Russia. In combination with acts of political opportunism, the central control generates significant mistrust among the regions. In reaction, the regions resist the center—they hide their activities, including their revenue. Further, they resist Moscow’s policies, often including those designed to improve national welfare. The lack of cooperation not only generates a series of costs but hinders center and region from solving a range of problems.
Russia’s center also fails some of the minimally necessary political aspects for economic growth. Russia fails to provide a stable political set of rules on which all can depend. Rules that are subject to ex post adjustment allow a degree of opportunism. A confusing system of de facto tax powers fosters the different levels of government to compete for taxes, often using the same taxes. As economists show, this type of "competetive taxation" implies too large a tax burden on the economy. This burden hinders both private and public investment. Further, the center’s apparent extractive tendencies exacerbate mistrust and fear by the regions. Worse, this behavior penalizes economic success, dramatically reducing the fiscal incentives of lower governments to promote local economic prosperity. The center also fails to provide a range of basic public goods and services that are standard in Western democracies. Rich regions can spend more than poor ones, exacerbating social inequality. Federal control of social expenditures allows uniform spending across regions.
Regions thus have poor fiscal incentives to promote prosperity, and the soft budget constraint implies only weak fiscal penalties for costly economic intervention and rent-seeking. Constraints on factor and product mobility hinder the competitive process among lower jurisdictions, thus weakening this source of incentives for good performance by local governments.
In short, we judge Russian-style federalism to be pathological because it lacks a consistent, credible, and financially sensible line of authority between center and regions. The result is a misallocation of energy and resources and a substantial impediment to Russia’s transition to a market economy. The substantial degree of mistrust and noncooperation represents a major impediment to Russia’s attempts to improve citizen welfare. The problems identified here are emblematic of Russia’s systematic failure to create a political system capable of promoting economic prosperity.