Do Indian States Mimic, Compete or Interact in Local Public Spending? A Spatial Econometric Analysis

• Date: 01 June 2018
• Author: Subash Sasidharan,Arfat Ahmad Sofi
• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/asej.12148

Do Indian States Mimic, Compete or Interact in

Local Public Spending? A Spatial Econometric

Analysis*

Arfat Ahmad Sofiand Subash Sasidharan

Received 3 March 2017; Accepted 2 April 2018

This paper analyses spatial interaction in public spending decisions across

22 Indian states during the period 1980–1981 to 2014–2015. In particular, we esti-

mate interactive hypotheses for different proximities of states using a spatial panel

data approach. The empirical results support strong spatial interaction and yard-

stick competition in public spending. Interactive behavior among the states has

been found to be consistent and conditional on per capita income, fiscal transfers,

infrastructure, literacy and population density. Interaction arising from yardstick

competition significantly affects public spending decisions. The present study real-

izes the need for a well-developed and comprehensive network to strengthen the

interdependence in public spending among the states for higher welfare gain.

Keywords: public spending, spatial interaction, spatial panel data, yardstick

competition.

JEL classification codes: C23, D7, H7.

doi: 10.1111/asej.12148

I. Introduction

Recently, the importance of analyzing spatial interaction in public spending

among regional governments has become a central theme in public economics.

The existing published studies mainly emphasize local considerations. For

instance, a particular type of public spending is assumed to influence and be

influenced by local factors such as per capita income, demographic structures,

taxes and political behavior. These studies explore possible determinants of such

*Arfat Ahmad Sofi: Institute Post –Doctoral Fellow, Department of Humanities and Social Sci-

ences, Indian Institute of Technology Madras, Chennai 600036, Tamil Nadu, India.

Email: aasofi50@gmail.com and hs16ipf01@smail.iitm.ac.in. Subash Sasidharan: Department of

Humanities and Social Sciences, Indian Institute of Technology Madras, Chennai 600036, Tamil

Nadu, India. Email: subash@iitm.ac.in.

An earlier version of the paper was presented at the Papers in Public Economics and Policy Confer-

ence, organized by NIPFP, New Delhi in March 2017 and the XIth World Conference of the Spatial

Econometrics Association at Singapore Management University, Singapore in June 2017. The

authors would like to thank Professor Wen-Chi Liao of the National University of Singapore, partici-

pants of the conferences and anonymous referees for their comments and suggestions.

© 2018 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2018, Vol.32 No. 2, 187–213 187

spending designs at national and regional levels (Borcherding and Deacon,

1972). Based on a simple theoretical framework, these studies show that the

level of public spending in a jurisdiction is assumed to be strictly specific to the

sub-national government through the lens of a Keynesian or Wagner’s setting.

However, concerns have been expressed about the validity of such estimates

because spatial interaction is ignored.

1

If ignored, may result in biased and

inconstant estimates (Anselin, 1988; Case et al., 1993; Brueckner, 2003).

A state-specificfiscal setting may exhibit interdependency if the decision-

making power of the reference state is being influenced by neighboring jurisdic-

tions. These effects can be positive or negative,mayreflect competition among

states and sometimes reveal mimicking or coordination behavior in their fiscal

decisions. Until recently, studies on the interaction among jurisdictions largely

focused on tax policy in a competition setting (Bordignon et al., 2003; Allers

and Elhorst, 2005). Due to the absence of large tax competencies among local

governments, the same framework has been extended to the sphere of public

spending (Faucault et al., 2008; Yu et al., 2013). A growing but nascent body of

literature has systematically improved our understanding of the interdependence

in fiscal decisions across different tiers of government. Specifically, this strand

of literature explores the spatial interaction of a particular government’s spend-

ing in response to neighboring governments in a comprehensive way.

In this paper, we undertake an empirical exercise to examine spatial interac-

tion among Indian states. India provides an ideal testing ground due to its decen-

tralized federal set up which involves multi-tier spending from central to local

governments

2

(Khemani 2007). A large portion of public spending is carried out

by local governments based on their individual capacities, with differential levels

of spending among them. Furthermore, Indian states provide a unique back-

ground to study spatial interactions, with the wide diversification in public

spending and varied cultural and demographic characteristics. It is assumed that

the states with higher revenue capacities are spending more than the low revenue

states. The centralized fiscal setting acts as an instrument to narrow down the

imbalance through transfers that permit states to homogenize spending avenues

in certain areas, which, in turn, permits the states to engage in interactive spend-

ing behavior (Beasley and Case, 1995).

3

The heterogeneous spending behavior

with the possibility of interaction at subnational level certainly has a differential

1 Spatial interaction is a dynamic flow process where one location interacts with another through a

set of networks and the spending decision is not a distinctive case for such a process. The network is

defined through a spatial weight matrix where a proper procedure is followed to form an interlinked

network space.

2 Generally, the term “local”is used to define the lowest tier of government, however, due to lack

of information at this level (i.e. for gram panchayats), we have considered states as the lowest tier of

government and the term “local”is used synonymously with “state,”which otherwise does not

change the efficacy of the unit chosen.

3 Earlier, the central fiscal setting was decided by the Finance Commission of India, a statuary

body which defines the relationship between the central government and states with the Planning

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