Are Fiscal Transfers and Bail-Outs the Perpetrators? A Study on Moral Hazard Problem in Indian Federal Finance

Abstract

The informational advantage of the sub-national governments in conjunction with central government’s involvement in bail-outs and financial assistance sometimes leads to negative incentives by relaxing the budget constraint. This produces moral hazard in terms of compromised fiscal behaviour; lower revenue effort, extravagance in expenditure, higher deficits and increased borrowings. At the same time, central assistance to low-performing states demotivates fiscally efficient states. The Indian fiscal federal structure and the fiscal transfer system are often criticized for prompting inefficiency and moral hazard in sub-national fiscal performance. Considering the issue of fiscal inefficiency in the Indian states, this study seeks to explore the fiscal mechanism of revenue effort, deficit, borrowing, capital outlay and revenue expenditure using a panel dataset of 28 states for the period 2000–2019. Accounting for the geographical and other disadvantages of the states, the findings of the panel-regression analysis confirm fiscal distress and the existence of soft-budget constraint and moral hazard in the Indian states.

JEL Classification: H, H2, H21, H3, H7