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Citation:
Sunita Parikh; Barry R. Weingast, Comparative Theory
of Federalism: India, A , 83 Va. L. Rev. 1593
(1997)

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A COMPARATIVE THEORY OF FEDERALISM: INDIA

Sunita Parikh*and Barry R. Weingast**

I. INTRODUCTION
Why do federal states differ so widely in their economic and political per-
formance? Some federal states, such as the United States, are among the
richest and least corrupt in the world. Others, such as India and Mexico, are
very poor and are mired in slow or negative growth. Mexico has also been
plagued by considerable corruption. China, another de facto federal system,
is very poor but is one of the fastest growing economies in the world. To ad-
dress this question, we develop a comparative theory of federal performance
and apply it to India.
The performance of federal systems differs in part because federalism is
not the only relevant variable influencing a country's economic and political
success. Nonetheless, we argue that differential performance does reflect
systematic differences among federal systems. Federalism is not a single type
of system, but a family of disparate systems. Although all such systems have
a hierarchy of governments, differences in federal architecture help to ac-
count for differential federal performance.
To understand how differences in federal structure affect federal perform-
ance, we begin with the traditional arguments favoring federalism. These fall
into two categories: economic benefits and non-economic benefits. The classic
economic arguments about the benefits of federalism are threefold. First,
Friedrich Hayek argues that the central government can never possess enough
information to tailor policies to specific circumstances.' Because lower gov-
ernments have better information about projects, policies, and citizen prefer-
ences, they will make better decisions about policies with a local impact
Hayek's argument implies that, except for truly national public goods such as
defense, a national, one-size-fits-all policy is not optimal.

"Assistant Professor of Political Science, Washington University, St. Louis.

""Senior Fellow, Hoover Institution, and Ward C. Krebs Family Professor and Chair,
Department of Political Science, Stanford University. The authors wish to thank Lisa
Mclntosh-Sundstrom for editorial assistance.
IFriedrich A. Hayek, The Economic Conditions of Interstate Federalism, in Individu-
alism and Economic Order 255,268-69 (1948).
2See id. at 268.

1593
1594 VirginiaLaw Review [Vol. 83:1593

Second, following Charles Tiebout,3 economists have built an impressive body

of theory emphasizing two related benefits of federalism. 4 The first argues that
the induced competition among jurisdictions forces political officials to attend
to the economic and political consequences of their decisions.5 Second, to the
extent that citizen preferences differ, competition among jurisdictions leads
to an optimal mix of policies across jurisdictions.6 In this way, citizens and
firms are matched with desirable policies of particular jurisdictions.
Third, the literature on fiscal federalism focuses on the optimal assignment
of policies and taxes across levels of government One principle emerging
from this literature is that the provision of public goods should be assigned to
the lowest jurisdiction compatible with producing that good.8
These theories have met with considerable debate and criticism. Truman
Bewley shows that Tiebout's conclusions may not always hold.9 Susan Rose-
Ackerman raises a problem ignored by most economists: local government
corruption."0 James Buchanan raises serious questions about the economists'
typical assumption of benevolent government." Finally, Robert Inman and
Daniel Rubinfeld build a new theory on the political economy of federalism,
showing how economic efficiency and democratic rights and virtues exist in
tension in a confederate republic."2
Political scientists, in contrast, emphasize the political benefits that flow from
federalism. Many argue, for example, that federalism helps avoid conflict in
societies that are polarized geographically and provides for the protection of
minorities in divided societies.'" In this view, federalism's decentralization of
power helps to prevent different ethnic or religious groups from fighting over

- Charles M. Tiebout, A-Pure Theory of Local Expenditures, 64 J. Pol. Econ. 416, 416-24
(1956).
'See, e.g., Daniel L. Rubinfeld, The Economics of the Local Public Sector, in II Hand-
book of Public Economics 571 (Alan J. Auerbach & Martin Feldstein eds., 1987).
5 See Tiebout, supra note 3, at 419-20.
6See id.
7Wallace E. Oates, Fiscal Federalism (1972), provides the classic statement.
8
See, e.g., id. at 31-53.
'Truman F. Bewley, A Critique of Tiebout's Theory of Local Public Expenditures, 49
Econometrica 713 (1981). Several models show how intergovernmental competition limits
but may not eliminate inefficiency. See, e.g., Paul N. Courant & Daniel L. Rubinfeld, On
the Welfare Effects of Tax Limitation, 16 J. Pub. Econ. 289 (1981); Dennis Epple & Alan
Zelenitz, The Implications of Competition Among Jurisdictions: Does Tiebout Need Politics?,
89 J. Pol. Econ. 1197 (1981).
See Susan Rose-Ackerman, Corruption: A Study in Political Economy (1978).
"See, e.g., Geoffrey Brennan & James M. Buchanan, The Power to Tax (1980); James
M. Buchanan, Federalism As an Ideal Political Order and an Objective for Constitutional
Reform, Publius, Spring 1995, at 2.
11See Robert P. Inman & Daniel L. Rubinfeld, The Political Economy of Federalism, in
Perspectives on Public Choice 73 (Dennis C. Mueller ed., 1997).
13See, e.g., Donald L. Horowitz, Ethnic Groups in Conflict 646-48 (1985).
1997] Response 1595
the policies about which they profoundly disagree. In these societies, major-
ity rule in a centralized system could be disastrous as groups fight for power
to promote their conflicting goals. This approach suggests that federalism
and other forms of decentralization can sometimes prevent such fights.
Both the economists' and political scientists' approaches to federalism suf-
fer from a significant problem, however: They ignore the critical issue of how
the rules of federalism are maintained. Consider the problem of assignment
of political authority. This issue does not merely concern technical details of
economic efficiency, as economists suggest. It is about the allocation of po-
liticalpower to political units of jurisdiction. Jurisdictions and interests fight
for power to be assigned where they have some influence; and once allo-
cated, jurisdictions and interests fight to preserve and enhance their power.
Most federal systems diverge considerably from the economists' prescription
for the optimal assignment of powers over public goods and taxes. In contrast,
the first 150 years of the United States remarkably paralleled the economists'
prescription. Consider the Constitution's Commerce Clause. 14 The power of
the federal government to regulate commerce is second nature today; so
much so that, for the past sixty years, the Commerce Clause has imposed few
restrictions on federal power. It is therefore remarkable that the federal
government did not exercise this power during its first hundred years, until
passage of the Interstate Commerce Act"5 in 1887 regulating the railroads. It
is hard to imagine the federal government's activity so constrained in the
modern United States-or anywhere in today's developing world. These ob-
servations raise the question, why do public officials so rarely abide by feder-
alism's rules?
For federalism to survive, political officials must have incentives to abide
by federalism's rules. 6 In other words, the rules and constraints of federalism
must be self-enforcing: Political officials must find it in their interests to abide
by a series of rules and to respect a series of citizen rights. For example, offi-
cials in the national government must refrain from invading the policy do-

4 U.S. Const. art. I, § 8, cl.

3.
11Ch. 104, 24 Stat. 379 (1887).
16What follows draws on an emerging literature on federalism. See, e.g., Gabriella
Montinola, Yingyi Qian & Barry R. Weingast, Federalism, Chinese Style: The Political
Basis for Economic Success in China, 48 World Pol. 50 (1995); Barry R. Weingast, The
Economic Role of Political Institutions: Market-Preserving Federalism and Economic De-
velopment, 11 J.L. Econ. & Org. 1 (1995); Jenna Bednar, Federalisms: Unstable by Design
(Apr. 15, 1997) (unpublished manuscript, on file with the Virginia Law Review Associa-
tion); Jenna Bednar, William N. Eskridge, Jr. & John Ferejohn, A Political Theory of
Federalism (Apr. 1996) (unpublished manuscript, on file with the Virginia Law Review
Association); Rui J. de Figueiredo, Jr. & Barry R. Weingast, Self-Enforcing Federalism:
Solving the Two Fundamental Dilemmas (Apr. 1997) (unpublished manuscript, on file
with the Virginia Law Review Association).
1596 Virginia Law Review [Vol. 83:1593
mains of the lower jurisdictions." Correspondingly, officials in lower govern-
ments must refrain from encroaching on the common market.
The issue of self-enforcing federalism reflects a more general problem of
how political officials respect the rules of government and the rights of citi-
zens. Implementing critical features of an ideal government and society will
always involve this problem. Democracy, for example, requires that political
officials respect citizen rights and obey a range of rules, such as holding peri-
odic elections according to agreed-upon procedures and allowing citizens'
votes to determine electoral outcomes. Also central to democracy is a re-
spect for civil and personal rights, such as freedoms of speech and assembly, a
requirement that punishment be commensurate with the crime, and a re-
quirement that citizens must be charged in order to be jailed. Political offi-
cials in most countries today adhere only incompletely, if at all, to these
rights. Finally, for markets to thrive political officials must maintain a range
of private rights, notably, a complex series of private property rights, the en-
forcement of contract and commercial law, and a stable tax and macro-
economic regime.
The rarity with which political officials adhere to a comprehensive system of
the rules and rights-such as those required to sustain democracy, federalism,
or private markets-implies that when they do, it is a remarkable phenome-
non requiring an explanation. The answer cannot be the country's constitution
alone, for this begs the deeper question of why anyone obeys a constitution.
Because political officials in most countries do, at times, ignore fundamental
aspects of their constitutions, a special set of circumstances must have to hold
for political officials to obey a constitution. Scholars have paid too little atten-
tion to the problem of how the rules and rights associated with constitutions,
democracy, markets, and federalism are enforced.
A group of scholars, whom Gibbons and Rutten call the "equilibrium insti-
tutionalists,"18 have recently begun to study this problem. These works sug-
gest two related observations. First, a series of political institutions is typi-
cally necessary to solve particular social dilemmas and thus to ensure social

17See William H. Riker, Federalism: Origin, Operation, Significance (1964); Weingast,

supra note 16, at 4; Bednar, Eskridge & Ferejohn, supra note 16, at 5.
"ISee Robert Gibbons & Andrew Rutten, Hierarchical Dilemmas: Social Contracts with
Self-Interested Rulers 6 (Oct. 8, 1996) (unpublished manuscript, on file with the Virginia Law
Review Association). Other works in this tradition include Bednar, supra note 16; Randall L.
Calvert, Rational Actors, Equilibrium, and Social Institutions, in Explaining Social Institu-
tions 57 (Jack Knight & Itai Sened eds., 1995); Avner Greif, Paul Milgrom & Barry R.
Weingast, Coordination, Commitment, and Enforcement: The Case of the Merchant Guild,
102 J. Pol. Econ. 745 (1994); Paul R. Milgrom, Douglass C. North & Barry R. Weingast,
The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and
the Champagne Fairs, 2 Econ. & Pol. 1 (1990); Barry R. Weingast, American Democratic
Stability and the Civil War: Institutions, Commitment, and Political Behavior (Dec. 1996)
(unpublished manuscript, on file with the Virginia Law Review Association).
1997] Response 1597
cooperation. One such dilemma is that repeated play is often insufficient to
enforce cooperation: for example, play is too infrequent, citizens do not have
sufficient information, or they fail to coordinate their actions. Institutions can
help resolve these dilemmas and sustain cooperation. Second, to succeed, these
institutions must be self-enforcing because they are themselves objects of
choice. If citizens do not have mutual incentives to maintain them, these in-
stitutions will ultimately collapse.
Using the notion of self-enforcing, limited government, we show below
that the form of federalism studied by economists requires a set of implicit
political assumptions called "market-preserving federalism."1 9 Part II dis-
cusses the five axioms of market-preserving federalism. In brief, these are: 1)
a hierarchy of governments and division of authority exists; 2) subgovern-
ments have primary political authority over the regulatory and police powers
concerning the economy; 3) the national government has authority to police
the lower governments (in particular, to assure the common market); 4) gov-
ernments face a hard budget constraint; and 5) some form of institution pro-
vides a credible commitment to the entire structure (that is, federalism must
provide for self-enforcing government).
An important benefit of the axiomatic approach to market-preserving fed-
eralism is that it provides the basis for a comparative theory of federalism. The
approach allows us to predict the economic and political performance of federal
systems with different characteristics. Federalisms without a common market,
for example, will exhibit far less inter-jurisdictional competition and thus far
less experimentation and adaptation of policies to the economy. These gov-
ernments will also exhibit more corruption. A central government that violates
the fifth condition is not really federal at all. In such states, the national gov-
ernment typically attempts to control or interfere with the subgovernments,
precluding the main benefits of market-preserving federalism. In Mexico, for
example, because states receive the lion's share of their revenue from the na-
tional government, they adhere to the national government's policies."' A

19See Ronald I. McKinnon, The Logic of Market-Preserving Federalism, 83 Va. L. Rev.

1573 (1997) [hereinafter McKinnon, Commentary]; Ronald I. McKinnon, Market-Preserving
Fiscal Federalism in the American Monetary Union, Spectrum, Summer 1995, at 36
[hereinafter McKinnon, Market-Preserving Fiscal Federalism]; Montinola, Qian, & Wein-
gast,
29 supra note 16; Weingast, supra note 16.
Montinola, Qian & Weingast, supra note 16, at 55.
2 Anwar Shah, an economist with the World Bank, reports that "Mexican states in 1990
derived 60% of their revenues from the federal governments as revenue sharing or trans-
fers." Email from Anwar Shah, The World Bank, to Barry Weingast (Sept. 30, 1997) (on
file with the Virginia Law Review Association). In violation of the spirit of market-
preserving federalism, Mexico's "central government exercises overwhelming control over
state and local governments." John Bailey, Fiscal Centralism and Pragmatic Accommoda-
tion in Nuevo Le6n, in Opposition Government in Mexico 173, 173 (Victoria E. Rodrfguez
& Peter M. Ward eds, 1995).
1598 Virginia Law Review [Vol. 83:1593
similar conclusion holds in federal systems designed to protect minority rights:
The absence of the fifth condition threatens federalism's purpose.
In Part III, we apply our approach to India. In brief, we show that India fails
to conform to the ideal of market-preserving federalism by failing to satisfy
several of its axioms. In violation of the second and fifth provisions, the na-
tional government has the authority to impose presidential rule, by which it
may take over the government of a particular state, clearly compromising state
independence. Similarly, India's central planning system lodges too much
control over the economy with the central government, precluding the benefits
of inter-jurisdictional competition. In sum, India's federalism compromises
all the benefits that should accrue from state sovereignty under market-
preserving federalism.
This approach to studying Indian federalism yields different conclusions from
those reached in Does Federalism Preserve Markets?22 by Jonathan Rodden and
Susan Rose-Ackerman ("Rodden/Rose-Ackerman"). Rodden/Rose-Ackerman
study India as a means for exploring the implications of market-preserving
federalism. Although they admit that India does not conform to market-
preserving federalism, they seem to argue that because India is federal and
because India has failed to foster economic growth, market-preserving feder-
alism fails to foster markets. In the absence of a comparative theory of fed-
eralism, they appear to have trouble distinguishing among different federal
systems. Our comparative theory of federalism shows why federal systems
systematically differ and, in particular, why some have poorly performing
economies. This approach suggests that India's systematic departure from
market-preserving federalism helps explain its poor economic performance.
Our comparative approach to federalism demonstrates that there is no
logical connection between federalism, per se, and governmental promotion
or preservation of markets. We identify one type of federalism that pro-
motes markets, labeling it market-preserving federalism. But as various of
the conditions characterizing market-preserving federalism are removed, a
federal system's incentives to promote markets are weakened or eliminated.
The theory makes clear that assessing a particular federal system's ability to
promote markets requires assessing which conditions it satisfies.

II. A COMPARATIVE THEORY OF FEDERALISM

All federal systems involve decentralized political authority, though not all
forms of decentralization constitute federal systems. To understand federal-
ism, we must identify its principal characteristics. The first condition is a de-
fining characteristic of any federal system:

22
Jonathan Rodden & Susan Rose-Ackerman, Does Federalism Preserve Markets?, 83
Va. L. Rev. 1521 (1997).
1997] Response 1599
Fl: A hierarchyof governments with a delineated scope of authority
(for example, between the national and subnational governments) ex-
ists so that each government is autonomous within its own sphere of
authority.2Y
Beyond this condition, federal systems differ enormously in their political
and economic performance. To build a theory of how their political and eco-
nomic characteristics differ, we begin with a special type of federalism called
market-preserving federalism.4 Formalized decentralization alone is insuffi-
cient to preserve markets; rather, a system must possess further conditions
concerning the allocation of authorities and responsibilities among different
levels of government. These conditions also prove useful for predicting the
differential performance of particular types of federal systems.
F2: The subnational governments have primary authority over the
economy within their jurisdictions.
F3: The national government has the authority to police the common
market [from encroachments by the states] and to ensure the mobility
of goods and factors across subgovernment jurisdictions.
F4: Revenue sharing among governments is limited and borrowing
by governments is constrained so that all governments face hard budget
constraints.
F5: The allocation of authority and responsibility has an institution-
alized degree of durability so that it cannot be altered by the national
government either unilaterally or under the pressures from subna-
tional governments.-'
These conditions represent an ideal type of institutional arrangement of
market-preserving federalism. From the perspective of preserving market
incentives, the authority of the national government over markets is limited to
policing subgovernmental shirking (here represented as F3: subgovernment
encroachment on the common market) and providing national public goods,
such as defense and a stable macroeconomic regime.
The institutional arrangements of federalism recognize a critical difference
between the national government and the subnational governments: There is
only one of the former, but there are many of the latter. Competition among
jurisdictions induces limits on the discretionary authority of the subnational
governments. A necessary condition for this competition to be beneficial is
the absence of trade barriers, so that the entire nation becomes a common
market as required by F3. Without F3, each subnational government would

1-Montinola, Qian & Weingast, supra note 16, at 55.

24See McKinnon, Market-Preserving Fiscal Federalism, supra note 19, at 37; Montinola,
Qian & Weingast, supra note 16, at 55; Weingast, supra note 16, at 4.
1 Montinola, Qian & Weingast, supra note 16, at 4. See also Weingast, supra note 16, at
4 (discussing the same conditions).
1600 Virginia Law Review [Vol. 83:1593

become something of a de facto national government in its jurisdiction, short-

circuiting federalism's limits on lower governments. Condition F2 enhances
the effects of Condition F3: If decentralization remained at the discretion of
the national government, the latter could intervene in the economy by using
its discretion (in the absence of F2) first to compromise the system of feder-
alism and then to intervene.
Condition F4 applies to both the national and subnational governments
and has two parts: fiscal transfers between levels of governments and gov-
ernment borrowing.6 Although Condition F4 does not preclude revenue
sharing among levels of government, the hard budget constraint limits the
ways in which revenue can be shared or equalized. In particular, it prevents
lower governments that perform increasingly poorly from getting increasingly
larger subsidies from higher levels of government. The hard budget con-
straint restricts open-ended access to capital markets, especially borrowing
from the central bank. For lower governments this is necessary to tie local
revenue to local economic prosperity: A local government's financial prob-
lems remain its own. This condition provides important incentives for local
officials, as their government's fiscal health is directly related to local eco-
nomic prosperity. If, in contrast, local governments were readily bailed out
of their financial problems, they would not need to worry about the conse-
quences of their choices. The hard budget constraint on the national gov-
ernment is necessary to prevent monetary discretion and inflation as attempts
to get around the constraints on its authority mandated under F2.
Condition F5 provides for credible commitment to the federal system.
This condition requires that, beyond simple decentralization, the federal
structure must not be under the discretionary control of the national govern-
ment. Condition F5 concerns the enforcement problem and is critically im-
portant. Due to different histories and unique social, political, and economic
situations, each country is likely to resolve this condition in a unique way.
For many large countries with diverse economies, market-preserving fed-
eralism's balance of power between the national and subnational govern-
ments is superior to either a centralized unitary government or complete de-
centralization with each region as an independent state. In the latter two
cases, the national government's authority is not limited through internal in-
stitutional arrangements; hence, the danger exists for the discretionary
authority to encroach on markets.

26See McKinnon, Market-Preserving Fiscal Federalism, supra note 19, at 37-38; see also
David E. Wildasin, Externalities and Bailouts: Hard and Soft Budget Constraints in Inter-
governmental Fiscal Relations (May 1997) (unpublished manuscript, on file with the Vir-
ginia Law Review Association) (discussing soft and hard budget constraints in relation to
the size of localities).
1997] Response 1601
Before turning to the economic implications of market-preserving federal-
ism, we pause for a few observations about the relationship between the mar-
ket-preserving federalism model and various systems of federalism throughout
the world. Our approach shows that whether a nation describes its political
system as federal is irrelevant. What matters for federal performance is the
combination of conditions that hold. Many de jure federalisms are nothing
like market-preserving federalism. For example, in Mexico, Conditions F2,
F4, and F5 fail. In this federal system, the lion's share of state revenue comes
from the national government.8 This raises several problems. First, it breaks
the link between local economic prosperity and fiscal health. Second and
perhaps more importantly, along with the revenue come restrictions, rules,
and regulations from the center. Money from the central government carries
the implicit threat, made explicit in Mexico,2 9 of withdrawing funds if the
lower government chooses to disobey. Local governments in these systems
have neither the incentive nor the ability to differentiate themselves from
their neighbors. More broadly, the failure of F2 and F5 implies that the po-
litical discretion and authority retained by the central government greatly
compromise its market-preserving qualities.
In sum, though many forms of political decentralization exist, market-
preserving federalism characterizes only a narrow subset.?

A. The Economic Effects of Market-PreservingFederalism

A critical feature of market-preserving federalism is that it limits the exer-
cise of arbitrary authority by all levels of government. Federalism limits the
central government directly by placing particular realms of public policy be-
yond that government's reach. For lower governments, constraints are im-
posed in two ways. First, under Condition F3, the central government polices
state abuses of the hierarchy, such as encroachments on the common market

7See Oliver E. Williamson, The Institutions and Governance of Economic Develop-

ment and Reform, in The Mechanisms of Governance 322,333-35 (1996).
z Bailey, supra note 21, at 173.
29 For example, when local governments elect opposition parties to power, the national
government cuts off many of their discretionary funds. See Victoria E. Rodrfguez & Peter
M. Ward, Conclusion: Regents From the Opposition, in Opposition Government in Mexico,
supra note 21, at 223, 227. ("But both PRD and PAN municipal governments have suf-
fered insofar as discretionary lines of funding for more elaborate special projects and pro-
grams (dams, highways, housing projects, and so forth) are concerned.").
- Notably, unlike de jure federalisms such as Mexico, 18th century England was char-
acterized by market-preserving federalism, although the English did not call their system
federal. See Weingast, supra note 16, at 15-17.
1602 Virginia Law Review [Vol. 83:1593

F3. Second, the induced competition among lower jurisdictions places self-
enforcing limits on these governments' ability to act arbitrarily?'
These limits have a number of salutary effects. First, no government has a
monopoly of regulatory authority over the entire economy. The national
government's absence of regulatory authority prevents it from creating mo-
nopolies and other forms of inefficient economic intervention that plague de-
veloping countries. Competition limits the ability of subnational govern-
ments to create monopolies and other policies that cripple markets, because
doing so would place firms in its jurisdiction at a considerable disadvantage.
When a particular jurisdiction imposes an onerous restriction on its firms, the
firms face a competitive disadvantage relative to competing firms from less
restrictive jurisdictions.
A further beneficial effect of market-preserving federalism is that compe-
tition among jurisdictions extends to factors of production, such as capital
and labor. This induces jurisdictions to provide a hospitable environment for
factors, typically through the provision of local public goods such as secure
rights of factor owners, provision of infrastructure, utilities, and access to
markets. Those jurisdictions which fail to provide these goods find that fac-
tors generally move to other jurisdictions. Although old firms may not move
old plant and equipment to new jurisdictions, they will locate new invest-
ments there. In less competitive jurisdictions, local economic activity and tax
revenue therefore decline. For example, the economic rise of the American
South since the 1960s reflects in part firms moving to jurisdictions with fewer
regulatory and labor restrictions. 32
Third, the hard budget constraint (F4) implies that local governments can
go bankrupt. This provides lower governments with incentives for proper fis-
cal management. Local enterprises, politicians, and citizens hardly want their
government to spend more money than is prudent, as bankruptcy would
greatly hinder the ability of local governments to finance necessary public
goods, such as those needed to attract foreign capital and lower business costs.
Finally, market-preserving federalism provides a secure political founda-
tion for markets.33 By resting the regulatory authority over markets with
lower governments, market-preserving federalism induces them to foster lo-
cal economic prosperity. In addition, by limiting national authority over the
economy, it also prevents the national government from causing the massive

3' This Section summarizes an extensive literature in economics, including the classic
work of Tiebout and Oates. See Oates, supra note 7; Tiebout, supra note 3. For a review
of this literature see Rubinfeld, supra note 4.
32See, e.g., Ronald I. McKinnon, Market-Preserving Fiscal Federalism in the American
Monetary Union, in Macroeconomic Dimensions of Public Finance: Essays in Honour of
Vito Tanzi 73, 89 (Mario I. Blejer & Teresa Ter-Minassian eds., 1997).
1 See Weingast, supra note 16.
1997] Response 1603

political distortion of markets typical of developing countries. Once market-

preserving federalism is established, markets are harder for governments to
plunder: National political forces are deflected from such tendencies, and, at
the local level, it is hard for any one interest group to capture the lion's share
of the local government. That, in turn, implies that at least some govern-
ments are always likely to retain their pro-market focus. Market-preserving
federalism therefore diminishes the prevalence of rent-seeking and patronage
systems. The latter can survive only in areas with political protection from
market forces, a phenomenon that market-preserving federalism is designed
to eliminate.
Market-preserving federalism therefore holds considerable promise for de-
veloping countries. The limits enforced by this type of federalism prevent much
harmful and often crippling intervention by governments in the economy.

B. PredictionsFollowing the Inception of Market-PreservingFederalism

Following the inception of a system of federalism, we should observe a di-
versity of policy choices and experiments by local governments. People in
different jurisdictions are likely to have markedly different interests, expecta-
tions, and capabilities. In making their decisions, jurisdictions may also con-
sider markedly different theories and ideologies. We should therefore ob-
serve that, after the inception of market-preserving federalism, lower govern-
ments choose a range of policies to promote their goals.
As the results of the new policies and experiments become known, citizens
and policymakers around the country will update their expectations about
the effects of various policies. Decentralization under market-preserving
federalism therefore results in an important degree of feedback that would
not be present under a unitary system that imposes a single national experi-
ment over all regions.
The competitive process among jurisdictions induces those that initially
chose poor strategies to adopt variants of the strategies that succeed else-
where. To the extent that some jurisdictions are better at promoting mar-
kets, generating wealth, and caring for the needs of their citizens, their poli-
cies are likely to be imitated by others that have been less successful. Still,
we do not expect the appearance of uniformity for several reasons. First,
citizens and firms will sort themselves into jurisdictions. For example, to the
extent that different industries require different types of public goods, they
may locate in different areas, which in turn provide different types of serv-
ices. Second, differing resources and access to markets among jurisdictions
imply that a variety of economic and political strategies will survive.- Fi-

mSee, e.g., Paul Krugman, Geography and Trade (1991).

1604 Virginia Law Review [Vol. 83:1593
nally, citizens are likely to vary in their tastes for public goods, as well as their
ability to pay for them.

C. PredictionsWhen Market-PreservingFederalismRemains Incomplete

The set of axioms used to define market-preserving federalism also forms
the basis for a comparative theory of federalism. The economic and political
performance of federal systems varies systematically with the combinations
of the conditions they satisfy. In this Section, we go beyond market-pre-
serving federalism to discuss implications of three other types of federal sys-
tems, characterized here by the particular combination of axioms they satisfy.
The first type of federalism satisfies all but the common market axiom
(F3), therefore allowing lower jurisdictions to erect trade barriers. The
common market is highly unlikely to be sustained without explicit protection
from the central authorities."' This implies that some areas, particularly those
not likely to perform well under competition with other jurisdictions, are
likely to erect trade barriers against firms and products from other areas. A
federalism of this sort (one which is only incompletely market-preserving)
will produce seemingly contradictory results. Some areas will be observed to
promote markets while others will closely control their economy, especially
to prevent influence from outside the jurisdiction. The absence of a common
market also implies far less pressure against political corruption, so corrup-
tion is likely to be higher in those jurisdictions that raise high trade barriers.
We also expect this variance in performance across lower jurisdictions to
be more pronounced just after a system of federalism is imposed than in a
more mature system. Thus, for an economy like China's, with only limited
experience with markets, economic performance across provinces in the late
1980s differed enormously. 6 As it has become clear that those provinces fos-
tering markets have gotten rich, the variance among provinces has dimin-
ished as others attempted to imitate those that have succeeded.37 Nonethe-

31For example, the common market in the early 19th century United States could not
have been sustained without the ever-vigilant policing of the Supreme Court. See, e.g.,
Gibbons v. Ogden, 22 U.S. (9 Wheat.) 1 (1824) (striking down New York State's grant of
an exclusive right to operate steamboats). Policing the market against encroachments by
state governments proved a major use of its constitutional powers. These cases reveal the
remarkable diversity and cleverness of the states in their efforts to erect such barriers.
See Barry R. Weingast, The Political Foundations of Antebellum American Growth 20
(Sept. 1, 1993) (unpublished manuscript, on file with the Virginia Law Review Associa-
tion). Similarly, such barriers are a major reason underlying the movement for economic
and political union in Europe. See Geoffrey Garrett, International Cooperation and Insti-
tutional Choice: The European Community's Internal Market, 46 Int'l Org. 533 (1992).
1 See Montinola, Qian & Weingast, supra note 16, at 73-79.
31See id. at 77-78.
1997] Response 1605

less, many interior provinces remain "dukedom" economies insulated from

the world, without free markets, and highly corrupt. "
Limited exposure to markets naturally generates suspicion of them and of
their potential for generating dependence on outsiders. The feedback pro-
vided by multiple jurisdictions that conduct independent experiments is there-
fore important to address these concerns. As market growth occurs in some
areas, the incentives for other jurisdictions to pursue protectionism will di-
minish. The experience with markets will reveal new information about how
they allow local governments to provide for the needs of citizens. Even in
the presence of strong trade barriers, fiscal pressures will push insulated areas
to substitute market mechanisms for those activities in which the market has
proven elsewhere to be a superior provider of particular goods and services.
A second type of federal system satisfies all the axioms except Condition
F4: It lacks centralized control over the monetary system. For example, to
the extent that the authority over credit is decentralized, so that it remains at
least in part at the discretion of lower governments, several problems are
likely to emerge. The most obvious is inflation, as each government over-
grazes the commons, causing too much growth in the money supply. The
second problem is a consequence of the first. Decentralized access to credit
under these circumstances also softens the hard budget constraint, as gov-
ernments that increase their exposure can always borrow more in the short
run. This induces moral hazard problems; for example, a jurisdiction may
borrow too much to finance too many investments, many of which would not
be financed were it not for access to credit in this manner. Decentralized ac-
cess to credit also allows lower jurisdictions to bail out ailing enterprises,
compromising economic incentives imposed by market discipline.
A final type of federalism consists of a center that can impose its will on
the lower governments. Various types of federal systems allow this behavior:
if the central government holds regulatory authority over the economy
(violating F2); if it provides lower governments with revenue (violating F4);
or if the federal system remains at the central government's discretion, al-
lowing it the unilateral authority to alter or remove the authority of the lower
governments (violating F5). Because each of these federal systems compro-
mises lower jurisdiction autonomy, all of them behave more like centralized
nations than nations characterized by market-preserving federalism. These
nations typically prevent lower governments from deviating from national
policies. With respect to the economy, lower governments in these federal
systems constitute administrative units of the central government, not auto-
nomous or sovereign governments. If the national government does not want

8Id. at 65-66.
1606 Virginia Law Review [Vol. 83:1593
a market economy, it has the power to prevent lower governments from fos-
tering markets.

D. Does FederalismPreserveMarkets?
We end this Part with the question asked by Rodden/Rose-Ackerman in
the title to their article: Does federalism preserve markets? Although their
title is a clever twist on the phrase "market-preserving federalism," it reflects
a fundamental alteration in the nature of the issue. The theory sketched in
this Part suggests that federal systems differ too considerably to have a uni-
form effect on markets. Indeed, the discussion above implies that many fed-
eral systems are very poor at preserving markets. The answer to Rodden-
/Rose-Ackerman's question must therefore be "no."
Our approach suggests further that the analysis cannot stop here. The
point of the theory of market-preserving federalism is to provide an approach
that explains which types of federalism protect markets. Federal systems that
differ from this ideal in predictable ways will have economies that differ from
an ideal market's society in predictable ways. Thus, federal systems that
violate a common market assumption will lose all benefits from competition
among jurisdictions. Lower governments will erect trade barriers and sub-
stantial interventions in their economies. Forms of federalism which violate
Conditions F2 and F5 will have too powerful a center, also compromising
federalism's market-preserving qualities.

III. FEDERALISM IN INDIA

In their critique, Rodden/Rose-Ackerman use India as a case study for ex-

ploring the conditions of market-preserving federalism. They acknowledge
that in India the central government is too powerful to meet market-
preserving federalism criteria, but they point out that the state-level govern-
ments have had important responsibilities since independence and that recent
economic reforms now encourage competition among the states. 9 Rod-
den/Rose-Ackerman attempt to make two important points with the Indian
case: First, they use it to cast doubt on the viability of market-preserving fed-
eralism,' ° and second, they draw on Indian examples to argue that corruption
will not necessarily decrease as power is decentralized.'
Rodden/Rose-Ackerman are correct in observing that India has an authentic
federal system and that some choices are being devolved to the states under
economic liberalization. But rather than providing an experiment for how a

19 Rodden & Rose-Ackerman, supra note 22, at 1524-25.

40 See id. at 1537-43, 1546-66.
41Id. at 1537-40.
1997] Response 1607
developing country might function under market-preserving federalism, In-
dia instead demonstrates precisely why it is important to differentiate mar-
ket-preserving federalism from other types of federalism. The comparative
theory of federalism sketched in Part II allows us to suggest how different
center-state relations affect economic performance. In this Part, we consider
how India measures up to the criteria for market-preserving federalism.
India meets Condition F1, that of minimal federalism. Its federal structure
is not in dispute; it is regularly cited as an exemplar of the type.42 The third
criterion (Condition F3), that of a common market, is also essentially met.
But India fails to meet the second, fourth, and fifth criteria. The central gov-
ernment retains enormous control over the economy, setting most economic
laws and regulations; state governments have little discretion in revenue
raising and spending. 43 States do not face a hard budget constraint. And fi-
nally, the center has important unilateral powers with respect to state pow-
ers.' The framers of the Indian Constitution created a strong center that
could, many Indians believed, direct economic growth, protect minority rights,
and defuse the political and economic tensions that might arise in such a het-
erogeneous nation.45
The Indian revenue collection system places states at the mercy of the cen-
tral government. The central government raises the bulk of its revenue
through taxes and distributes that revenue to the states according to the rec-
ommendations of several central agencies.4' States may raise revenue in only
a few areas on their own, chiefly sales, liquor excise, and various fees.47 States
therefore have been dependent on the various commissions and ministries.
Two primary central bodies hold authority over revenue disbursement: the
Planning Commission and the Finance Commission. The Planning Commis-
sion was set up to implement the Five Year Plans, and it has been the corner-
stone of India's economic development strategy from independence to the
recent economic reforms. Although the commission's powers have ebbed
and flowed, reaching their high-water mark in the 1960s, it still controls sub-

2 Arend Lijphart, Democracy in Plural Societies 181 (1977); Riker, supra note 17, at
120-22.
43See B.S. Grewal, Fiscal Federalism in India 15-18 (1974).
See Asok Chanda, Federalism in India: A Study of Union-State Relations 68-72 (1965)
(discussing the historical background of the center's authority over the states).
45See, e.g., Granville Austin, The Indian Constitution: Cornerstone of a Nation 189-91
(1966).
46 See Grewal, supra note 43, at 15-32.
47See K.S. Krishnaswamy, I.S. Gulati & A. Vaidyanathan, Economic Aspects of Feder-
alism in India, in Federalism in India: Origins and Development 180, 188 (Nirmal Mukerji
& Balveer Arora eds., 1992) (suggesting that, "Though States were given the exclusive
right to agricultural taxation, political conditions made its exploitation extremely difficult,
if not virtually impossible.").
1608 Virginia Law Review [Vol. 83:1593

stantial portions of the total revenue transfers from the center to the states.4
These expenditures include those stipulated by central development plans,
state-level plans, and centrally sponsored schemes. This last program has be-
come increasingly important both as a patronage tool and as a way for the
center to dominate investment and distribution decisions.
While the Planning Commission controls Plan expenditures, the Finance
Commission has authority over all non-Plan disbursements. The commission's
main job is to address the gap between committed expenditures and the state's
expected revenues.f It does not rank or evaluate different types of expendi-
tures, however, and its main goal is to avoid deficits in non-Plan areas."
The lack of coordination between the two commissions creates a soft
budget constraint for the states. Because the Finance Commission tends to
provide funds to make up shortfalls, states have an incentive to commit to
expenditures regardless of funds. This behavior by states emerged soon after
independence. In the 1960s, for example, an astute observer remarked that
"states indulge in competitive importuning, putting up scheme after scheme
to attract funds, and then happily run up big deficits by failing to collect their
own share .... .""
In the 1950s and 1960s the two commissions controlled almost all revenue
transfer decisions. 53 But in the last two decades, other central government
agencies have acquired considerable influence over economic policies. Since
all foreign projects must be routed through ministries or central financial in-
stitutions, 4 the recent introduction of economic reforms does not necessarily
mean greater decentralization to the states. Moreover, the bulk of industrial
policy, especially through regulation and licensing, is controlled by centrally
appointed boards and agencies. This system, known in India as License Raj,
means that the center retains control over the distribution of permits and li-
censes for new areas of economic development through the relevant central
ministry.55 Although recent central governments have pledged to loosen the
grip of License Raj,56 the center still reserves the right to decide which changes
will be made.
Apart from the distribution of revenue and returns from investments,
states can potentially increase their total revenue by borrowing. But the states'

See id. at 193-95.

41 See id. at 203-04.
oChanda, supra note 44, at 188-225.
I See Krishnaswamy, Gulati & Vaidyanthan, supra note 47, at 189-90.
52 W.H. Morris-Jones, The Government and Politics of India 144 (1964).

53See Chanda, supra note 44, at 188-225,260-94; Grewal, supra note 43, at 25-32.
14Jagdish N. Bhagwati, India in Transition: Freeing the Economy 49-50 (1993).
51See id. at 50-51
16 Id. at 86-87.
1997] Response 1609
ability to borrow is limited. The Constitution mandates that, as long as a
state owes outstanding loans to the center, it cannot raise loans without the
center's consent. 7 Although this rule is not always followed, states do borrow
much more from the center than from the market."8 This has two results: First,
the states have racked up enormous debt to the center, with an increasing
share of their resource transfers to the center taken up by debt service
charges.59 Second, this makes states further reliant on center decisions.
Why would provincial leaders agree to such an asymmetric division of
economic control in a heterogeneous, federal country? A number of expla-
nations emerge from the debates that took place during the drafting of the
new Indian Constitution. It should be emphasized that the Constituent As-
sembly distinguished between economic and political decentralization. While
political decentralization was seen as inevitable, economic decentralization
was never seriously contemplated given the differences in language, ethnicity,
and previous forms of government (e.g., between the British colonial prov-
inces and the princely states).
Nehru and the socialist wing sought to implement central economic plan-
ning because they believed it would more quickly create a strong industrial
base. Leaders more receptive to capitalist theories went along because they
were afraid that open markets, especially those that were permeable by in-
ternational investments, would wipe out nascent local industries that had al-
ready been damaged by centuries of colonial domination. 6' They accepted
central government control as the lesser of the possible evils that could befall
Indian capitalism.
In addition, many feared that without central control, the disparities be-
tween rich and poor states would increase. Both types of states were well
represented in the Constituent Assembly, and their divergent interests were
apparent from the outset. At one point the governments of the rich states of
West Bengal and Bombay suggested that they receive tax shares that re-
flected their contributions.? Their proposal would have given these states,
which represent a mere seventeen percent of the total population, sixty-two
percent of all income tax revenues.? Although these suggestions were never
adopted, they revealed the potential problems that could arise if states were
given greater economic powers. Central dominance was thus considered to
be a way to avoid destructive interstate disputes and increase equality across

India Const. pt. XII, ch. II, art. 293.

See Grewal, supra note 43, at 18-19.
S9 Krishnaswamy, Gulati & Vaidyanathan, supra note 47, at 196.

6 Austin, supra note 45, at 45.

61See id. at 60-61.
6 Id. at 222-23.
3 Id.
1610 Virginia Law Review [Vol. 83:1593

disparate regions. These deliberations did result in a system in which the na-
tional government makes all the important economic decisions. But it is far
from clear that centralization led to greater equality.
The data reveal important differences in the resources transferred to rich
and poor states; these differences are the greatest in those areas in which the
central government has the greatest discretion. Between 1956 and 1981, in
discretionary transfers made by central ministries, per capita transfers to low
income states were only seventy-seven percent of those to high income states;
middle income states did somewhat better at eighty-six percent. 4 Non-
discretionary expenditure decisions were slightly more equitable but revealed
the same type of disparity: Statutory transfers were twenty percent higher for
middle income than low income states, and plan transfers were ten percent
higher. '
The distribution of revenue surpluses reveals similar disparities. Because of
the division of responsibilities between the Financial and Planning Commis-
sions, a few states, primarily those with higher per capita income, have regularly
been left with substantial revenue surpluses.66 For example, in the 1980s,
poor Bihar's non-Plan surplus was only ten percent of that of rich Punjab.
These surpluses are important because they can they be plowed back into
further development schemes, creating even wider disparities in the future.
Finally, in violation of Condition F5, the Indian Constitution enhances the
central government's economic control over the states still further. 6 Specifi-
cally, the central government has unilateral control over federal provisions in
several important ways. For example, state boundaries can be redrawn by a
simple majority in Parliament.4 Even more importantly, the Indian Constitu-
tion provides that the President of India may dissolve state governments in
three circumstances: threats to national security by external aggressors, a
breakdown of a state's constitution, and financial crisis. 69 This power was en-
visaged for use in infrequent and extreme cases, and it was never invoked be-
tween 1950 and 1960.70 Since 1962, however, its usage has increased, and it
has become highly politicized. Although the financial crisis provision is
rarely invoked (the most common is the second case, breakdown of the Con-
stitution)," greater economic autonomy for states could change this pattern.

64
Krishnaswamy, Gulati & Vaidyanathan, supra note 47, at 195-96.
64
Id. at 195.
6
67 Id.
For a discussion of the Indian federalist system in comparison with those of other
countries, see Durga Das Basu, Introduction to the Constitution of India 49-63 (9th ed.
1982).
61 India Const. pt. I, art. 3.
69See India Const. pt. XVIII, arts. 352, 356, 360.
10Austin, supra note 45, at 216.
71Basu, supra note 67, at 302-16 (discussing emergency powers generally).
1997] Response 1611
If economic strategies in a state ran counter to the interests of the parties in
power at the center, the financial crisis provision could become as politicized
as the breakdown provision.
Despite Rodden/Rose-Ackerman's contention that India provides a good
case with which to assess market-preserving federalism, India's failure to
meet the approach's criteria makes it an inappropriate test for the theory.
The Indian case far better illustrates what occurs in the absence of market-
preserving federalism. The ways in which India has failed to develop are
consistent with the predictions of our theory about federal performance when
the various conditions of market-preserving federalism are not present. To
summarize, India's federalism departs considerably from market-preserving
federalism, failing to meet criteria F2, F4, and F5. Violating F2 grants the
central government sufficient power over the economy to prevent competi-
tion among the states, which results in an absence of state policy experimen-
tation and innovation. It also prohibits the natural matching of policies to lo-
cal conditions, which in turn inhibits specialization and exchange. The
absence of F4 means that states have no financial incentive to be concerned
about the effects of their policies. Finally, India's violation of F5 provides the
national government with additional leverage over the states. In short, In-
dia's federalism retains the hierarchy of federalism but eliminates the main
mechanisms that sustain strong markets. States are not free to set their own
economic policies. Nor can they capture the gains from policies that foster
economic growth.
Although Roddeh/Rose-Ackerman overstate the extent to which India can
be considered a fair current or future example of market-preserving federalism,
they are correct to point out that a certain amount of economic decentralization
and state innovation is taking place there. 2 From this evidence they conclude
that market-preserving federalism cannot succeed in India. Although we be-
lieve that it remains too early to tell, considerable evidence indicates other-
wise. For example, Gujarat and Karnataka are two states that have taken
greatest advantage of economic liberalization. As market-preserving feder-
alism predicts, the provision of local public goods, such as infrastructure and
utilities, has increased in these states, 3 and it can be argued that their advan-
tages over other states, such as an educated labor force and a history of in-
digenous capital, have helped them attract foreign investment.
Rodden/Rose-Ackerman emphasize the importance of political corruption
in distorting prospects for economic growth. They argue that, contrary to the
predictions of market-protecting federalism, corruption is likely to increase in

72
Rodden & Rose-Ackerman, supra note 22, at 1524-25.
"See Charan D. Wadhva, Economic Reforms in India and the Market Economy 127-29
(1994); Energy: Need for a Comprehensive Policy, DATA india, Sept. 24, 1995, at 764,
765; Lukewarm Response to Telecom Tenders, DATA india, July 9,1995, at 556,557.
1612 Virginia Law Review [Vol. 83:1593
developing democracies if economic decentralization occurs, and they use
evidence on civil service transfers to support their claim. 4 Unfortunately for
their argument, the evidence runs counter to their position: Despite high lev-
els of civil service transfers in Gujarat, economic growth is increasing there."
In order to attribute properly the effect of corruption on economic growth,
it is necessary to have a theory of corruption and its effects. Although some
forms of corruption, such as pervasive and widespread rent-seeking, clearly
inhibit investment and growth, others become accepted as another cost of
doing business. In successful Indian states such as Gujarat and Karnataka,
corruption exists, but it is routinized and predictable, and it is not sufficiently
high to deter capital that desires to locate in India.
In conclusion, although the rhetoric of decentralization in India has in-
creased, it remains to be seen whether state autonomy will increase in prac-
tice. In the 1997 budget announcement, the Finance Minister recommended
that central government resources be consolidated into a single fund and
twenty-nine percent be set aside for the states. 7 6 Although this would increase
their current share, it is still far from parity. In addition, the central govern-
ment is clearly moving toward market reform and away from socialist plan-
ning. Nonetheless, it is far from apparent that the central government will
yield primacy to the states.

IV. CONCLUSIONS

Rodden/Rose-Ackerman ask a critical question: Does federalism preserve

markets? Our answer is that nothing inherent in federalism either promotes
or preserves markets. Federal systems differ too widely to have a uniform
effect on the economy. To address this thesis, we sketched a comparative
theory of federalism and then applied it to India. In Part II, we showed how
a particular kind of federalism, called market-preserving federalism, protects
and husbands markets. Those federal systems that diverge from market-
preserving federalism are unlikely to foster thriving markets. Further, we ar-

74
Rodden & Rose-Ackerman, supra note 22, at 1538.
75
Wadhva, supra note 73, at 127-28. In addition, Rodden/Rose-Ackerman do not distin-
guish between preexisting corruption and the increased corruption they hypothesize would
occur with economic decontrol. Corruption is widespread in Indian politics and admini-
stration, Paul R. Brass, The Politics of India Since Independence 53 (1990), and there may
well be a correlation between the central government's decision to initiate investment and
a state's level of corruption. But the mere existence of high levels of civil service transfers
cannot be used to conclude that corruption is increasing or is presenting a threat to eco-
nomic development and social welfare. The politicization of civil service transfers is not in
question; what remains to be determined is the extent to which these postings systemati-
cally inhibit economic and social welfare across diverse states.
76Finance Minister P. Chidambaram, 1997-1998 Union Budget Speech before the Lok
Sabha (March 1997), available in India on Internet, Budget '97 (visited Sept. 18, 1997)
<http://budget.allindia.comlbudgetlspeechlndLhtm>.
1997] Response 1613

gued that the theory's predictions conform to reality. Those federalisms

roughly characterized by market-preserving federalism's conditions, such as
the United States or contemporary China, have thriving markets. Those that
fundamentally diverge from market-preserving federalism tend to be devel-
oping states mired in poor growth, such as Argentina, Mexico, and India. In
each of the latter systems, the central government has too much power over
the economy and the lower governments to allow these systems to exhibit
market-preserving federalism.
Sustaining federalism requires that political officials obey a series of rules
concerning the allocation of political power. This issue raises a larger ques-
tion. Many of the principal values associated with good government and so-
ciety-including democracy, the rule of law, and thriving markets-require
that political officials respect a range of citizen rights. Because there are no
external authorities to enforce this respect, these rights must be self-enforcing
in the sense that political officials have sufficient incentives to abide by them.
That political officials in most countries today fail to do so suggests that this
is a profound problem, which economists and political scientists studying fed-
eralism have neglected. Given this dilemma, we know too little about how
federalism is sustained.
Our focus on market-preserving federalism suggests some of the political
prerequisites necessary for federalism to sustain markets. To do so, it must
meet more than the minimal condition of federalism, a hierarchy of govern-
ments. Beyond a hierarchy of government, the economic benefits of federal-
ism require that: the national government's powers over the economy be
limited (F2); there must be a common market (F3); all governments must
face a hard budget constraint (F4); and institutions must credibly commit po-
litical officials at all levels to these restrictions (F5).
These conditions provide the political foundations underlying the econo-
mists' approach to federalism, though economists rarely specify or discuss
them. The theory makes explicit the allocation of political powers among the
different levels of government. In particular, federalism requires that the na-
tional government must, somehow, be restricted in its powers to providing
truly national public goods, considerations of equity, and policing the federal
system. Market-preserving federalism's hard budget constraint and its in-
duced competition among jurisdictions limit the exercise of powers by lower
jurisdictions.
Federal systems can fail to be market-preserving in a variety of ways. In
the absence of Condition F3, lower governments have the power to erect
trade barriers, thereby insulating their economies from competition. This
power obviates many of the benefits of federalism by allowing corruption, in-
terest groups influence, and rent-seeking. When Condition F2 fails, the na-
tional government has too much power over the economy. If this occurs in
combination with national government control over lower government reve-
1614 Virginia Law Review [Vol. 83:1593
nue, lower governments tend to become administrative arms of the national
government. Federal systems of this sort remain only nominally federal, sac-
rificing many of the economic benefits of lower government independence
and failing to exhibit the economic benefits of market-preserving federalism.
We applied our perspective to India, in part responding to Rodden/Rose-
Ackerman's claims about Indian federalism. India's federalism has never
conformed to the conditions of market-preserving federalism, nor was it de-
signed to do so. Part of the purpose of federalism in India concerns the
problem of maintaining harmony among different ethnic and religious groups.
Turning to the economy, India's central government simply has too much77
power over the states to be characterized as market-preserving federalism.
The dominant role of the central government in economic planning, regula-
tion, taxation, and redistribution implies that Condition F2 fails. The ability
of the national government to redraw state boundaries and to take over state
governments by declaring presidential rule implies that Condition F5 fails.
The central government's powers thus allow it to overwhelm the states, and
in doing so, to allow the interventionist national policies that cripple the In-
dian economy.
Nonetheless, we agree with Rodden/Rose-Ackerman that India is unlikely
to adopt anything comparable to market-preserving federalism.m The requisite
restrictions on government would harm a large range of interests that benefit
from the current system and would oppose restrictions that limit these benefits.
What would happen if India moved toward greater state autonomy, as re-
quired by market-preserving federalism? Rodden/Rose-Ackerman argue that
the result would be far more corruption. We responded by suggesting that
this prediction is only partially correct. Even if corruption initially increased
in most states, this is not likely to be universal. This is so because there are
some states and areas that we argue are greatly harmed by the current set of
restrictions, such as Maharashtra, Gujarat, and Karnataka. These states would
be likely to use new freedoms to foster markets and to attempt to become
rich in just the way that Guangdong has done under China's decentralization.
Further, just as in China, the success of a few states in India is likely to
change politics in other states. After observing what can happen elsewhere,
citizens in other states will pressure their political officials, asking why their
state has remained mired in corruption while others have been getting rich.
An essential feature of the current pattern of corruption is that the central
government prevents state officials from pursuing independent policies. More

nJoachim Ahrens, The Political Institutions of Economic Development: Experiences,

Failure and Prospects in East and South Asia, in 88 Diskussionsbeitrige aus dem Volks-
wirtschaftlichen
78
Seminar der Universit~it Gbttingen 25-26 (June 1996).
Rodden & Rose-Ackerman, supra note 22, at 1525.
1997] Response 1615
local state freedom in India might initially result in more corruption in many
states, but we predict that this would not be the final political equilibrium.
We therefore disagree with Rodden/Rose-Ackerman's claim that India pro-
vides an excellent opportunity to explore the validity of market-preserving
federalism's predictions. Yes, India has performed poorly on many dimen-
sions. But, along the economic dimension, this is in part because India sys-
tematically diverges from market-preserving federalism, not because the the-
ory of market-preserving federalism fails.