Interest groups or incentives: the political economy of fiscal decay

One view is that concessions demanded by and granted to interests groups are responsible for steady fiscal decline, and delay in reforms. We argue that negative supply shocks combined with the political objective of protecting the poor can build in incentives leading to these results. Pricing rules for government services, generated in such circumstances, would be equivalent to a fixed price contract that left the government with negative rent. A decline in investment in and quality of government services would follow, since price controls in the presence of cost shocks would lead to systematic incentives to lower quality and investment. Tax capacity and the ability to reduce poverty in the future would fall. The framework helps to understand the Indian experience. Time series based tests of causality support the causal priority of positive cost shocks. If it is accepted that incentives, and not only interest groups are responsible for fiscal decay, a concerted attempt to rationalize user charges and improve quality may be politically feasible.