In a federal state with weak political institutions, constituent units might protect their enterprises from enforcement of federal taxes. The effectiveness of such protection depends on the ability of local politicians to extract rents from enterprises. They can easily do so when local monopolies can be effectively sustained and electoral competition is weak.

In this paper, the analysis focuses on the perverse incentives of federalism, i.e. that separation of power between the center and regions create in a weakly institutionalized environment and does not seek a full evaluation of the performance of federalism in transition countries.

To analyze the effects of political decentralization in a country with powerful regional industries like Russia, the author builds a simple general-equilibrium model where local politicians’ electoral positions are levels of competition in the regional market, heterogenous firms provide campaign finance and compete in the labor market, and voters care about their wages, but are not immune from influence of campaign spending.

After introducing the setup of the model, the paper:

• discusses comparative statics in regional equilibria
• analyses federal equilibria
• describes the federalism, “Russian style” which is used as a motivating example

The author contrasts the Russian case with the case of China in provincial protectionism which is a manifestation of the center’s inability to efficiently oppose emergence of trade barriers across provinces.

The author demonstrates that the industrial structure inherited from Soviet times has undermined political centralization in Russia at the early stages of transition and precludes federalism from providing correct incentives to politicians, both local and central, and managers of industrial enterprises.

In China, political centralization reduces regional administration incentives to protect firms from the federal center and there is no incentive to reduce market competition, since there are no large local monopolies to extract rents from. In Russia, there are disincentives to soft-budget constraint elimination, since a firm might use excess employment as a substitute for a payment for protection. Since excess employment is likely to be in old enterprises, governors keep old enterprises and restrict entry of new ones.