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Prudent Fiscal Policy in the Presence of Bailout Expectations

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  • Zarko Y. Kalamov

Abstract

This paper analyzes the introduction of an automatic correction mechanism (ACM) in an economic union whose member states expect to be bailed out in the case of a debt crisis. An ACM can be used to penalize governments that run deficits. We show that if the mechanism is appropriately structured, it can harden the governmental budget constraints. Thus, in the presence of an ACM, bailout expectations of a regional government do not lead to excessive borrowing. However, we find that simultaneous introduction of an ACM and a credible commitment not to bail out indebted regions may lead to inefficiently hard budget constraints and an overshoot of the policy objectives.

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Bibliographic Info

Article provided by Mohr Siebeck, Tübingen in its journal FinanzArchiv.

Volume (Year): 68 (2012)
Issue (Month): 4 (December)
Pages: 365-382

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Handle: RePEc:mhr:finarc:urn:sici:0015-2218(201212)68:4_365:pfpitp_2.0.tx_2-g

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Related research

Keywords: automatic correction mechanism; soft budget constraint;

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References

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  1. Robin Boadway & Jean-François Tremblay, 2006. "A Theory of Fiscal Imbalance," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, Mohr Siebeck, Tübingen, vol. 62(1), pages 1-27, March.
  2. David E. Wildasin, 2001. "Externalities and Bailouts: Hard and Soft Budget Constraints in Intergovernmental Fiscal Relations," Public Economics, EconWPA 0112002, EconWPA.
  3. Marko Köthenbürger, 2006. "Ex-Post Redistribution in a Federation: Implications for Corrective Policy," CESifo Working Paper Series 1754, CESifo Group Munich.
  4. Timothy Goodspeed, 2002. "Bailouts in a Federation," International Tax and Public Finance, Springer, vol. 9(4), pages 409-421, August.
  5. Toshihiro Ihori, 2011. "Overlapping tax revenue, soft budget, and rent seeking," International Tax and Public Finance, Springer, vol. 18(1), pages 36-55, February.
  6. Kothenburger, Marko, 2004. "Tax competition in a fiscal union with decentralized leadership," Journal of Urban Economics, Elsevier, vol. 55(3), pages 498-513, May.
  7. Breuille, Marie-Laure & Madies, Thierry & Taugourdeau, Emmanuelle, 2006. "Does tax competition soften regional budget constraint?," Economics Letters, Elsevier, vol. 90(2), pages 230-236, February.
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