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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.

Suggested Citation

  • Zarko Y. Kalamov, 2012. "Prudent Fiscal Policy in the Presence of Bailout Expectations," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 68(4), pages 365-382, December.
    • Handle: RePEc:mhr:finarc:urn:sici:0015-2218(201212)68:4_365:pfpitp_2.0.tx_2-g
    DOI: 10.1628/001522108X659538
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    References listed on IDEAS

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    1. Timothy Goodspeed, 2002. "Bailouts in a Federation," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 9(4), pages 409-421, August.
    2. Kothenburger, Marko, 2004. "Tax competition in a fiscal union with decentralized leadership," Journal of Urban Economics, Elsevier, vol. 55(3), pages 498-513, May.
    3. Robin Boadway & Jean-François Tremblay, 2006. "A Theory of Fiscal Imbalance," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 62(1), pages 1-27, March.
    4. Kothenburger, Marko, 2007. "Ex-post redistribution in a federation: Implications for corrective policy," Journal of Public Economics, Elsevier, vol. 91(3-4), pages 481-496, April.
    5. Wildasin, David E., 1997. "Externalities and bailouts : hard and soft budget constraints in intergovernmental fiscal relations," Policy Research Working Paper Series 1843, The World Bank.
    6. Emmanuelle Taugourdeau, 2006. "Does tax competition soften regional budget constraint ?," Post-Print halshs-00094283, HAL.
    7. Toshihiro Ihori, 2011. "Overlapping tax revenue, soft budget, and rent seeking," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 18(1), pages 36-55, February.
    8. 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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    More about this item

    Keywords

    automatic correction mechanism; soft budget constraint;

    JEL classification:

    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing
    • H77 - Public Economics - - State and Local Government; Intergovernmental Relations - - - Intergovernmental Relations; Federalism

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