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Soft Budget Constraints, Taxes, and the Incentive to Cooperate

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  • Joshua Aizenman

Abstract

This paper considers an economy where the macroeconomic equilibrium is the outcome of the conduct of an administration, consisting of a large number of decision makers whose horizon is uncertain, being endogenously determined by their behavior. Limited monitoring enables each decision maker to behave opportunistically in the short run, abusing his 'official' budget constraint, generating in the short run a degree of 'softness' in his budget. The uncertainty has two dimensions: the temporal one relates to the detection possibility facing the opportunistic decision maker, and the intertemporal one relates to the survival probability of the administration. We assume that the survival probability of the administration goes down with signals like inflation, tax rates and the like. In such a system, the public imposes a degree of discipline on the policy makers by its option to replace the administration, and the administration imposes discipline on the policy makers by monitoring their effective expenditure. We characterize the equilibrium, identifying conditions that yield limited cooperation. We show that adverse shocks (like a lower tax collection, lower international transfers, higher real interest rates and the like) or shorter horizon (due to greater instability) will tend to reduce cooperation among policy makers and will increase the inflation rate and the use of discretionary taxes.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3561.

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Date of creation: Dec 1990
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Publication status: published as International Economic Review, November 1993, pp. 819-832
Handle: RePEc:nbr:nberwo:3561

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  1. Rotemberg, Julio J & Saloner, Garth, 1986. "A Supergame-Theoretic Model of Price Wars during Booms," American Economic Review, American Economic Association, American Economic Association, vol. 76(3), pages 390-407, June.
  2. Kornai, Janos, 1986. "The Hungarian Reform Process: Visions, Hopes, and Reality," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 24(4), pages 1687-1737, December.
  3. Buiter,Willem H. & Marston,Richard C., 1986. "International Economic Policy Coordination," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521337809.
  4. Aizenman, Joshua, 1992. "Competitive Externalities and the Optimal Seigniorage," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 24(1), pages 61-71, February.
  5. Alex Cukierman & Sebastian Edwards & Guido Tabellini, 1989. "Seigniorage and Political Instability," NBER Working Papers 3199, National Bureau of Economic Research, Inc.
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Cited by:
  1. Beetsma, R.M.W.J. & Bovenberg, A.L., 1995. "Monetary union without fiscal coordination may discipline policymakers," Discussion Paper, Tilburg University, Center for Economic Research 1995-59, Tilburg University, Center for Economic Research.
  2. Joshua Aizenman & Ricardo Hausmann, 1994. "Why is Inflation Skewed? A Debt and Volatility Story," NBER Working Papers 4837, National Bureau of Economic Research, Inc.
  3. Svensson, Jakob, 1997. "Collusion Among Interest Grops: Foreign Aid and Rent Dissipation," Seminar Papers, Stockholm University, Institute for International Economic Studies 610, Stockholm University, Institute for International Economic Studies.
  4. Mehrdad VAHABI, 2001. "The Soft Budget Constraint : A Theoretical Clarification," Discussion Papers (REL - Recherches Economiques de Louvain) 2001024, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  5. Valeria De Bonis & Pompeo Della Posta, 2005. "Strategic interactions between monetary and fiscal authorities in a monetary union," Working Papers de Economia (Economics Working Papers), Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro 26, Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro.
  6. Qian, Rong, 2012. "Why do some countries default more often than others ? the role of institutions," Policy Research Working Paper Series 5993, The World Bank.
  7. Sebastian M. Saiegh & Mariano Tommasi, 1999. "Why is Argentina’s Fiscal Federalism so Inefficient? Entering the Labyrinth," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 169-209, May.

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