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Are Hard Budget Constraints for Sub-National Governments Always Efficient?

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  • Besfamille, Martin

    (Department of Economics, Universidad Torcuato Di Tella, Ciudad Autonoma de Buenos Aires,)

  • Lockwood, Ben

    (CEPR and Department of Economics, University of Warwick,)

Abstract

In fiscally decentralized countries, sub-national governments (SNGs) may face soft budget constraints and consequently invest and borrow too much. The policy literature claims that, with competitive capital markets and central governments imposing hard budget constraints (HBCs), inefficient investment by SNGs should not arise. We present a model where this is not the case : HBCs can be too "hard" and discourage investment that is socially efficient. The model combines a dynamic commitment problem as in Kornai, Maskin and Roland (2004) for central government with a moral hazard problem between central and SNG. The HBC over-incentivises the SNG to provide effort by penalizing it too much for project failure, thus leading ultimately to the possibility that socially efficient projects may not be undertaken.

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Bibliographic Info

Paper provided by University of Warwick, Department of Economics in its series The Warwick Economics Research Paper Series (TWERPS) with number 717.

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Length: 26 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:wrk:warwec:717

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Keywords: Fiscal federalism ; Bailouts ; Hard budget constraints;

References

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  1. John Joseph Wallis & Wallace E. Oates, 1988. "Decentralization in the Public Sector: An Empirical Study of State and Local Government," NBER Chapters, in: Fiscal Federalism: Quantitative Studies, pages 5-32 National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Toshihiro Ihori, 2008. "Overlapping Tax Revenue, Local Debt Control and Soft-Budget Constraint," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-552, CIRJE, Faculty of Economics, University of Tokyo.
  2. Antonio Sciala' & Paolo Liberati, 2008. "The impact of economic openness on the vertical structure of the public sector," "Marco Fanno" Working Papers 0085, Dipartimento di Scienze Economiche "Marco Fanno".
  3. Toshihiro Ihori, 2010. "Overlapping Tax Revenue, Soft Budget, and Rent Seeking," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-750, CIRJE, Faculty of Economics, University of Tokyo.

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