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

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Author Info
Besfamille, Martin (Department of Economics, Universidad Torcuato Di Tella, Ciudad Autonoma de Buenos Aires,)
Lockwood, Ben (CEPR and Department of Economics, University of Warwick,)

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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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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
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Handle: RePEc:wrk:warwec:717

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Related research
Keywords: Fiscal federalism ; Bailouts ; Hard budget constraints;

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  1. Kornai, Janos, 1986. "The Soft Budget Constraint," Kyklos, Blackwell Publishing, vol. 39(1), pages 3-30.
  2. Besley, Timothy & Coate, Stephen, 2003. "Centralized versus decentralized provision of local public goods: a political economy approach," Journal of Public Economics, Elsevier, vol. 87(12), pages 2611-2637, December. [Downloadable!] (restricted)
  3. Fisman, Raymond & Gatti, Roberta, 2000. "Decentralization and corruption - evidence across countries," Policy Research Working Paper Series 2290, The World Bank. [Downloadable!]
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  4. Janos Kornai & Eric Maskin & Gerard Roland, 2002. "Understanding the Soft Budget Constraint," Economics Working Papers 0019, Institute for Advanced Study, School of Social Science. [Downloadable!]
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  5. Sanguinetti, Pablo & Tommasi, Mariano, 2004. "Intergovernmental transfers and fiscal behavior insurance versus aggregate discipline," Journal of International Economics, Elsevier, vol. 62(1), pages 149-170, January. [Downloadable!] (restricted)
  6. Lockwood, Ben, 2002. "Distributive Politics and the Costs of Centralization," Review of Economic Studies, Blackwell Publishing, vol. 69(2), pages 313-37, April.
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  7. Qian, Yingyi & Roland, Gerard, 1998. "Federalism and the Soft Budget Constraint," American Economic Review, American Economic Association, vol. 88(5), pages 1143-62, December. [Downloadable!] (restricted)
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  8. 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. [Downloadable!]
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  9. Yingyi Qian & Barry R. Weingast, 1997. "Federalism as a Commitment to Preserving Market Incentives," Working Papers 97042, Stanford University, Department of Economics. [Downloadable!]
  10. 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. [Downloadable!]
  11. Timothy Goodspeed, 2002. "Bailouts in a Federation," International Tax and Public Finance, Springer, vol. 9(4), pages 409-421, August. [Downloadable!] (restricted)
  12. Teresa Ter-Minassian, 1997. "Decentralization and Macroeconomic Management," IMF Working Papers 97/155, International Monetary Fund.
  13. Ellingsen, Tore, 1998. "Externalities vs internalities: a model of political integration," Journal of Public Economics, Elsevier, vol. 68(2), pages 251-268, May. [Downloadable!] (restricted)
  14. Bardhan, Pranab & Mookherjee, Dilip, 2005. "Decentralizing antipoverty program delivery in developing countries," Journal of Public Economics, Elsevier, vol. 89(4), pages 675-704, April. [Downloadable!] (restricted)
  15. Dewatripont, M & Maskin, E, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," Review of Economic Studies, Blackwell Publishing, vol. 62(4), pages 541-55, October. [Downloadable!] (restricted)
  16. Qian, Yingyi & Weingast, Barry R, 1997. "Federalism as a Commitment to Reserving Market Incentives," Journal of Economic Perspectives, American Economic Association, vol. 11(4), pages 83-92, Fall. [Downloadable!] (restricted)
  17. Alesina, Alberto & Spolaore, Enrico, 1997. "On the Number and Size of Nations," The Quarterly Journal of Economics, MIT Press, vol. 112(4), pages 1027-56, November.
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  18. Faguet, Jean-Paul, 2004. "Does decentralization increase government responsiveness to local needs?: Evidence from Bolivia," Journal of Public Economics, Elsevier, vol. 88(3-4), pages 867-893, March. [Downloadable!] (restricted)
  19. Wallace E. Oates, 1999. "An Essay on Fiscal Federalism," Journal of Economic Literature, American Economic Association, vol. 37(3), pages 1120-1149, September. [Downloadable!] (restricted)
  20. Pranab K. Bardhan & Dilip Mookherjee, 2000. "Capture and Governance at Local and National Levels," American Economic Review, American Economic Association, vol. 90(2), pages 135-139, May. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. 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". [Downloadable!]
  2. Takero Doi & Toshihiro Ihori, 2006. "Soft-Budget Constraints and Local Expenditures," CIRJE F-Series CIRJE-F-422, CIRJE, Faculty of Economics, University of Tokyo. [Downloadable!]
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