Dynamics of Fiscal Habits and Soft Budgets in Federations

In this paper, we are motivated by empirical evidence of persistent, implicit or explicit, bailouts in federations from high‐tier (e.g., center) governments to low‐tier (e.g., state) governments. We build a novel dynamic model for a federation containing N ≥ 2 $N\ge 2$ identical regional governments and a central government. We assume that regional governments care about the wellbeing of residents and bureaucrats. Residents derive utility from consumption of numeraire and regional public goods. The utility of the bureaucracy depends on habit formation. The bureaucrat derives utility from consumption of current and past regional public good levels. The central government's objective function is the sum of regional utilities. Regional and central governments play an infinite‐horizon sequential game in which regional governments are policy leaders with respect to their choices of public‐good levels. These choices produce regional deficits. The central government observes regional deficits and then choose deficit‐relief federal transfers to reduce regional costs of fiscal insecurity faced by regional residents. There is a common‐pool property associated with federal funds. The federal transfers do not eliminate regional deficits. Observing this, regional governments raise additional funds to eliminate deficits. We derive the steady‐state equilibrium, examine its properties and compare it with alternative equilibria, which provide useful benchmarks. We show that the dynamic model produces equilibrium outcomes that are consistent with empirical evidence; namely, they involve persistent deficits and partial federal bailouts. Deficits increase as the federation expands in size.