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Fiscal decentralization, regional inequality and bail-outs: Lessons from Brazil's debt crisis

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  • Facchini, Giovanni
  • Testa, Cecilia

Abstract

This paper develops a simple two-period model of public good provision within a federation. A national public good is provided to both states by the federal government, while a local public good is supplied by each state government. The federal government levies a proportional income tax, and in each period the state governments receive a share of the revenues collected equal to the amount needed to finance the first best provision of the local public good. In the first period the local governments can also use borrowing to finance the provision of the public good, but any debt contracted must be repaid in the second period. We show that when the states face a hard budget constraint, they do not find it optimal to increase the provision of the local public good above the first best level guaranteed by the federal grant. However, if the federal government cannot credibly commit not to bail-out the states, then the local governments may find it optimal to borrow in order to increase the provision of the public good above the first best in the first period. Furthermore, we show that the commitment problem is more likely to arise vis-á-vis states whose default results in a negative externality on the federation. Hence, those states are more likely to carry on budget deficits and benefit from a federal bail-out.

Suggested Citation

  • Facchini, Giovanni & Testa, Cecilia, 2008. "Fiscal decentralization, regional inequality and bail-outs: Lessons from Brazil's debt crisis," The Quarterly Review of Economics and Finance, Elsevier, vol. 48(2), pages 333-344, May.
  • Handle: RePEc:eee:quaeco:v:48:y:2008:i:2:p:333-344
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    1. M. Dewatripont & E. Maskin, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," Review of Economic Studies, Oxford University Press, vol. 62(4), pages 541-555.
    2. Alesina, Alberto & Tabellini, Guido, 1989. "External debt, capital flight and political risk," Journal of International Economics, Elsevier, vol. 27(3-4), pages 199-220, November.
    3. Carlos R. Azzoni, 2001. "Economic growth and regional income inequality in Brazil," The Annals of Regional Science, Springer;Western Regional Science Association, vol. 35(1), pages 133-152.
    4. Branko Milanovic, 2004. "Half a World: Regional inequality in five great federations," Urban/Regional 0404002, University Library of Munich, Germany.
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    1. Imran Hanif & Sally Wallace & Pilar Gago-de-Santos, 2020. "Economic Growth by Means of Fiscal Decentralization: An Empirical Study for Federal Developing Countries," SAGE Open, , vol. 10(4), pages 21582440209, October.
    2. Richard M. Bird, 2012. "Subnational Taxation in Large Emerging Countries: BRIC Plus One," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1201, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.

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