Soft budget constraints in a federation: the effect of regional affiliation

This paper revisits the soft budget constraint problem, pushing sub-central (state) borrowing to the limit in multi-tiered countries. Accounting for the institutional design and political practice common to many federations, bargaining and log-rolling are introduced to the analysis. In our intertemporal model, a federal legislature of regionally elected representatives bargains on federal grants going to the states. As a result, voters will elect federal candidates in favour of looser state public spending than otherwise expected. This strategic voting not only leads to overly generous bailout policies. Also, and compared to a setting where federal decision making does not follow from bargaining and regional affiliation, states over-borrow more inefficiently. Allowing for heterogeneity in state income and population does not affect this inefficient outcome. Lower relative per capita incomes even boost federal generosity and subsequent over-borrowing by the states.