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Soft Budget Constraints, Taxes, and the Incentive to Cooperate

Listed author(s):
  • Joshua Aizenman

This paper considers an economy where the macroeconomic equilibrium is the outcome of the conduct of an administration, consisting of a large number of decision makers whose horizon is uncertain, being endogenously determined by their behavior. Limited monitoring enables each decision maker to behave opportunistically in the short run, abusing his 'official' budget constraint, generating in the short run a degree of 'softness' in his budget. The uncertainty has two dimensions: the temporal one relates to the detection possibility facing the opportunistic decision maker, and the intertemporal one relates to the survival probability of the administration. We assume that the survival probability of the administration goes down with signals like inflation, tax rates and the like. In such a system, the public imposes a degree of discipline on the policy makers by its option to replace the administration, and the administration imposes discipline on the policy makers by monitoring their effective expenditure. We characterize the equilibrium, identifying conditions that yield limited cooperation. We show that adverse shocks (like a lower tax collection, lower international transfers, higher real interest rates and the like) or shorter horizon (due to greater instability) will tend to reduce cooperation among policy makers and will increase the inflation rate and the use of discretionary taxes.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3561.

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Date of creation: Dec 1990
Publication status: published as International Economic Review, November 1993, pp. 819-832
Handle: RePEc:nbr:nberwo:3561
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  1. Buiter,Willem H. & Marston,Richard C., 1986. "International Economic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521337809, March.
  2. Aizenman, Joshua, 1992. "Competitive Externalities and the Optimal Seigniorage," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(1), pages 61-71, February.
  3. Rotemberg, Julio J & Saloner, Garth, 1986. "A Supergame-Theoretic Model of Price Wars during Booms," American Economic Review, American Economic Association, vol. 76(3), pages 390-407, June.
  4. Kornai, Janos, 1986. "The Hungarian Reform Process: Visions, Hopes, and Reality," Journal of Economic Literature, American Economic Association, vol. 24(4), pages 1687-1737, December.
  5. Cukierman, Alex & Edwards, Sebastian & Tabellini, Guido, 1992. "Seigniorage and Political Instability," American Economic Review, American Economic Association, vol. 82(3), pages 537-555, June.
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