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Overlapping Tax Revenue, Local Debt Control and Soft-Budget Constraint

  • Toshihiro Ihori

    (Faculty of Economics, University of Tokyo)

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    This paper investigates how the soft budget constraint with grants from the central government to local governments tends to internalize the vertical externality by stimulating insufficient local expenditure when both the central and local governments impose taxes on the same economic activities from public investment. The theoretical model incorporates local governments' rent-seeking activities in a multi- government setting with and without central controls on local borrowing. Two channels through debt issuance and public investment cause the soft budget outcome. In the unrestricted scheme of local debt issuance we have the positive effect on public investment and debt issuance although it would also stimulate wasteful rent seeking activities. In the restricted scheme of local debt issuance the soft budget case may not stimulate public investment since its effect through debt issuance is absent. In either case the soft budget constraint is welfare improving if the marginal valuation of central public goods is relatively small and/or the tax share of local government is relatively small.

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    File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2008/2008cf552.pdf
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    Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-552.

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    Length: 28 pages
    Date of creation: Apr 2008
    Date of revision:
    Handle: RePEc:tky:fseres:2008cf552
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    1. 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.
    2. Besfamille, Martin & Lockwood, Ben, 2004. "Are Hard Budget Constraints for Sub-National Governments Always Efficient?," The Warwick Economics Research Paper Series (TWERPS) 717, University of Warwick, Department of Economics.
    3. Motohiro Sato, 2002. "Intergovernmental Transfers, Governance Structure and Fiscal Decentralization," The Japanese Economic Review, Japanese Economic Association, vol. 53(1), pages 55-76.
    4. Michael Keen, 1997. "Vertical Tax Externalities in the Theory of Fiscal Federalism," IMF Working Papers 97/173, International Monetary Fund.
    5. David E. Wildasin, 2004. "The Institutions of Federalism: Toward an Analytical Framework," Public Economics 0403006, EconWPA.
    6. Nobuo Akai & Motohiro Sato, 2005. "leadership meets soft budget," CIRJE F-Series CIRJE-F-391, CIRJE, Faculty of Economics, University of Tokyo.
    7. Persson, Torsten & Svensson, Lars E O, 1989. "Why a Stubborn Conservative Would Run a Deficit: Policy with Time-Inconsistent Preferences," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 325-45, May.
    8. DelRossi, Alison F. & Inman, Robert P., 1999. "Changing the price of pork: the impact of local cost sharing on legislators' demands for distributive public goods," Journal of Public Economics, Elsevier, vol. 71(2), pages 247-273, February.
    9. Michael J. Keen & Christos Kotsogiannis, 2002. "Does Federalism Lead to Excessively High Taxes?," American Economic Review, American Economic Association, vol. 92(1), pages 363-370, March.
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