Externalities and bailouts : hard and soft budget constraints in intergovernmental fiscal relations
Subnational governments are assuming greater fiscal responsibility in many developing and transition countries. There is concern, however, that fiscal decentralization may weaken fiscal discipline -that local authorities may undertake commitments or incur debt obligations that subsequently result in massive central government support, in the form of extraordinary transfers, or bailouts. (Recent experience in major U.S. cities shows that these problems are not restricted to developing countries.) Such bailouts could in turn cause national fiscal imbalances, excessive borrowing, and macroeconomic instability. Some analysts recommend that central authorities maintain strict control over the fiscal behavior of lower-level governments, but others argue that such controls could undercut the goals of fiscal decentralization, including autonomy. The author shows that central authorities may have strong incentives to prop up the finances of local governments when the public services provided locally benefit the rest of society. The prospect of such interventions may in turn create incentives for localities to underprovide services that produce substantial spillover benefits, using local resources instead for purposes that may benefit local constituencies but not nonresidents. When central fiscal interventions are big enough, and when a loss of local control over the use of fiscal resources is not too costly to local residents, local decisionmakers will act to induce central government bailouts, resulting in inefficient outcomes for the system as a whole. This is not to say that fiscal decentralization produces perverse incentives or requires central government control over local fiscal policies. But incentives for bailouts can be especially strong when local governments are considered too big to fail -for example, New York, Philadelphia, and Washington, DC (in the United States) and Sao Paulo and Rio de Janeiro (in Brazil). In such cases, the repercussions from major breakdowns in the provision of services -or in debt servicing- can be too costly for central governments to ignore. Problems of fiscal discipline may result not because there is too much fiscal decentralization, says the author, but because there is too little. It may make sense to carry out more thorough decentralization -for example, devolving fiscal authorities to smaller jurisdictions or special-purpose functional units, or subdividing large subnational jurisdictions into many smaller units.
|Date of creation:||30 Nov 1997|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: (202) 477-1234
Web page: http://www.worldbank.org/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Eaton, Jonathan & Gersovitz, Mark & Stiglitz, Joseph E., 1986.
"The pure theory of country risk,"
European Economic Review,
Elsevier, vol. 30(3), pages 481-513, June.
- Mathias Dewatripont & Eric Maskin, 1995.
"Credit and efficiency in centralized and decentralized economies,"
ULB Institutional Repository
2013/9603, ULB -- Universite Libre de Bruxelles.
- Dewatripont, M & Maskin, E, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," Review of Economic Studies, Wiley Blackwell, vol. 62(4), pages 541-55, October.
- Mathias Dewatripont & Eric Maskin, 2004. "Credit and efficiency in centralized and decentralized economies," ULB Institutional Repository 2013/9605, ULB -- Universite Libre de Bruxelles.
- McKinnon, Ronald I., 1995. "Intergovernmental competition in Europe with and without a common currency," Journal of Policy Modeling, Elsevier, vol. 17(5), pages 463-478, October.
- von Hagen,Juergen, .
"A note on the empirical effectiveness of formal fiscal restraints,"
Discussion Paper Serie B
155, University of Bonn, Germany.
- von Hagen, Jurgen, 1991. "A note on the empirical effectiveness of formal fiscal restraints," Journal of Public Economics, Elsevier, vol. 44(2), pages 199-210, March.
- Prud'homme, Remy, 1995. "The Dangers of Decentralization," World Bank Research Observer, World Bank Group, vol. 10(2), pages 201-20, August.
- Ades, Alberto F & Glaeser, Edward L, 1995.
"Trade and Circuses: Explaining Urban Giants,"
The Quarterly Journal of Economics,
MIT Press, vol. 110(1), pages 195-227, February.
- Glaeser, E.L. & Ades, A.F., 1993. "Trade and Circuses: Explaining Urban Giants," Harvard Institute of Economic Research Working Papers 1646, Harvard - Institute of Economic Research.
- Alberto F. Ades & Edward L. Glaeser, 1994. "Trade and Circuses: Explaining Urban Giants," NBER Working Papers 4715, National Bureau of Economic Research, Inc.
- Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
- Bahl, Roy W. & Wallich, Christine, 1992. "Intergovernmental fiscal relations in China," Policy Research Working Paper Series 863, The World Bank.
- János Kornai, 2014.
"The soft budget constraint,"
Akadémiai Kiadó, Hungary, vol. 64(supplemen), pages 25-79, November.
- Poterba, James M, 1994.
"State Responses to Fiscal Crises: The Effects of Budgetary Institutions and Politics,"
Journal of Political Economy,
University of Chicago Press, vol. 102(4), pages 799-821, August.
- James M. Poterba, 1993. "State Responses to Fiscal Crisis: The Effects of Budgetary Institutionsand Politics," NBER Working Papers 4375, National Bureau of Economic Research, Inc.
- Inman, Robert P, 1995. "How to Have a Fiscal Crisis: Lessons from Philadelphia," American Economic Review, American Economic Association, vol. 85(2), pages 378-83, May.
- Jonathan Eaton & Mark Gersovitz, 1987. "Country Risk and the Organization of International Capital Transfer," NBER Working Papers 2204, National Bureau of Economic Research, Inc.
- Dennis Epple & Katherine Schipper, 1981. "Municipal pension funding: A theory and some evidence," Public Choice, Springer, vol. 37(1), pages 141-178, January.
- von Thadden, Ernst-Ludwig, 1995. "Long-Term Contracts, Short-Term Investment and Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 62(4), pages 557-75, October.
When requesting a correction, please mention this item's handle: RePEc:wbk:wbrwps:1843. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Roula I. Yazigi)
If references are entirely missing, you can add them using this form.