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Are Hard Budget Constraints for Sub-National Governments Always Efficient?

  • Besfamille, Martin

    (Department of Economics, Universidad Torcuato Di Tella, Ciudad Autonoma de Buenos Aires,)

  • Lockwood, Ben

    (CEPR and Department of Economics, University of Warwick,)

In fiscally decentralized countries, sub-national governments (SNGs) may face soft budget constraints and consequently invest and borrow too much. The policy literature claims that, with competitive capital markets and central governments imposing hard budget constraints (HBCs), inefficient investment by SNGs should not arise. We present a model where this is not the case : HBCs can be too "hard" and discourage investment that is socially efficient. The model combines a dynamic commitment problem as in Kornai, Maskin and Roland (2004) for central government with a moral hazard problem between central and SNG. The HBC over-incentivises the SNG to provide effort by penalizing it too much for project failure, thus leading ultimately to the possibility that socially efficient projects may not be undertaken.

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File URL: http://www2.warwick.ac.uk/fac/soc/economics/research/workingpapers/2008/twerp717.pdf
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Paper provided by University of Warwick, Department of Economics in its series The Warwick Economics Research Paper Series (TWERPS) with number 717.

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Length: 26 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:wrk:warwec:717
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