Bailouts in a Federation

The recent move towards decentralization in countries such as Spain, Hungary, and South Africa and the difficulties that central governments have had in dealing with fiscal irresponsibility on the part of regional governments in countries such as Argentina, Brazil, and India has made the study of tr...

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Bibliographic Details
Published inInternational tax and public finance Vol. 9; no. 4; pp. 409 - 421
Main Author Goodspeed, Timothy J
Format Journal Article
LanguageEnglish
Published New York Springer 01.08.2002
Springer Nature B.V
SeriesInternational Tax and Public Finance
Subjects
Alliances
Bailouts
Borrowing
Consumption
Costs
Decentralization
Economic theory
Federal government
Federalism
Fiscal policy
Game theory
Government grants
Incentives
International finance
Opportunity costs
Politics
Public enterprise
Public finance
Regional government
Regions
soft budget constraint
Studies
Tax increases
Tax rates
Taxes
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Summary:The recent move towards decentralization in countries such as Spain, Hungary, and South Africa and the difficulties that central governments have had in dealing with fiscal irresponsibility on the part of regional governments in countries such as Argentina, Brazil, and India has made the study of transfer systems one of the most important areas of research in federalism today. A model of a federation is developed in which regional governments act as Nash competitors with each other but are first-movers in a Stackelberg game with the central government. The central government finds that it will maximize its expected votes by increasing transfers as regions borrow. This bail out of regional governments creates a regional soft budget constraint and results in two incentive effects, a common pool effect on tax payments and an opportunity cost effect. The soft budget constraint lowers the opportunity cost of borrowing for the region, but also increases the tax-cost since a portion of the borrowing must be paid for through increased taxes. The common property problem associated with tax payments implies that the increased tax cost must be less than the decrease in the opportunity cost (leading to excessive borrowing) unless the central government increases grants to other regions when it institutes a bailout. Somewhat surprisingly, in the latter case the additional increased taxes may increase costs enough to offset the lower opportunity cost resulting from the bailout, leading to efficient borrowing decisions as in the case of a hard budget constraint. The results are also useful for understanding the empirical estimation of soft budget constraints. Copyright Kluwer Academic Publishers 2002
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ISSN:0927-5940
1573-6970
DOI:10.1023/A:1016563902580