Federalism and the Soft Budget Constraint
39 Pages Posted: 13 Feb 1999
Abstract
The government's incentives to bail out inefficient projects are determined by the trade-off between political benefits and economic costs, the latter depending on the decentralization of government. Two effects of federalism are derived: First, fiscal competition among local governments under factor mobility increases the opportunity costs of bailout and thus serves as a commitment device, (the "competition effect"). Second, monetary centralization, together with fiscal decentralization, induces a conflict of interests and thus may harden budget constraints and reduce inflation (the "checks and balance effect"). Our analysis is used to interpret China's recent experience of transition to a market economy.
JEL Classification: E62, E63, H7, L30, P3
Suggested Citation: Suggested Citation
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