Federalism and the Soft Budget Constraint

We study the relationship between the organization of government involving fiscal decentralization (i.e. federalism) and the degree of the soft budget constraint. The incentives of the government to bail out inefficient projects are determined by the trade-off between political benefits and (endogenous) economic costs. Two effects of federalism are derived: First, fiscal competition among local governments in the presence of mobile factors increases the opportunity costs of bailout at the margin and thus can be viewed as a commitment device (the "competition effect"). Second, monetary centralization together with fiscal decentralization may not only harden budget constraints but also reduce inflation (the "checks and balance effect"). Our theory is used to interpret China's transition to markets.