Externalities and Bailouts: Hard and Soft Budget Constraints in Intergovernmental Fiscal Relations

Abstract

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.