Externalities, incentives, and failure to achieve national objectives in decentralized economies

Abstract

This paper studies why decentralized economies often fail to achieve national objectives. We assume that the central government allocates its tax revenues among a large number of decision makers (provincial authorities or ministers). Decision makers are facing a soft budget constraint because of limited monitoring by the central authorities. Spending in excess to allocations fuels inflation. Cooperation to limit aggregate spending occurs when no decision maker can benefit by opportunistic behavior. Adverse macroeconomic shocks are shown to reduce the likelihood that decentralized decision makers will cooperate in order to achieve national objectives. Debt relief can induce higher investment because it can promote a shift from opportunistic behavior to cooperation.