Fiscal Decentralization with Regional Redistribution and Risk Sharing

Abstract

The paper examines the incentive effects of intergovernmental transfers on regional government spending levels in a multi-period model. The focus is on the repeated strategic interaction between the regional and federal governments and the exploration of the factors influencing the federal government's incentive to create soft budget constraints. The paper models the time-path of regional government spending when regional governments face uncertainty in regard to the federal government's ability to commit to its announced transfer scheme. The results show that in the presence of small shocks to regional endowments, the softness of regional government budget constraints increases over time if the federal government has a known finite mandate. Large shocks, however, can result in discrete changes in regional government spending that persist for the remainder of the federal government's mandate. The paper also shows how the time-path of regional government spending depends on the discount rate, the time horizon, and the regional governments’ prior uncertainty regarding the federal government's commitment ability.