Martin Besfamille and Ben Lockwood
In fiscally decentralized countries, sub-national governments (SNGs) may face soft
budget constraints and consequently invest and borrow too much. The policy literature
claims that, with competitive capital markets and central governments imposing
hard budget constraints (HBCs), ineffcient investment by SNGs should not arise. We
present a model where this is not the case: HBCs can be too "hard" and discourage
investment that is socially effcient. The model combines a dynamic commitment
problem as in Kornai, Maskin and Roland (2004) for central government with a moral
hazard problem between central and SNG. The HBC over-incentivises the SNG to provide
effort by penalizing it too much for project failure, thus leading ultimately to the
possibility that socially effcient projects may not be undertaken.
Keywords: Fiscal federalism - Bailouts - Hard budget constraints.