Bailouts and soft budget constraint in a context of incomplete fiscal decentralization

Background: In the area of intergovernmental fiscal relations, some studies attribute the problem of soft budget constraint to positive externalities that derive from jurisdictional provision of public goods. The present study explores how the problem of soft budget constraint can also arise when incomplete fiscal decentralization is combined with divergent fiscal policies of the central and local governments. Methodology: We construct a model in which each level of government is assigned a fiscal-behavior function that responds to three possibilities. Based upon that model, we formalize a dynamic, non-cooperative game of fiscal competition between the two levels of government. We then determine the combination of policies that constitute the model's equilibrium. Results: We show that budget constraint softens when incomplete fiscal decentralization is combined with opposing fiscal policies at the local and central levels of government. In addition, the vicious circle of fiscal irresponsibility and bailouts of local governments is a Nash equilibrium. Conclusions: In economies with strong fiscal imbalances, and in which an efficient (i.e. complete) decentralization cannot be carried out, soft budget constraint becomes a significant moral-hazard problem that inevitably degrades a nation's societal well-being.