The status of the budget constraint, federalism and the relative size of government: A bureaucracy approach

We develop a model along the lines of Niskanen, articulating that under a soft government budget constraint the full production cost of the public good is not reflected in the tax price as perceived by the consumer-taxpayer-voter. Various proportions of non-tax financing and different degrees of voter myopia with respect to discounting the future tax liabilities are taken into account. It can be shown that both the actual level of public output and the amount of slack resources are lower under a hard budget constraint than under a soft budget regime. Lower levels of government typically operate under a hard budget constraint when compared with the federal level since they have only limited (public) borrowing opportunities and no access to money creation (seignorage). In a federalist setting more government decisions are taken under a hard budget constraint than in a unitary state. Hence one would expect that the overall size of government is relatively smaller in a structure with fiscal federalism. An empirical test for 19 OECD-countries (1990-1992) seems to support this hypothesis.