Fiscal decentralization, regional inequality and bail-outs: Lessons from Brazil's debt crisis

This paper develops a simple two-period model of public good provision within a federation. A national public good is provided to both states by the federal government, while a local public good is supplied by each state government. The federal government levies a proportional income tax, and in each period the state governments receive a share of the revenues collected equal to the amount needed to finance the first best provision of the local public good. In the first period the local governments can also use borrowing to finance the provision of the public good, but any debt contracted must be repaid in the second period. We show that when the states face a hard budget constraint, they do not find it optimal to increase the provision of the local public good above the first best level guaranteed by the federal grant. However, if the federal government cannot credibly commit not to bail-out the states, then the local governments may find it optimal to borrow in order to increase the provision of the public good above the first best in the first period. Furthermore, we show that the commitment problem is more likely to arise vis-a-vis states whose default results in a negative externality on the federation. Hence, those states are more likely to carry on budget deficits and benefit from a federal bail-out. (C) 2007 Board of Trustees of the University of Illinois. All rights reserved.