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Federalism and the Soft Budget Constraint

The government's incentives to bail out inefficient projects are determined by the trade-off between political benefits and economic costs, the latter depending on the decentralization of government. Two effects of federalism are derived: first, fiscal competition among local governments under factor mobility increases the opportunity costs of bailout and, thus, serves as a commitment device (the 'competition effect'); second, monetary centralization, together with fiscal decentralization, induces a conflict of interests and, thus, may harden budget constraints and reduce inflation (the 'checks and balance effect'). The authors' analysis is used to interpret China's recent experience of transition to a market economy. Copyright 1998 by American Economic Association.