Federalism and the Soft Budget Constraint ⑧ Yingyi Qian; Gerard Roland The American Economic Review, Vol. 88 No.(Dec., 1998), 1143-1162 Stable URL: http: //links. jstor.org/sici?sici=0002-8282%28199812%2988%3A5%3C1143%3AFATSBC%3E2.0.%3B2-7 The American Economic Review is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http: //www.jstor.org/about/terms. html. jstor's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the JSTOR archive only for your personal, non-commercial use. P Please contact the publisher regarding any further use of this work Publisher contact information may be obtained at http: //www. jstor.org/journals/aea. html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to creating and preserving digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org. http: //www.jstor.org/ Sat May2211:50:282004
Federalism and the soft budget constraint By YINGYI QIAN AND GERARD ROLAND 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 ncreases the opportunity costs of bailout and thus serves as a commitment device(the"com- tition effect). Second, monetary centralization, together with fiscal decen ralization, induces a confict of interests and thus may harden budget constraints and reduce infation( the*checks and balance effect). Our analysis is used to interpret China's recent experience of transition to a market economy (JEL E62, E63,H7,L30,P3) Soft budget constraints represent a major in- In reality, soft budget constraints mostly in- centive problem. They were a key character- volve a government, through the bailout of en istic of socialist economies and remain an terprises and banks(public and private )or of important concern in transition economies. lower-level governments. This paper studies There are also instances of soft budget con- the relationship between forms of federalism, straints in market economies such as bailouts that is, organizations of government involving of banks(e.g, the s&ls) and corporations some fiscal decentralization, and the degree of (e.g, Chrysler ). Following Janos Kornai the soft budget constraint Based on the trade (1980, 1986), an enterprise or any organiza- off between political benefits and(endoge- tion is said to have a soft budget constraint nous)economic costs, it analyzes how the when it expects to be bailed out in case of fi- government 's incentive to soften budget con- nancial trouble. This creates an incentive prob- straints depends on the extent of decentral lem because the manager of the organization zation of fiscal and/or monetary authority cording to Mathias Dewatripont and Eric Chinese experience where devolution of au- Maskin (1995), the fundamental reason for thority from the central to local governments the soft budget constraint problem is the in is a major feature of reform, the theme of the ability of rescuers to commit to no bailout ex paper is more general. Indeed, in the United and transition economies, there is a growing nterest in studying the relationship between federalism and government incentives 品三 Department of Economics, Stanford Univer We build a model of the soft budget con straint in a three-tier hierarchy with a"central lof. Patrick bolton. Jiahua Che. Mathias government'at the top, multiple"local gov MeKinnpont, Patrick bolto Eric Maskin, Ronald ernments"in the middle, and"enterprises Tng ngast, David Wildasin, Chenggang Xu, three referee has the following features. First, the soft and the cepr annual workshop in macroeconomics in budget constraint game between government Tarragona for helpful discu d comments bodies and ente Subsidization of loss-making enterprises is often an ment bodies face sequential bail-out decisions indicator of soft budget constraints. However, subsidies in the presence of sunk costs and enterprises are not identical to soft budget constraints. There are cases behave strategically in securing subsidies in which firms receive subsidies but do not expect to be bailed out in cases of bad financial performance. Second, the local governments compet 1143
THE AMERICAN ECONOMIC REVIEW cach other in allocating their own budgets to has no discretionary powers in the allocation attract mobile factors and grants from the cen- of seigniorage revenue between local govern- tral government in a simultaneous-move ments, inflation will be lower than under fiscal game. And third, the central government plays centralization. The reason is that the difference a sequential game against local governments in spending preferences between the central in deciding on the allocation of grants and, if and local governments due to fiscal competi monetary financing is possible, on total money tion induces endogenously a conflict of inter supply. The study of incentive problems in a ests, which may achieve both harder budget three-tier hierarchy is generally complicated constraints and monetary restraint( the and difficult, and this difficulty is only rein-checks and balance effect) forced by the introduction of fiscal competi In the extreme case of monetary decentral ion and factor mobility. Nevertheless, we are ization, with the externality of inflation, each able to derive several results on the effect of local government receives the full benefits federalism in hardening budget constraints from its monetary creation but shares the costs We first show that decentralization of fiscal of inflation with other regions. This creates authority to local governments together with high inflation and generally softens budget obility of nonstate capital across regions constraints may be effective in hardening the budget con Our analysis can be used to interpret the in traints of enterprises under local govern- teresting features of China's transition process ments'control. This is because competition to markets. In Eastern Europe and Russia, pri- among local governments in attracting capital vatization is the main focus of transition. In to their region creates an externality which contrast China's transition was first and fore- reases the opportunity cost of subsidizing in- most associated with the devolution of gov efficient enterprises, which in turn reduces the ernment authority from the central to local incentives for bailouts. Fiscal competition can level. Recently, local governments in China thus be viewed as a commitment device(the took the initiative to lay off excess workers competition effect). However, this comes and even privatize the enterprises under their at the cost of distortions such as excessive in- supervision. This happened at a time when frastructure investment monetary authority was recentralized and in- When fiscal decentralization is not complete fation was lowered. According to our analy and the central government has the power to sis, decentralization together with competition allocate part of the fiscal revenues, local gov- has a profound impact on the incentives of ernments will also compete for grants. Inter- local governments. It induces harder budget estingly, if the central government earmarks constraints because it increases the local gov- grants for local public goods and subsidies, ernments'costs of subsidies and, furthermore, strategic distortions by local governments fur- this effect requires the support of monetary ther increase the opportunity cost of bailout, centralization. From this perspective, reform thus achieving harder budget constraints, pro- of government organization, such as fiscal de- grant size is not too lar centralization, is an important dimension of We then consider the possibility of mone- the transition from a plan to a market tary financing with the central government cre- economy ting money and allocating seigniorage Our paper presents the first macroeconomic revenue while local governments continue to model of the soft budget constraint viewed as have full authority over their expenditures. a dynamic commitment problem in the frame- Fiscal competition together with competition work of a federal government. Even though for monetary grants works in a similar way towards hardening the budget constraint of terprises. However, inflation will be higher than under fiscal centralization if the centra 2 In a recent paper, David E. wildasin(1997a)studied government allocates earmarked grants hoping rd v. soft federal grants to local gov to" distortionary decisions by local He argues that, due to an externality of local public oods, large local jurisdictions are likely to face softer governments. But if the central government budget constraints than small jurisdictions.This is because
VO. 88 NO 5 QIAN AND ROLAND: FEDERALISM AND THE SOFT BUDGET CONSTRAINT our concept of the soft budget constraint is the The paper is organized as follows. Section same as that of Dewatripont and Maskin I presents a three-tier hierarchy model involv- 995), there are a number of important dis- ing the soft budget constraint in a macroeco- tinctions between our model and theirs. First, nomic context. Section Il demonstrates the in their model, firms are bailed out by profit- role of fiscal competition among local govern maximizing banks, and in ours by a govern- ments as a commitment device to harden the ment which also cares about employment budget constraints of enterprises. Section Ill rents. Second, our model endogenizes sources introduces monetary creation as an additional of revenue for bailouts. This allows us to en- source of financing and analyzes the implica dogenize the opportunity cost of bailouts tions of alternative monetary arrangements un which depends on the organization of govern- der fiscal decentralization on the budget ment. Finally, crucial conditions leading to constraints and inflation. Section IV uses our hard budget constraints in their model are the erpret the reform exp of limited liquidity of the bank and the costly in- China. Section V concludes with some general formation transfer between banks. In our implications of our analysis. model, the size of the budget matters less than its allocation among various expenditures. In L. The Model fact, g larger whe get constraints are hard since a higher ef- We consider an economy with N identical ficiency yields more tax revenues regions In each region, there are state enter This paper contributes to the literature on prises and new nonstate enterprises. The econ local public finance and fiscal federalism(e. g, omy can be viewed as a three-tier hierarchy Charles Tiebout, 1956; Wallace Oates, 1972: composed of a central government at the top. Roger H. Gordon, 1983; Wildasin, 1988)by N local governments in the middle, and enter- he link between fiscal competition rises at the bottom. Although the setup of the and government incentives for bailouts. Thus, model is tailored to the situation of the Chinese it adds to the growing literature on incentive economy, the logic of the model can be ap- problems in the context of the organization of plied to other federal states. The model has government. For example, Jean-Jacques three dates. Laffont and David Martimort(1994) investi- gate the role of duplication of regulators in State Enterprises preventing collusion, and Torsten Persson et At date 0, there are n (n is large)state en (1997)study the role of separation of terprises, each having one project in place. The powers in the organization of government in return on a project has two components: a ver improving the accountability of government. ifiable(taxable )return R and a nonverifiable Our results are also in accordance with recent (nontaxable )private benefit b(net of effort) historical analysis(e.g, Barry R. Weingast, accruing to employees(workers and manag 1995)and studies on transition economies ers). a type l project, present in proportion a (e. g, Qian and Weingast, 1996, 1997) yields(Ra, Ba) at date l independent of emphasizing the commitment effects of worker/manager effort(Figure 1). A type 2 federalism project, present in proportion(1-a), yields (Rg, B,)at date 1 only if the enterprise chooses action(effort)en, which can be interpreted the failure to bail out the former would have far more to a too big uences for the economy as a whole, leading Both the models of llya Segal(1993) the role of reputation in sustaining hard budget constraints s an effective mechanism only if there is a he government and the private sector. In the e prefer to focus on the role of institutions in hardening about the total social surplu budget constraints
THE AMERICAN ECONOMIC REVIEW DECEMBER /998 type 1 type 2 0,0) date 0 date 1 date 2 FIGURE 1. THE MECHANISM OF THE SOFT AND HARD BUDGET CONSTRAINT restructuring"or "privatization. If, how- Thus, public infrastructure investment ever,action(effort)e, is chosen, which means the marginal productivity of nonstate maintaining the"status quo, then the project For analytical simplicity, we assume that the ields(0, 0)at date 1. In the latter case, the total amount of nonstate capital is fixed government and the enterprise can engage in (2i K=K) and nonstate capital is perfectly efficient renegotiation: if 1 unit of funds is in- mobile across regions. All we really need for jected(i.e, bailout ), a type 2 project will yield our qualitative conclusions, however, is the as (R, Bs)at date 2. For the sake of simplicity, sumption that nonstate capital is less mobile ye assume no discounting and R, =0. We across countries than across regions within a assume further that the private benefits are country ranked such that Bs B.>0. This implies We offer two interpretations of nonstate that if all verifiable revenues are taxed away, capital. The first interpretation is domestic the manager with a type 2 project prefers e, to nonstate or private capital. with this interpre en if and only if bailout is expected tation, the assumption of inelastic supply of nonstate capital is realistic because formally Nonstate Enterprises domestic capital in China is not allowed to Nonstate enterprises emerge at date I and leave the country(even though some capital their activities in region i are described by a flight is inevitable in practice). On the other production function f(Ki, I), where K; rep- hand, despite the fact that allocation of state resents nonstate capital and I, represents pub- capital remains under state control, domestic lic infrastructure investment which is financed nonstate capital in China has a considerable from the government budget at date 1. We degree of mobility across provinces The second interpretation is foreign capit In such a c fk(K1,l)>0,f(K,l)>0 capital is less mobile across countries than across regions within a country can be justified fkx(K;,)<0,fn(K,)<0, on empirical grounds in general and in partic ular for the case of China. Following the influ- and fx (Ki, 11)>0 ential paper by Martin Feldstein and Charles