The rest of this book builds on the framework established in this chapter to lay out the conditions under which the soft budget con- straint problem is most severe and the mechanisms that are most likely to mitigate it. Our ultimate goal is to understand better what factors, policies, and institutions make a country prone to soft budget con- straints and begin to identify some realistic institutional reforms that can harden subnational budget constraints in practice. First, in each case study, we try to understand the basic pathologies discussed in section 1.2. Some of the case studies include detailed descriptions of the strategic interactions that culminate in subnational fiscal crises and, in some cases, bailouts. In other cases, however, fiscal crises have largely been avoided or bailouts denied, even if other forms of ineffi- ciency persist.
Second, it is useful to examine the role of each of the mechanisms outlined in sections 1.3 and 1.4 in mitigating the problem. We seek to ascertain which mechanisms work under which conditions, which complement one another and which are antithetical, and, perhaps most important, which are most realistic as targets for reform.
Most of the case studies point out significant weaknesses in the basic underlying political and fiscal structures. An important lesson, also fea- tured in Inman’s theoretical treatment, is that when higher-level government cannot be committed to firmness ex post, hierarchical mechanisms can be an important defense. Many of the conditions dis- cussed above and in the next chapter that underpin firm no-bailout commitments are simply not present in most of the countries under analysis. But in order to understand the hierarchical rules and the con- ditions under which they work, it is necessary to understand the larger institutional context in which they are embedded. Thus, the case studies try to strike a balance between addressing basic, overarching institutional design issues and examining specific rules pertaining to borrowing, bankruptcy, and the like.
The cases were chosen to represent the widest possible diversity in geography and experience with fiscal and political decentralization and also to provide a range of variation in the hardness of subnational budget constraints. Every continent except Australia is represented, and the countries range in size from Norway to China and include both highly centralized, top-down unitary systems and some of the world’s most decentralized federations.19 We include some countries, like the United States, where some subnational governments are older than the country itself, and others, like Hungary and South Africa, where new subnational entities are being created and their powers just beginning to evolve.
Chapter 2, by Robert Inman, serves as both a theory chapter and the first case study. It expands on and formalizes many of the issues raised in this chapter, building on the sequential bailout game to drive home lessons about the conditions under which central governments are likely to resist calls for bailouts and examining conditions under which hierarchical restrictions might be attractive. Inman then provides a segue into the case studies by applying these general concepts in one of the oldest and most frequently studied federations—the United States—pointing to the evolution of credible no-bailout commitments by the central governments and identifying the institutions that under- gird them, even while also illuminating some weaknesses in the system.
Chapter 3, by Richard Bird and Almos Tassonyi, also makes impor- tant distinctions between the federated units and the municipal gov- ernments in a large, wealthy North American federation. As in Inman’s discussion of the U.S. states, they argue that credible no-bailout com- mitments facilitate strong market discipline among the provinces, but fiscal discipline is achieved largely through hierarchical rules among Canadian municipalities. Chapter 4, by Jørn Rattsø on Norway, devel- ops further some of the themes introduced in the discussion of the Canadian municipalities; in spite of some other inefficiencies, fiscal dis- cipline can be maintained among constrained, highly regulated local governments by an array of strict hierarchical restrictions. Jonathan Rodden’s chapter on the German states is alone among the OECD cases in describing a potentially serious soft budget constraint problem embedded in the basic institutional structure, though to date outright bailouts have been provided to only two of the smallest and most trou- bled states.
Chapters 6 through 8 consider large, developing federations with histories of fiscal decentralization and rather serious recent manifesta- tions of the soft budget constraint problem. Stephen Webb’s study of Argentina describes incentives that created soft budget constraints and bailout dynamics in the 1980s and 1990s, but also draws attention to recent reforms aimed at hardening provincial budget constraints.
Similarly, Jonathan Rodden’s examination of the Brazilian states points out political and fiscal institutions that have created a serious moral hazard problem and engendered a series of very costly recent bailout episodes, but also discusses prospects for reform. William McCarten’s study of the Indian states describes both the accomplishments and (increasingly) the failures of a rather elaborate system of central regu- lation of state finances, emphasizing the complexities of administration and politics in a poor, diverse country undergoing significant political change.
Chapters 9 through 12 examine countries in which decentralization is unfolding in the context of major political and economic transitions.
Jing Jin and Heng-fu Zou describe the complexities of China’s oft- changing fiscal contracting system and the unique challenges of struc- turing a hard budget constraint when the subnational governments are heavily involved in operating state-owned enterprises and the center is in a poor position to monitor their activities. Junaid Ahmad’s chapter illuminates the monumental task of structuring a hard budget con- straint while building a workable new postapartheid system of fiscal
and political federalism in a rapidly changing South Africa. Next, in analyzing the difficulties of decentralization in Ukraine, Sean O’Connell and Deborah Wetzel touch on a long list of pathologies and basic institutional issues that remain to be resolved in a fragile, complex post-Soviet environment. In the final case study, Wetzel and Anita Papp tell a much more encouraging story about the potential hardening of budget constraints in Hungary, where an evolving nexus of adminis- trative rules and judicial enforcement mechanisms appears to have clarified expectations and improved incentives.
While the emphasis and most important lessons from each case are dif- ferent, their contributions aggregate into a useful body of information.
Taken together, the case studies create an impressive database with eleven observations. This database is used in the final chapter to make some broad assessments, general arguments, and specific recommendations.
Notes
1. For examples of this debate, see Prud’homme (1995) and McLure (1995).
2. Several empirical studies using pooled cross section and time-series techniques have suggested that fiscal decentralization may be harmful for efficiency and stability. Results indicate that fiscal decentralization has not been associated with faster economic growth (Davoodi and Zou 1998) and promotes fiscal imbalance (De Mello 2000). Yet these studies are highly controversial for the choice of decentralization variables used in the regres- sions. For example, Ebel and Yilmaz (2001) tested the others’ results by using different, more precise variables and have produced different results.
3. Adam Smith (1776), not in general impressed by markets and the forces of political economy, coined decentralization results with the seductive phrase, “He is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”
4. Other examples include excessive vertical or horizontal tax competition and the local protectionism that arises when subnational politicians gain opportunities and incentives to obstruct the free flow of labor, goods, and services across jurisdictional boundaries.
5. See, e.g., Inman and Rubinfeld (1997), Litvack, Ahmad, and Bird (1998), Rodden and Rose-Ackerman (1997), Tanzi (1995), Qian and Weingast (1997), and Ter-Minassian (1997).
6. See Bardhan and Mookherjee (2000).
7. For general overviews, see Azfar et al. (2001a,b) and Rao (2001).
8. See figure 2.1.
9. This problem is called the time-consistency problem in the economics literature. An appropriate example in public finance may be that a bridge project is found worthwhile and funded under a certain cost estimate. A stated policy not to increase funding if the cost estimate is exceeded is not time consistent (i.e., not credible), given that it is still worthwhile to complete a half-built bridge when the new estimate arrives.
10. For example, bailouts in Germany have been concentrated in two of the smallest states: Bremen and Saarland. In Brazil, bailouts have gone not only to large, externality- producing states like Sa˜o Paulo, but also to some of the smallest, most isolated states, like Tocantins.
11. Game-theoretic treatments (e.g., Bulow and Rogoff 1989 and the broader literature on repeated games) show that if economic agents try to calculate their opponents’ best responses, in important settings there is no scope for changing expectations by playing in a certain way (there simply is no reputation effect).
12. In a system of pure proportional representation, elected members do not respond to geographically based constituents. Strong, disciplined political parties under propor- tional representation may have some disadvantages if they weaken the incentives of indi- vidual representatives to respond to the preferences of their constituents.
13. Hopes and ambitions should be modest, however. Most governments, high and low, rich and poor, if they can produce a list of explicit liabilities, cannot produce a list of assets, let alone a balance sheet. Furthermore, while credit markets react to the likelihood of default, they are silent about the optimal debt level being exceeded, as long as it is sustainable.
14. It may be argued that powerful creditors would cause political intervention (the system would not allow too much citizen suffering because of municipal mismanage- ment), and thus that municipal bankruptcy codes must give creditors quite limited powers to protect the enforcement machinery from political intervention. The U.S.
municipal bankruptcy procedure can be interpreted this way. It protects from creditors those assets of the municipality that are crucial to its government functions. In practice, this has shielded almost all assets and powers to change taxes and expenditures from creditor influence (McConnell and Picker 993). Thus, actual institutions do not allow citizens to lose their school, for instance. Rather, it distributes all of the pain ex post to the creditors. This, in the absence of higher-level guarantees, constrains credit by limit- ing the harm to jurisdictions that borrow too much.
15. Bulow and Rogoff (1989) provide a good discussion of what sustains credit in the case of sovereigns.
16. See Oates (1972) generally and Sprunger and Wilson (1998) for an application to local borrowing.
17. For an analysis of differing incentives facing owners and renters, see Epple and Romer (1991).
18. For overviews, see Ter-Minassian and Craig (1997) and Inter-American Development Bank (1997). In our treatment, we do not consider self-imposed constraints, such as the balanced budget requirements of most U.S. states, as a hierarchical mechanism.
19. The term federalismis often used by economists simply to highlight a hierarchical structure of government, but among political scientists it describes more specifically a structure in which the lower level—constituent units in a federation—has powers that cannot easily be taken over or reduced by the higher level.
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