Jennie Litvack, Senior Economist, Poverty Reduction and Economic Management Network, Public Sector Management Department, World Bank. Deborah Wetzel, Senior Economist, Europe and Central Asia, Poverty Reduction and Economic Governance Network, World Bank.
The Context of Decentralization
Decentralized countries are particularly susceptible to overspending in situations of soft budget constraints, because subnational governments are likely to put their own interests (and those of their constituents) above those of the larger country. Our analysis begins in the next section by defining and discussing the problem of soft budget constraints, to gain an understanding of soft budget constraints that goes well beyond describing them as unfortunate policy mistakes.
Soft Budget Constraints and Bailouts: Exploring the Commitment Problem
In the first stage of the game, the central government sets up its institutions and announces its co-financing and regulatory policies with respect to sub-national governments. Some of the case studies discuss historical episodes in which some subnational governments learned through painful failures that the central government would not provide.
Basic Fiscal and Political Institutions
By the same token, cost shifting and deficit shifting should be less likely if central government is not involved in the provision of purely local public goods. It is important to know who owns the local debt and how they are represented in the political process at the center (see Inman, chapter 2, this volume).
Additional Hard Budget Constraint Mechanisms
The case studies determine the strength of the political mechanism to tighten subnational budget constraints. Some of the case studies describe such laws, their associated penalties and methods of enforcement.
Introduction to the Case Studies
Most of the case studies highlight significant weaknesses in the underlying political and fiscal structures. The Myth of the East Asian Miracle: The Macroeconomic Implications of Soft Budgets.” American Economic Review.
Discipline with Lessons from U.S. Federalism
Ensuring Local Fiscal Discipline
Figure 2.2 illustrates when the central government may offer a fiscal rescue package to a local government threatened with bankruptcy. Central government spending will occur when local taxpayers or bondholders (or both) are on average favored over national taxpayers (vi>0) even when there is no financial cost of failing to provide a bailout (Yi·s =0 ). or when local taxpayers or bondholders are not particularly favored (or perhaps even slightly disadvantaged, vi£0) but financial outflows become significant (Yi·s >0).
Strong Executives and National Political Parties are Required for Efficiency
Missing one or more of the institutional preconditions in Exhibit 2.3 opens up the possibility for ineffective transfers or bailouts of the state and local public sector. Today (2001), federal aid to the state and local public sector for services other than income support is $1,071 per capita.
Constitutional Regulations Require Clean Guidelines to Acceptable Local Behaviors
Whatever the value of s is—see Lesson 4 below—the necessary condition for a hard central government to which we£ -Yi·s will apply. The consequence has been a steady erosion of the city's tax base over time (see O'Cleireacain 1997). Although there is little redistributive reason to save either the taxpayers or the bondholders in Washington, D.C. – the city's median income is equal to the national median income (so vi0) – there are good spillover reasons why the federal government can offer such support (Yi >0).
A Constitutional Bankruptcy Standard Requiring Local Debt Repayment is Essential
A key lesson from this fiscal history is that central governments can resist the political and economic need for local government bailouts if the market and appropriate fiscal institutions are in place to minimize the economic impacts (Yi 0) and negative consequences of distribution (vi 0) from a failure of local government. In Camden's case, local officials successfully exploited the redistributive preferences of the state's relatively affluent middle-income household. Perhaps more than coincidentally, the New England states also showed the lowest local government default rates during this period (see Hillhouse 1936).
A Competitive Local Bond Market Disciplines Defaulting Local Governments and Discourages Strategic Borrowing
Defaulting states from the 1840s were initially denied access to the bond market and only regained access when they began making at least some payments on their early defaults. The bond market showed a similar ability to distinguish between risky and safe debt, even when the debt was issued by local governments. Governments in states with full disclosure are required to meet the standards of the Government Finance Officers Association.44 If the local government bond market is fully informed, the presence or absence of disclosure laws should not have a significant effect on the pricing of local debts.
With Appropriate Incentives, Local Governments will Borrow Efficiently
It is therefore not surprising that the states borrowed as they did in the three decades leading up to the default of the 1840s. The widespread defaults of local authorities in the 1870s appear to have been the result of two facts. Unlike the defaults of the 1840s and 1870s, the local government debt defaulted in the 1930s was for capital expenditures for local roads and new schools and was not used to subsidize current account expenditures or politically connected private enterprises.
Land Markets May be a Less Effective Check on Inefficient Local Borrowing
Finally, the recent fiscal crises in New York, Philadelphia, Miami, Bridgeport, and Orange County also appear to have originated not in the incentives of the default bailout game, but in other causes, most likely an attempt to reduce current costs through the strategy of deficit conversion and taxpayer exit. With independent estimates of the price elasticity of demand for local services and knowledge of MC, Xe and X1, Inman is able to estimate the implied rate of subsidy for local services (Figure 2.1) and from this estimate to the implied rate of deficit capitalization.51 On balance, the cities in Inman's sample act as if F > 0—that is, as if full capitalization of local deficits does not apply. Local budgets will therefore be inefficiently too large (X1>Xe; figure 2.1), and Inman estimates the resulting inefficiency at an average of $20 for every dollar of local spending for his sample of the large U.S.
Balanced Budget Rules Enforced by a Politically Independent Court Can Control Inefficient Local Borrowing
- Conclusion
The net benefits B1-C1b for the citizens of the local government from the debt displacement strategy will be area [A+B+C]. Perhaps the most difficult to assess is the fiscal ability of the local government to repay. 833 (1976) when it applied the language of the Tenth Amendment – “powers not delegated to the United States by the Constitution.
Different Approaches, Similar Results?
Hardening Soft Budget Constraints: The Provinces
Federal transfers to the provinces rose sharply in the first half of the post-war period, but have since stabilized and, in recent years, declined (figure 3.2). As in the pre-Confederation period, many provincial difficulties were caused by municipal indiscretions, with the result that many of them. One of the most transfer-dependent provinces, although governed by the Socialists (Saskatchewan), was among the first to take corrective action, and one of the least transfer-dependent provinces, although controlled by the Conservatives (Ontario), was among the last.
The “Second World” of Canadian Public Finance: The Municipalities
They also claimed expenses which were not properly within the scope of the agreement with the province” (Commission to Enquire, 1933, 9). The seriousness of the problem in the Windsor area led to the appointment of the Royal Commission, which reported in 1935. On the whole, local governments in Canada cannot incur any significant amount of long-term debt without prior approval from the provincial government (and in some cases also by local taxpayers).
Two Roads to Realism?
The federal government's ability to run deficits for more than two decades after revenue declines in the early 1970s (Bird, Perry, and Wilson 1998) effectively financed undue provincial (and indirectly local) expansion during this period. At least two aspects of surpluses seem to merit consideration in the context of hard budgets. The first is perhaps unique to Canada: everything the federal government does must be seen in the context of the federal-provincial system.
Conclusion
Divide this total estimate by the population of the province to get the per capita income capacity. A full comparative analysis of the situation of the two provinces in the 1930s can be found in Bates (1939). The commission will investigate the handling of York County's unemployment benefit fund.
Welfare State: Norway Jørn Rattsø
Scandinavian-Style Administrative Federalism
Second, population mobility is low and local jurisdictions are heterogeneous in preferences for social services and local public goods. When local governments are agents rather than clubs, the operation of the local public sector is very different from the standard theoretical model. Existing local public sector regulations can be seen as a way to avoid bailouts by limiting the room for maneuver to distort local decisions.
Centralized Financing of Decentralized Spending
In order to properly understand the system, it is necessary to follow the central regulations. The regulations must be understood in light of the serious horizontal income imbalance between municipalities and districts. The effect is similar to Rodden's (2001) description of Germany, where “the last becomes the first”. In addition to a complex balancing system, services were controlled by a series of matching grants, usually to encourage new services and expand old services with central government preference.
The Political Control Mechanism
Instead, the executive committee is elected from among council members with proportional representation of parties (and non-party groups) on the council. The mayor and deputy mayor are elected by the council and run by the executive committee. The share of the local public sector in the national economy increases with increasing per capita income.
Evaluation of Fiscal Performance
Stagnant GDP growth has reduced growth in investment spending, even as the government has kept revenue growth in the local public sector high and stable. The investment decisions of the local public sector emphasize the underlying economic development of the country more than the revenue growth of the sector. On the other hand, a temporary reduction in local taxes increases the operating deficit by 80 percent of the revenue loss.
Strategic Behavior and Bailouts
The only available research on the allocation of discretionary subsidies looks at data from the 1970s (Fevolden and Sørensen 1983). The government uses various categorical subsidies, often of the matching type, to promote new services. Nevertheless, the central government is aware of the problem and has reviewed hospital financing.
Reform
The deeper issue is the handling of welfare services, which will determine the role of the local public sector in the future. At first glance, the Federal Republic of Germany appears to have one of the most decentralized public sectors in the world. Yet the German public sector is not an example of the benefits of fiscal decentralization.
Hierarchical Structure and Intergovernmental Fiscal Relations Most of the theoretical literature on federalism in economics and polit-
The discretion of the Länder with regard to expenditure is limited in most areas by uniform federal legislation. The budgeting and tax administration processes in the Confederation and the states are constitutionally autonomous and independent. Nor must the Länder's loan decisions be approved or revised by the Confederation.
The Political Mechanism
As a result, electoral incentives for sound fiscal policy at the state level are sometimes diluted; it is relatively easy for country-level officials to escape electoral sanctions for imprudent fiscal policy. Such evasion of blame may be even easier in states controlled by the opposition party.9 Moreover, in some circumstances, county-level leaders may actually face electoral incentives to overspend and run deficits. While the growing debt burden of the 1980s and 1990s does not seem to have been a political liability at the time for the Bremen and Saarland governments, the bailouts were ultimately politically embarrassing for the leaders in power when the bailouts were handed out.
The Capital Market and Its Regulation
However, this system may be changing as some states and their state banks look for new forms of lending. Most analysts agree that the pressure to privatize regional banks is likely to be even stronger. In any case, the introduction of the euro and increasing international competition have the potential to push countries forward in the direction of credit market discipline.
Deficits and Bailouts in Saarland and Bremen
This gave the governments of Bremen and Saarland hope that they would eventually receive special federal funds, and throughout the rest of the 1980s they had no incentives to improve their finances. Unlike some of the bailouts described elsewhere in this book, Bremen and Saarland are under no obligation to make repayments. Empirical analysis by Seitz (1998) shows that primary expenditure growth in Bremen and Saarland continued to outpace some of the other states after the bailout agreements.
Conclusions and Prospects for Reform
Because of the equalization system, the Land governments have weak incentives to make prudent fiscal decisions. Bavaria and Baden-Württemberg, two of the wealthiest states, have aggressively challenged the equalization system in the courts and in the political process. For these reasons, battles over fiscal federalism will continue to be a key feature of the German political landscape in the coming years.
Federalism and
Fiscal Decentralization
Constraint Steven B. Webb
