Mature federations allow subnational governments considerable autonomy in their expenditure, revenue, and debt policies. In the US, subnational governments account for a very substantial share (nearly one-third) of all public-sector debt, and yet there are extremely few instances in which these governments approach insolvency. The incentives embedded in this system permit liberal access to credit markets without producing fiscally-irresponsible policies that lead to frequent local financial crises. Although such crises are rare in US experience, this is not always true elsewhere. Numerous case studies show how the fiscal policies pursued by subnational governments have triggered fiscal and financial distress not only for these governments but also for superior governments that intervene with infusions of financial resources ("bailouts"), typically accompanied by a loss in local fiscal independence. What institutional differences account for such divergent outcomes?

The present paper outlines one possible theoretical framework to explain why some institutional arrangements are conducive to stable fiscal and financial performance by subnational governments while other arrangements lead to local fiscal distress, soft budget constraints, bailouts, and loss of local autonomy. This framework can help to identify important avenues for empirical research as well as to provide useful guidance in the formulation of policies for institutional reform and development in evolving federations.

Spillover benefits, often used in the normative theory of federalism to justify the use of intergovernmental fiscal transfers, are identified as a potential source of tension between higher- and lower-level governments. Higher-level governments may be able to induce efficient policies by local governments through the use of well-designed grants. Depending on the precise nature of these externalities, however, such fiscal transfers may not provide adequate incentives for local governments to take external effects into account, leading them to pursue policies that ultimately lead higher-level authorities to assume control over the externality-producing activity. This control make take the form of temporary administrative arrangements in which local policies, management, and accounting systems are reformed, but the structure of local and spillover benefits from a public service may be such an upward-reassignment of the responsibility for providing the public service may be a less-costly institutional outcome.

The assignment of expenditure responsibilities and fiscal autonomy among governments and the system of intergovernmental transfers are closely related to the structure of borrowing in a federation. In the US, a large fraction of all public-sector borrowing is undertaken by subnational governments; alternatively, these governments could obtain larger transfers from the Federal government, which could then increase its deficit, serving as a "delegated borrower" for the entire public sector. This raises a number of issues regarding the monitoring and control of local financial policy, either by higher-level governments or through private credit market institutions.

The problems of soft budget constraints, bailouts, intergovernmental fiscal relations, and subnational debt policy thus raise issues similar to those that have been investigated in the literature of industrial organization, financial economics, and macro and monetary economics. Theoretical and empirical investigations in these fields can be extended and adapted in the context of fiscal federalism to arrive at a better understanding of the role played by public-sector institutions in shaping the incentives that guide the making of policy by higher- and lower-level governments.

David Wildasin / dew@davidwildasin.us

Last updated: March 17, 2004.