EXTERNALITIES AND BAILOUTS

Hard and Soft Budget Constraints in Intergovernmental

Fiscal Relations

by

David E. Wildasin Department of Economics Vanderbilt University

Abstract

Central government matching grants can, in principle, induce socially-efficient provision of local public goods that produce spillover benefits. Local underprovision of public goods may however
elicit direct central-government provision and finance (a ``bailout") that makes local residents better off than under grant-subsidized local provision; local underprovision that induces bailouts reveals the local budget constraint to be ``soft." Simulations suggest that the ability of a locality to extract a welfare-improving bailout depends positively on its size: budget constraints are more likely to be ``hard" for small localities.

David Wildasin / wildasin@ctrvax.vanderbilt.edu

Last updated: August 31, 1997