forthcoming, American Economic Review
Federalism and the Soft Budget Constraint
By Yingyi Qian and Gérard Roland
The government's incentives to bail out inefficient projects are determined by the tradeoff
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 increases the opportunity
costs of bailout and thus serves as a commitment device (the "competition effect").
Second, monetary centralization, together with fiscal decentralization, induces a conflict
of interests and thus may harden budget constraints and reduce inflation (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 incentive problem. They were a key characteristic of
socialist economies and remain an important concern in transition economies. There are also instances of soft
budget constraints in market economies such as bailouts of banks (e.g., the S&Ls) and corporations (e.g.,
Chrysler). Following Janos Kornai (1980, 1986), an enterprise or any organization is said to have a soft
budget constraint when it expects to be bailed out in case of financial trouble. This creates an incentive
problem because the manager of the organization could fail to observe financial discipline. According to
Mathias Dewatripont and Eric Maskin (1995), the fundamental reason for the soft budget constraint problem
is the inability of rescuers to commit to no bailout ex ante.1
In reality, soft budget constraints mostly involve a government, through the bailout of enterprises and
banks (public and private) or of lower level governments. This paper studies the relationship between forms
of federalism, that is, organizations of government involving some fiscal decentralization, and the degree of
2
the soft budget constraint. Based on the tradeoff between political benefits and (endogenous) economic costs,
it analyzes how the government's incentive to soften budget constraints depends on the extent of
decentralization of fiscal and/or monetary authority. Although our study is motivated by the recent Chinese
experience where devolution of authority from the central to local governments is a major feature of reform,
the theme of the paper is more general. Indeed, in the U.S. and Europe, and in many developing and
transition economies, there is a growing interest in studying the relationship between federalism and
government incentives.
We build a model of the soft budget constraint in a three-tier hierarchy with a "central government"
at the top, multiple "local governments" in the middle, and "enterprises" (state and non-state) at the bottom.
The model has the following features. First, the soft budget constraint game between government bodies and
enterprises is sequential: government bodies face sequential bailout decisions in the presence of sunk costs
and enterprises behave strategically in securing subsidies. Second, the local governments compete with each
other in allocating their own budgets to attract mobile factors and grants from the central government in a
simultaneous-move game. And third, the central government plays a sequential game against local
governments in deciding on the allocation of grants and, if monetary financing is possible, on total money
supply. The study of incentive problems in a three-tier hierarchy is generally complicated and difficult, and
this difficulty is only reinforced by the introduction of fiscal competition and factor mobility. Nevertheless,
we are able to derive several results on the effect of federalism in hardening budget constraints.
We first show that decentralization of fiscal authority to local governments together with mobility of
non-state capital across regions may be effective in hardening the budget constraints of enterprises under
local governments' control. This is because competition among local governments in attracting capital to
their region creates an externality which increases the opportunity cost of subsidizing inefficient enterprises,
which in turn reduces the incentives for bailouts. Fiscal competition can thus be viewed as a commitment
device (the "competition effect"). However, this comes at the cost of distortions such as excessive
infrastructure investment.
When fiscal decentralization is not complete and the central government has the power to allocate
part of the fiscal revenues, local governments will also compete for grants. Interestingly, if the central
3
government earmarks grants for local public goods and subsidies, strategic distortions by local governments
further increase the opportunity cost of bailout, thus achieving harder budget constraints, provided the grant
size is not too large.
We then consider the possibility of monetary financing with the central government creating money
and allocating seigniorage revenue while local governments continue to have full authority over their
expenditures. Fiscal competition together with competition for monetary grants works in a similar way
towards hardening the budget constraint of enterprises. However, inflation will be higher than under fiscal
centralization if the central government allocates earmarked grants hoping to "correct" distortionary decisions
by local governments. But if the central government has no discretionary powers in the allocation of
seigniorage revenue between local governments, inflation will be lower than under fiscal centralization. The
reason is that the difference in spending preferences between the central and local governments due to fiscal
competition induces endogenously a conflict of interests, which may achieve both harder budget constraints
and monetary restraint (the "checks and balance effect").
In the extreme case of monetary decentralization, with the externality of inflation, each local
government receives the full benefits from its monetary creation but shares the costs of inflation with other
regions. This creates high inflation and generally softens budget constraints.
Our analysis can be used to interpret the unique features of China's transition process to markets. In
Eastern Europe and Russia, privatization is the main focus of transition. In contrast, China's transition was
first and foremost associated with the devolution of government authority from the central to local level.
Recently, local governments in China took the initiative to lay off excess workers and even privatize the
enterprises under their supervision. This happened at a time when monetary authority was recentralized and
inflation was lowered. According to our analysis, decentralization together with competition has a profound
impact on the incentives of local governments. It induces harder budget constraints because it increases the
local governments' costs of subsidies, and furthermore, this effect requires the support of monetary
centralization. From this perspective, reform of government organization, such as fiscal decentralization, is
an important dimension of the transition from a plan to a market economy.
Our paper presents the first macroeconomic model of the soft budget constraint viewed as a dynamic
4
commitment problem in the framework of a federal government. Even though our concept of the soft budget2
constraint is the same as that of Dewatripont and Maskin (1995), there are a number of important distinctions
between our model and theirs. First, in their model, firms are bailed out by profit-maximizing banks, and in
ours by a government which also cares about employment rents. Second, our model endogenizes sources of3
revenue for bailouts. This allows us to endogenize the opportunity cost of bailouts which depends on the
organization of government. Finally, crucial conditions leading to hard budget constraints in their model are
the limited liquidity of the bank and the costly information transfer between banks. In our model, the size of
the budget matters less than its allocation among various expenditures. In fact, government budgets are
larger when budget constraints are hard since a higher efficiency yields more tax revenues.
This paper contributes to the literature on local public finance and fiscal federalism (e.g., Charles
Tiebout, 1956, Wallace Oates, 1972, Roger Gordon, 1983, and David Wildasin, 1988) by analyzing the link
between fiscal competition and government incentives for bailouts. Thus, it adds to the growing literature on
incentive problems in the context of the organization of government. For example, Jean-Jacques Laffont and
David Martimort (1994) investigate the role of duplication of regulators in preventing collusion, and Torsten
Persson, Gérard Roland, and Guido Tabellini (1997) study the role of separation of powers in the
organization of government in improving the accountability of government. Our results are also in
accordance with recent historical analysis (e.g., Barry Weingast, 1995) and studies on transition economies
(e.g., Yingyi Qian and Barry Weingast, 1996; 1997) emphasizing the commitment effects of federalism.
The paper is organized as follows. Section I presents a three-tier hierarchy model involving the soft
budget constraint in a macroeconomic context. Section II demonstrates the role of fiscal competition among
local governments as a commitment device to harden the budget constraints of enterprises. Section III
introduces monetary creation as an additional source of financing and analyzes the implications of alternative
monetary arrangements under fiscal decentralization on the budget constraints and inflation. Section IV uses
our theory to interpret the reform experience of China. Section V concludes with some general implications
of our analysis.
I. The Model
5
We consider an economy with N identical regions. In each region, there are state enterprises and new
non-state enterprises. The economy can be viewed as a three-tier hierarchy composed of a central
government at the top, N local governments in the middle, and enterprises at the bottom. Although the setup
of the model is tailored to the situation of the Chinese economy, the logic of the model can be applied to other
federal states. The model has three dates.4
State Enterprises
At date 0, there are n (n is large) state enterprises, each having one project in place. The return on a
project has two components: a verifiable (taxable) return R and a non-verifiable (non-taxable) private benefiti
B (net of effort) accruing to employees (workers and managers). A type 1 project, present in proportion ",i
yields (R , B ) at date 1 independent of worker/manager effort (Figure 1). A type 2 project, present inq q
proportion (1 - "), yields (R , B ) at date 1 only if the enterprise chooses action (effort) e , which can beq q h
interpreted as "restructuring" or "privatization." If, however, action (effort) e is chosen, which meansl
maintaining the "status quo," then the project yields (0, 0) at date 1. In the latter case, the government and the
enterprise can engage in efficient renegotiation: if 1 unit of funds is injected (i.e., bailout), a type 2 project
will yield (R , B ) at date 2. For the sake of simplicity, we assume no discounting and R = 0. We assumes s s
further that the private benefits are ranked such that B > B > 0. This implies that if all verifiable revenuess q
are taxed away, the manager with a type 2 project prefers e to e if and only if bailout is expected.l h
[place Figure 1 here]
Non-State Enterprises
Non-state enterprises emerge at date 1 and their activities in region i are described by a production
function f(K , I ), where K represents non-state capital and I represents public infrastructure investmenti i i i
which is financed from the government budget at date 1. We make standard assumptions
f (K , I ) > 0, f (K , I ) > 0, f (K , I ) < 0, f (K , I ) < 0, and f (K , I ) > 0.K i i I i i KK i i II i i KI i i
6
Thus, public infrastructure investment raises the marginal productivity of non-state capital. For analytical
simplicity, we assume that the total amount of non-state capital is fixed (E K = K) and non-state capital isi
perfectly mobile across regions. All we really need for our qualitative conclusions, however, is the
assumption that non-state capital is less mobile across countries than across regions within a country.
We offer two interpretations of non-state capital. The first interpretation is domestic non-state or
private capital. With this interpretation, the assumption of inelastic supply of non-state capital is realistic
because formally domestic capital in China is not allowed to leave the country (even though some capital
flight is inevitable in practice). On the other hand, despite the fact that allocation of state capital remains
under state control, domestic non-state capital in China has a considerable degree of mobility across
provinces.
The second interpretation is foreign capital. In such a case, the assumption that foreign capital is less
mobile across countries than across regions within a country can be justified on empirical grounds in general
and in particular for the case of China. Following the influential paper by Martin Feldstein and Charles
Horioka (1980), extensive evidence has accumulated indicating substantial capital immobility across
countries in general (e.g., Roger Gordon and Lans Bovenberg, 1996). This includes a high correlation
between domestic savings and investment; real interest differentials across countries; and a lack of
international portfolio diversification. In contrast, capital mobility within countries is high. For example,
Tamim Bayoumi and Andrew Rose (1993) found strong evidence of capital mobility across regions in the
U.K. using the Feldstein-Horioka methodology.
But international capital mobility to China is particularly imperfect for idiosyncratic reasons. Unlike
most OECD and newly industrializing countries, China has maintained formal control over its capital
account. Officially, capital is not free to flow into or out of China: Capital inflow to China is controlled as
well as repatriation of profits. In fact, it was not until December 1996 that the Chinese government
announced the current account convertibility of its currency, but it has no plans to make capital accounts
convertible in the near future. These imperfections in international capital mobility need to be contrasted5
with much more perfect foreign capital mobility within China. Once a foreign firm manages to invest in
China, it can freely choose its location. The only consideration is profitability. Moreover, international
7
investors must incur some costs before investing in China to overcome language barriers and acquire
knowledge of Chinese laws, etc. Once these costs are sunk, it is much less costly to move capital from, say,
Guangdong to Shanghai.
The Government's Budget
We consider the government budget at date 1. In each region, on the revenue side, T - J is the neti i
tax revenue exclusively from state enterprises, where T is total taxes and J is transfers to state employees. i i
On the expenditure side, the budget is used for three purposes: subsidies (or bailout) S for type 2 projects;i
public infrastructure investment I and local public goods provision z :i i6
T - J = S + I + z .i i i i i
Actual tax revenues and expenditures will depend on whether the budget constraints of enterprises
are hard (action e and no bailout of type 2 projects) or soft (action e and bailout of type 2 projects). We canh l
rewrite the government budget as:
J + I + z = T - S = Ei i i i i
where E = E = nR or E = E = "nR - (1-")n (E > E ), depending on whether budget constraints are hard orH S H Sq q
soft.
We assume no tax on returns to non-state capital. This can be justified by the difficulty of such
taxation in practice. It is difficult to tax domestic non-state capital in transition economies due to the lack of
good tax institutions. Indeed, the great majority of taxes in China were collected from the state sector. It is
also well known that foreign firms are able to evade income taxes in host countries by transfer pricing
schemes. This is true in developed countries and more so in developing countries like China. However, in
Appendix A we show that our analysis goes through and our results continue to hold even with taxation of
returns to non-state capital.
8
The Government's Objective Function
We assume a welfare maximizing government: The local government in region i maximizes W andi
the central government maximizes W = E W . We assume that the population in region i consists of twoi
groups: employees in state enterprises and in non-state firms. Let the total private benefits of the employees
in non-state firms be
x = x(K , I ) = f(K , I ) - K f (K , I ),i i i i i i K i i
where x is assumed to be an increasing and concave function of I . The total private benefits of thei i
employees in state enterprises are y , where y = nB + J under hard budget constraints and y = "nB + (1-i i q i i q
")nB + J under soft budget constraints. The total utility of the two groups derived from local public goodss i
is u(z ), which is assumed to be concave in z . i i
Under the interpretation of K as domestic non-state capital, the objective function of local
government in region i is expressed as
W = f(K , I ) + y + u(z ),i i i i i
assuming the government puts an equal weight between rents to non-state employees and returns to non-state
capital. Under the interpretation of K as foreign capital, the objective function of local government in region i
becomes
W = x(K , I ) + y + u(z ),i i i i i
because the government is not concerned with returns to foreign capital. The two specifications will give
qualitatively similar results; for concreteness we will use the interpretation of foreign capital.
Equilibrium
9
We define the game played under federal institutions as follows:
The interaction between governments and state enterprises. In this sequential interaction an
equilibrium is defined by: a) a choice of action e of state enterprises at date 0 to maximize private benefits
given the expected choice of J , S , I and z by the government; and b) the government's choice of J , S , I andi i i i i i i
z at date 1 in order to maximize social welfare, given the choice of action by state enterprises. We define softi
budget constraint equilibria as subgame perfect equilibria in which enterprises with type 2 projects choose el
and the government chooses bailout, and hard budget constraint equilibria as equilibria in which enterprises
with type 2 projects choose e and the government chooses no bailout.h
The interaction among local governments. Except for the case of complete centralization, there is a
competition between local governments at date 1 to attract foreign capital and grants from the central
government. Local governments move simultaneously where strategies are choices of budget allocation. The
equilibrium is a Nash equilibrium in which each local government takes the budget allocation of other local
governments as given.
The interaction between the central and local governments. The interaction between the central
and local governments at date 1 concerns allocation of grants and monetary creation (except for the cases of
complete centralization and complete decentralization). This is a sequential interaction between the central
government and local governments. We will consider the case in which the central government makes
decisions (such as allocating grants and creating money) after the local governments' decisions, which reflects
the fact that the central government often accommodates the local governments' needs. We will also consider
the case of no accommodation in which the central government moves before local governments.
We define an equilibrium of the above game as strategy profiles of state enterprises, local
governments and the central government, such that none of the parties has incentives to deviate unilaterally.
Our analysis is considerably simplified because whether an enterprise has a soft or a hard budget constraint is
determined by a simple comparison between the benefits of bailout (B ) and the opportunity cost of doing so. s
Soft budget constraints are obtained when the benefits exceed the cost of doing the best alternative. Hard
budget constraints are obtained otherwise.
10
II. Fiscal Competition As a Commitment Device
This section demonstrates a main theme of our paper: Fiscal competition among local governments
may serve as a commitment device to harden budget constraints of enterprises.
A. The "First-Best" Allocation
In the "first-best" allocation, all inefficient projects are terminated (S = 0), and infrastructureiFB
investment (I ) and local public goods provision (z ) are chosen to maximize social welfare W = E W . i i iFB FB 7
The first best optimum (I , z ) satisfiesi iFB FB 8
(1) Mx(K , I )/MI = u'(z )i i i iFB FB
(2) I + z = E .i iFB FB H
B. Fiscal Centralization
In the benchmark case of fiscal centralization, the central government is entitled to all tax revenues,
has full authority over its budget, and has control rights over public investment and subsidies. Here the three-
tier hierarchy degenerates into a two-tier one in which local governments play no role. Define (I , z ) as ai iC C
solution to
(3) Mx(K , I )/MI = u'(z )i i i i
(4) I + z = E .i iS
The following proposition provides a condition under which hard budget constraints cannot be
achieved with fiscal centralization. Proofs of all propositions are in Appendix B.
Proposition 1: Under fiscal centralization, there exists a soft budget constraint equilibrium with I and zi iC C
but no hard budget constraint equilibrium, provided B > Mx(K , I )/dI . Furthermore, there iss i i iC
11
underinvestment in infrastructure I < I and underprovision of local public goods z < z .i i i iC FB C FB
There is a soft budget constraint equilibrium because, once enterprises with type 2 projects have
chosen e , the marginal benefit from bailing out an enterprise is greater than the marginal cost, measured byl
the welfare loss from less infrastructure investment and local public goods. Notice that because E > E , hardH S
budget constraints would yield more tax revenues and thus would allow a higher welfare level. Thus, the
government would prefer a commitment to no bailout.9
Comparative statics on ", the proportion of type 1 projects, yield interesting results which provide a
reason for the increased number of bailouts after the reforms of expanding enterprise autonomy in China and
other transition economies. To see this, assume that the government monitors enterprises with probability p,
thereby forcing enterprises with type 2 projects to choose e . Because monitored enterprises with type 2h
projects behave as if they had type 1 projects, the effective proportion of type 1 projects becomes "' = " + p(1
- "), which increases with p. Reforms for expanding enterprise autonomy reduce government monitoring and
have the effect of reducing ". A decrease in " worsens the average quality of the projects and thus increases
the number of bailouts under a soft budget constraint equilibrium.
C. Fiscal Decentralization
We now examine the effect of fiscal competition under the conditions of Proposition 1. With fiscal
decentralization, each local government is entitled to all tax revenues generated in its region. Moreover, it has
full authority over its own budget and has control over public investment and subsidies in its jurisdiction.
Because the number of projects n is large, each region seen in isolation is identical in structure to a centralized
nation. Because local governments are assumed to have the same objective function as the central
government, it is therefore not self-evident that fiscal decentralization should be superior in achieving harder
budget constraints.10
The crucial element is that fiscal decentralization induces competition among jurisdictions under
factor mobility. In addition to the game between government and enterprises, there is a game among local
governments. In our model, local governments compete with each other by making infrastructure investment
12
I to attract foreign capital K into their region. Given the choices of any other region j (j … i), locali i
government i chooses S , I , and z so as toi i i
max W = x(K , I ) + y + u(z )i i i i i
s.t. I + z = E.i i
Given any choices (I , ..., I ), perfect mobility of foreign capital implies that1 N
f (K , I ) = f (K , I )K i i K j j
for all i and j. This, together with equation E K = K, determines foreign capital allocation (K (I , ..., I ), ...,i 1 1 N
K (I , ..., I )) for any given (I , ..., I ).N 1 N 1 N
Since all regions are identical, we will look at symmetric Nash equilibria. Complementarity between
infrastructure investment and foreign capital inflow gives the following standard result:
Lemma 1: If f (K, I) < 0 and f (K, I) > 0, then dK /dI > 0 and dK /dI < 0 for all j … i.KK KI i i j i
Because of the fiscal competition, the first order condition for local government i becomes:11
(5) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) = u'(z ).i i i i i i i i i
Define I and z as a solution to (5) above and (6) belowi iD D
(6) I + z = E .i iH
Proposition 2: If Mx(K , I )/MI < B < Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ), then budget constraints arei i i s i i i i i i i iC D D
hard under fiscal decentralization but soft under fiscal centralization. However, hard budget constraints under
13
fiscal decentralization come at the cost of an allocative distortion: I > I and z < z .i i i iD C D C
The intuition is as follows. Competition among local governments in our model generates
externalities under intranational capital mobility: It increases the marginal regional value of infrastructure
investment above its marginal social value. This creates an allocative distortion with too much infrastructure
investment and too few local public goods for a given budget. This distortion increases the marginal utility
from local public goods provision and thus increases the opportunity cost of subsidizing type 2 projects in the
state sector. When this cost outweighs the benefit of bailout (B ), terminating type 2 projects becomess
credible. To the extent that under-provision of local public goods is a general feature of fiscal competition,
our results about fiscal competition hardening budget constraints should be robust.
The above results depend crucially on the difference between international and intranational mobility
of capital. Without this difference, there would be no difference between centralization and decentralization
because the central and local governments would compete in the same way for capital from the rest of the
world. On the other hand, our results do not depend on the assumption that foreign capital is not taxed. We
show in Appendix A that the results continue to hold for any given tax rate on foreign capital (or domestic
non-state capital). Indeed, taxation of foreign capital will reinforce the government's incentive to increase
infrastructure investment because an increase in foreign capital not only increases the employment benefits in
the non-state sector but also increases tax revenue.
Hard budget constraints under decentralization yield more tax revenues but the cost of obtaining
commitment is an under-provision of public goods, not only compared to the first-best solution but even
compared to fiscal centralization. Figure 2 shows a possible welfare comparison (in terms of the total utility
derived from infrastructure investment and local public goods, excluding the private benefits of the
employees in state enterprises) among the first-best optimum, the soft budget constraint equilibrium under
fiscal centralization, and the hard budget constraint equilibrium under fiscal decentralization. If the income
effect from hard budget constraints dominates the distortionary effect in the choice of I and z , fiscali i
decentralization yields a higher total utility from infrastructure investment and local public goods compared
to fiscal centralization.
14
[place Figure 2 here]
It is important to note the difference between commitment to hard budget constraints and
commitment to decentralization. Interestingly, they differ for the same reason -- irreversibility of earlier
decisions. The lack of commitment to hard budget constraints is due to the irreversibility of effort decisions
of enterprises at date 0, which gives rise to a bailout possibility at date 1. In contrast, because of the
irreversibility of expenditure decisions of local governments, commitment to fiscal decentralization is self-
enforced. Indeed, after observing the allocative choices of local governments at date 1, the central
government would find it impossible to bail out enterprises since revenues would have already been spent.
But the central government would have no incentives for recentralization before date 1 if the total welfare is
higher under fiscal decentralization. Recentralization is then either ineffective ex post, or undesirable ex ante.
D. Partial Fiscal Decentralization and Competition for Grants
In federal states, the central and local governments generally share fiscal revenues. One motivation
for fiscal transfers between the central and local governments is to "correct" distortions created by fiscal
competition between regions. In our model, this could happen through earmarked grants for local public
goods and/or subsidies. However, such "corrections" may have adverse consequences for incentives. One
may in particular wonder to what extent hard budget constraints can still be obtained when there are inter-
governmental transfers.
Consider a situation of partial fiscal decentralization where each local government transfers G to the
central government which then reallocates NG back to N local governments. Suppose the central government
earmarks grants for local public goods and subsidies. Partial fiscal decentralization introduces the12
possibility of soft budget constraints of local governments since the fiscal grants they receive ex post depend
on the expenditure decisions they make ex ante. But at the same time it also introduces a competition among
local governments for grants from the central government, in addition to competition for foreign capital.
Given the choices of any other region j (j … i), local government i chooses S , I , and z toi i iP P P
max W = x(K , I ) + y + u(z + z )i i i i i iG
15
s.t. I + z = E - G,i i
with the expectations of the rule determining z and S from the central government and K by foreign firms. i i iG G
Given the choices of local governments, the central government chooses (z , S ), i = 1, ..., N, toi iG G
max E {x(K , I ) + y + u(z + z )}i i i i iG
s.t. E (z + S ) = NG.i iG G
Foreign capital is allocated to equalize the marginal returns: f (K , I ) = f (K , I ), for all i and j.K i i K j j
Because foreign capital allocation K in a particular region depends only on the allocation of locali
infrastructure investment (I , ..., I ), the central government's allocation of grants does not have a direct1 N
impact on foreign capital allocation. Hence the central government's optimal allocation of grants must satisfy
u'(E - G - I + z ) = u'(E - G - I + z )i i j jG G
for all i and j. This, together with E z = NG (assuming S = 0), determines the allocation of grants (z (I ,i i 1 1G G G
..., I ), ..., z (I , ..., I )) for any given (I , ..., I ). We have an analogue to Lemma 1:N N 1 N 1 NG
Lemma 2: If u" < 0, then dK /dI > 0 and dK /dI < 0 for all j … i.i i j i
The mechanisms underlying competition for grants and for foreign capital are in fact the same: By
distorting more in the direction of higher I , a local government can obtain more grants from the centrali
government, given the choice of other regions. In any symmetric Nash equilibrium with S = 0, we will haveiG
z = G for all i. Let (I , z ) satisfyi i iG P P
(7) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) + (Mu/Mz)(dz /dI ) $ u'(z + z )i i i i i i i i i i i iP P G P G
(8) I + z = E - Gi iP P H
with a strict inequality holding under z = 0.iP
16
Proposition 3: Under partial fiscal decentralization with the earmarking of grants for local public goods and
subsidies and under the conditions of Proposition 2, there is a hard budget constraint equilibrium and no soft
budget constraint equilibrium if and only if G < z, where u'(z) = B .s
The competition for grants pushes local governments toward even more infrastructure investment
and keeps the budget constraints of enterprises hard as long as the grant size is not too large. When the size13
of the grant is small (i.e., G < z - z ), the central government is unable to provide a sufficient amount ofi iD P
local public goods. Competition for grants then leads to more distortions. Total local public goods provision
is even smaller than under complete decentralization, and so is total welfare. When the size of the grant is
moderate (i.e., z < G < z), local public goods provided by the central government through grants are larger,iD
but hard budget constraints still prevail because the central government prefers allocating grants for local
public goods rather than for bailouts. Welfare is also improved because the distortion by local governments
is partly corrected while maintaining hard budget constraints.
III. Fiscal Decentralization and Monetary Finance
In reality, the central government also has access to monetary sources of revenue. By incorporating
the possibility of monetary financing by the central government, we can analyze the relationship between
fiscal and monetary arrangements under federalism on the one hand, and soft budget constraints and inflation
on the other. Two effects will occur: (1) monetary finance will increase budgets and thus tend to soften
budget constraints; and (2) monetary finance may induce more distortions towards infrastructure investment
due to competition for monetary grants. To obtain a hard budget constraints equilibrium, the latter effect
must dominate the former.
We assume that R is the level of real resources from inflationary taxation available for additional
government expenditures. Because inflationary finance is distortionary, we assume that the total welfare loss
is equal to the amount of resources withdrawn R plus a quadratic deadweight loss (a/2)R . Therefore the2
central government maximizes
17
W = E{x(K , I ) + y + u(z )} - (R + (a/2)R ).i i i i2
A. The "First Best" Allocation
In the "first best" allocation, all inefficient projects are terminated (S = 0) and total monetaryFB
financing (R ), infrastructure investment (I ), and local public goods provision (z ) are chosen toFB FB FBi i
maximize total social welfare. We therefore have:
(9) Mx(K , I )/MI = u'(z ) = 1 + aR , i i i iFB FB FB
and
(10) z + I = E + R /N.i iFB FB H FB
B. Fiscal and Monetary Centralization
In the benchmark case of fiscal and monetary centralization, the central government maintains both
fiscal and monetary authority, but termination of inefficient projects is determined endogenously. Let (I ,iCC
z , R ) be the solution toiCC CC
(11) Mx(K , I )/MI = u'(z ) = 1 + aR ,i i i iCC CC CC
and
(12) I + z = E + R /N.i iCC CC S CC
Proposition 4: If soft budget constraints prevail under fiscal centralization without monetary finance, they
will also prevail under fiscal and monetary centralization. Moreover, soft budget constraints have
inflationary effects: R > R .CC FB
The possibility of monetary finance increases the government budget and thus reduces the
opportunity cost of subsidies. Therefore, the budget constraint of enterprises can only be made softer, the
softer the lower the marginal cost of inflation (1 + aR ). In the following discussions, we take as the caseCC
18
where budget constraints under fiscal and monetary centralization are soft as the benchmark case.
C. Fiscal Decentralization and Monetary Centralization
We first consider a situation which we call "accommodation," where the central government intends
to use monetary grants to "correct" the distortionary decisions of local governments. In such a game, the local
governments first decide on their expenditures, then the central government chooses total monetary finance
and allocates monetary grants to local governments earmarked for local public goods and subsidies.
Given the choices of I and z of local governments, the central government determinesi iDA DA
simultaneously aggregate monetary finance R and allocation of grants z (and possible subsidies S ) forDA G Gi i
each region to solve:
max E {x(K , I ) + y + u(z + z )} - (R + (a/2)R )i i i i iDA DA G 2
s.t. E (z + S ) = R,i iG G
The first order conditions of the central government are given by
(13) u'(z + z ) = u'(z + z ) = 1 + aR , i i j jDA G DA G DA
and
(14) E (z + S ) = R .i iG G DA
Anticipating the central government's decisions, local governments behave strategically and make
their choice (I , z ) according toi iDA DA
(15) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) + (Mu/Mz)(dz /dI ) $ u'(z + z )i i i i i i i i i i i iDA DA G DA G
(16) I + z = E,i iDA DA
with a strict inequality holding in (15) if z = 0.iDA
19
Proposition 5: There exists a hard budget constraint equilibrium under fiscal decentralization with monetary
accommodation if a > (B -1)/R . However, it is associated with higher inflation than that under fiscal andsDA
monetary centralization: R > R .DA CC
Proposition 5 shows that, due to the fiscal competition and competition for grant effects, hard budget
constraints may still be obtained under monetary centralization with accommodation when inflation is costly
enough (a is large). In such a case, the distortion towards infrastructure investment due to the competition for
monetary grants, which hardens budget constraints, will not be offset by the expansion of local budgets due to
inflationary finance. This situation in fact resembles closely that under partial fiscal decentralization without
monetary finance as presented in Proposition 3. Nevertheless, hard budget constraints are necessarily
associated with higher inflation than under fiscal and monetary centralization. Indeed, as local governments
behave strategically to invest less in local public goods, this increases the marginal benefit of inflation for the
central government. The latter then uses monetary creation to correct the distortions of the local
governments, which increases inflation. Clearly, when inflation is not too costly (a is small), budget
constraints can become soft.
Under what conditions is it possible to obtain lower inflation than under fiscal and monetary
centralization, together with hard budget constraints? To answer this question we examine the situation
opposite to the preceding one ("no accommodation"). The central government commits ex ante to a rule of
money creation and seigniorage allocation between regions (which eliminates competition for grants), and
local governments have full control over the use of revenues including the allocated seigniorage. More
precisely, the central government first decides total monetary creation R and allocates monetary grants to each
region. Afterwards, each local government decides on I , z and S , given their grant. For a given grant R/N, ai i i
Nash equilibrium I (R/N) and z (R/N) satisfies:i iDN DN
(17) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) = u'(z ).i i i i i i i i iDN DN DN
Anticipating the local governments' decisions, the central government thus chooses R to solve:
20
max E{x(K , I (R/N)) + y + u(z (R/N))} - (R + (a/2)R ).i i i iDN DN 2
The first order conditions of the central government are given by
(18) (Mx(K , I )/MI )(dI /dR) + u'(z )(dz /dR) = 1 + aR .i i i i i iDN DN DN DN DN
Proposition 6: Compared with fiscal and monetary centralization, budget constraints can only be hardened
under fiscal decentralization with no monetary accommodation. Moreover, inflation will be lower (R <DN
R ) provided dI /dR is sufficiently high.CC DNi
Because of fiscal competition, the central and local governments exhibit (endogenously) different
spending preferences since the marginal regional value of infrastructure investment is higher than the
marginal national value. Therefore the local governments will use an increased regional budget in a different
way (more for infrastructure investment) from the one the central government prefers (more for local public
goods). When the central government has no power to correct the distortion created by the local governments
towards infrastructure investment, total expenditures on local public goods under fiscal decentralization and
monetary centralization can only be lower than those under fiscal and monetary centralization. Therefore,
budget constraints will be harder since the marginal utility of local public goods is higher. Furthermore, the
conflict of interest between the central and local governments also reduces the marginal benefit from inflation
for the central government, and thus the central government has fewer incentives for monetary creation,
provided that fiscal competition induces significant responses from local governments (i.e., dI /dR isiDN
sufficiently high).
Comparing the results of Propositions 5 and 6 with those of Proposition 4, we see that higher
inflation is obtained under fiscal decentralization when the central government has the power to use monetary
creation to correct distortions made by local governments. In contrast, when the local governments have full
control over their expenditures and the central government has no discretion over the allocation of seigniorage
revenues between regions, both lower inflation and hard budget constraints can be achieved. The system of
21
separation of powers underlying Proposition 6 is thus better structured to achieve both objectives.
D. Fiscal and Monetary Decentralization
Although the case of monetary decentralization in which the central government completely loses
control over the money supply to local governments is extreme, it is empirically relevant in several occasions.
In the 1980s, some local governments in China (mainly provincial governments) managed to secure easy
credit from local branches of the central bank, which amounts de facto to a decentralization of the money
supply (Qian and Weingast, 1996). Similarly, Brazil had a recent experience where the money supply policy
was also de facto decentralized from the central bank to heavily indebted states, which controlled state-owned
banks (Wildasin, 1997b). Another striking example is the case of the Commonwealth of Independent States
where, after the break-up of the Soviet Union, independent republics continued to print rubles that circulated
in the former Soviet territory.
Decentralized monetary creation creates an inflationary externality as each local government gets the
full benefit from money creation but shares the costs of inflation with other regions, which leads to an
extreme form of a beggar-thy-neighbor policy, a "tragedy of the commons." In our model, because regions
are all identical, we assume that when region i secures R from inflationary finance, it only bears 1/N of thei
total cost. The local government in region i
max x(K ,I ) + y + u(z ) - (R + (a/2)R )/Ni i i i2
s.t. S + I + z = E + R ,i i i i
by taking other regions' decisions (including R , j … i) as given. The first order conditions are:j
(19) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) = u'(z ) = (1 + aR )/N.i i i i i i i i iDD DD DD DD
Proposition 7: Inflation is always higher under fiscal and monetary decentralization: R > R . DD CC
Furthermore, soft budget constraints also prevail as long as R # NR + (N-1)/a.DD CC
22
Because of the externality of inflation, inflation is always higher. Concerning budget constraints,
there are two offsetting effects: Fiscal competition tends to harden them while monetary expansion tends to
soften them. The latter effect tends to dominate because the inflation externality reduces the marginal cost of
inflation, leading to higher budgets with high I and z and thus with a lower opportunity cost of bailouts.i i14
IV. Interpreting the Reform Experience of China
The above analysis sheds light on China's reform experience and its unique features. It is well known
that in Eastern Europe and Russia, privatization is the main focus of transition and it is also considered a
major instrument in hardening the budget constraints of enterprises. Privatization is also largely driven by the
central government. In contrast, one of the most distinct features of China's transition has been associated
with devolution of authority from the central to local levels of government (Qian and Weingast, 1996).
Decentralization in China started as early as 1980 and has continued as a fundamental component of reform
since then. As a result, local governments in China at all levels have acquired authority as well as
responsibility over their own local economies. To see the extent of decentralization in China, consider, for
example, the relative importance of local government expenditures. In 1994, local government expenditure
represented 60% of government expenditures in China, compared with 34% in industrialized countries and
22% in developing countries (World Bank, 1996).
Decentralization induces fiscal competition among local governments. Indeed, local governments in
China compete vigorously in investing in infrastructure and establishing development zones in order to attract
foreign capital and domestic business into their regions. Harry Broadman and Xiaolun Sun (1997) show that
the level of infrastructure development, along with the market size, the educational level of the labor force,
and the geographical location, accounts for 80% of the variation in the stock of foreign direct investment
across provinces.
Decentralization also entails devolution of the supervision power of state-owned enterprises from the
central to local governments. During the 1980s, state-owned enterprises supervised by local governments
accounted for about three-quarters of the total industrial output in the state sector. Using a data set of 769
23
state enterprises covering this period, David D. Li (1997) found that state enterprises with directors
appointed by local governments were more likely to reduce workers' wage and bonuses in cases of poor
performance than the enterprises with directors appointed by the central government, where "poor
performance" is measured by an annual decrease in two alternative indicators: real net output and real total
returns to the state (tax, profits, plus interests). These results indicate that local government supervision over
state enterprises, as opposed to central government supervision, has an effect of hardening the enterprise's
budget constraints.
In recent years between 1994 and 1997, local governments in China took the initiative to massively
lay off excess workers from state-owned enterprises and even to privatize some enterprises under their
supervision (Yuanzheng Cao, Yingyi Qian, and Barry Weingast, 1997). Layoffs were mostly organized by
the local governments at the city level. In 1996 alone, about 10 million workers were laid off (most of them
were from state enterprises), and even more in 1997. Privatization, on the other hand, was most significant at
the county level. By 1996, some pioneering counties, such as Yibin of Sichuan, Shunde of Guangdong, and
Zhucheng of Shandong, had privatized almost all of the state-owned enterprises under local supervision; and
by 1997, most counties in the country had progressed to privatize more than half of the state-owned
enterprises under local supervision.
What is more interesting are the institutional changes behind (and, relatedly, the timing of) such local
government-led restructuring and privatization. Before 1993, China's monetary institutions were
problematic. On some occasions China experienced a de facto monetary decentralization when some local
governments forced the central bank branches in their regions to extend credit and print money; and on other
occasions the central bank made a monetary expansion hoping to correct distortions made by the local
governments (Wang, 1991; Qian and Weingast, 1996). Since 1993, China has centralized its monetary
authority and the central bank has refused to accommodate monetary policy to the local governments'
behavior (World Bank, 1996). As a result, a nationwide credit crunch was imposed and inflation has declined
drastically, from over 20 percent in 1993 to about 2 percent in 1997.
The local government-led restructuring and privatization of state-owned enterprises in China is an
important and interesting phenomenon. The existing theories on government-owned firms and privatization
24
(e.g., Shleifer and Vishny, 1994) cannot account for it, because they do not address the issue of how the
organization of government matters in providing government itself with incentives for reform. According to
our analysis, the incentives of local governments for restructuring and privatization can be induced
endogenously by decentralization and competition, reflecting harder budget constraints for local governments
and enterprises. Furthermore, the effect of hardening budget constraints of state-owned enterprises
supervised by local governments should be stronger under monetary centralization. Our analysis fits the fact
that local governments' initiatives of restructuring and privatization took place at the time when fiscal
decentralization was maintained together with monetary recentralization.
V. Conclusions
Until recently, the microeconomic literature on transition economies has focused largely on the
privatization and liberalization of markets in isolation from the reform of the organization of government in
these economies. In this paper, we focus on the relationship between the reform of the organization of
government and the incentive of government, and its effect on enterprises. We analyzed specifically how
fiscal and monetary arrangements under federalism limit the government's behavior and affect the degree of
the soft budget constraints of enterprises. Therefore, reform of the organization of government such as fiscal
decentralization is an important dimension of the transition process, and can have a profound impact on many
other dimensions of the transition.
Although our model was tailored to the Chinese economy, the themes we analyzed can apply to more
than China. The first general insight relates to the commitment effects of fiscal competition which tends to
change the incentives of government and limit its behavior. The literature on fiscal federalism has shown
how fiscal competition can inefficiently reduce government activity. Our paper has shown that in a second
best world fiscal competition may serve as a commitment device to prevent inefficient government spending.
The issue is important in the context of European unification, where the question of the adequate level of
fiscal centralization or decentralization is high on the policy agenda. It is also important in the U.S. context
where there are renewed debates over the advantages of fiscal expenditures being taken away from the federal
25
government and given to the states.
Second, the paper sheds light on the effects of fiscal decentralization on the composition of
government expenditures in general. Recent empirical evidence on developing and industrialized countries
alike shows that decentralization of fiscal authority leads to a change in the composition of public
expenditures, and, in particular, to an increase in the share of infrastructure expenditures (Antonio Estache
and Sarbajit Sinha, 1994). Our model precisely predicts such a change due to fiscal competition.
Third, the paper shows the importance of the link between monetary institutional arrangements and
the degree of fiscal decentralization. In our model, low inflation and hard budget constraints are associated
with the decentralization of fiscal expenditures and the centralized rules of money supply and allocation of
seigniorage revenues to local governments. Fiscal centralization would lead to higher inflation and softer
budget constraints. The issue is of particular concern for Europe from the perspective of monetary
unification. Because the issue of how to allocate seigniorage revenue to European Union members in a
monetary Union has not been settled, competition among national governments for monetary grants may lead
to higher inflation.
26
Appendix A
We show that even if we allow for taxation of returns to non-state capital, our results continue to
hold. First, consider the interpretation of K as foreign capital. Suppose the government imposes an
exogenously given tax rate t on the returns to foreign capital (our original model corresponds to the case of t
= 0). Under centralization, the central government receives the tax revenue, and under decentralization, the
local governments receive the tax revenue. We want to compare centralization and decentralization for any
level of t, 0 # t # 1.
Under fiscal centralization, by symmetry, the central government, taking K =K/N as given,i
max x(K , I ) + u(z )i i i
s.t. I + z = E + tK f (K , I ).i i i K i i
The first order conditions become
(A1) Mx(K , I )/MI = u'(z )[1 - tK f (K , I )],i i i i i KI i i
I + z = E + tK f (K , I ).i i i K i i
When t > 0, as compared with the case of t = 0, the government wants to spend more on I and less on
z in order to get more tax revenue for any given budget. Therefore, introducing taxation tends to harden the
budget constraint. On the other hand, the income effect tends to increase z, thus softening budget constraints.
The net effect is not clear. But our main interest is to compare centralization with decentralization for the
same t.
Under fiscal decentralization, perfect capital mobility implies that
(1-t)f (K , I ) = (1-t)f (K , I ),K i i K j j
27
which is the same as t = 0. Thus, foreign capital allocation (K (I , ..., I ), ..., K (I , ..., I )) for any given (I ,1 1 N N 1 N 1
..., I ) remains the same.N
However, the first order conditions for local governments are changed to
(A2) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) = u'(z )[1-td(K f (K , I ))/dI ],i i i i i i i i i i K i i i
I + z = E + tK f (K , I ).i i i K i i
Note that
td(K f (K , I ))/dI = t[(f (K , I )+Kf (K , I ))(dK /dI ) + K f (K , I )]i K i i i K i i KK i i i i i KI i i
which is greater than
tK f (K , I )i KI i i
provided
(A3) f (K , I ) + Kf (K , I ) > 0.K i i KK i i
We assume (A3) holds (this is satisfied for Cobb-Douglas function f = K I )." 1-"
Comparing (A1) and (A2), starting with the optimal solution under centralization, then under
decentralization, the left hand side becomes bigger, and the right hand side becomes smaller. Therefore,
adding taxation reinforces the fiscal competition effect because the local government has more incentives to
increase infrastructure investment. Therefore, with taxation t, under condition (A3), our results on
decentralization are strengthened. The intuition is that, under decentralization, more investment in
infrastructure attracts more foreign capital, which not only increases employment rents but also increases tax
revenues. This double benefit makes the local governments spend more of their budget on infrastructure and
less on other local public goods, which thus raises the opportunity cost for bailout.
28
The benefit of bailout is still B , and the opportunity cost of bailout is still u'(z ). Then ifs i
u'(z ) < B < u'(z ),i s iC D
or equivalently,
{Mx(K , I )/MI } / {1 - tK f (K , I )} < Bi i i i KI i i sC C
< {Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI )} / {1-td(K f (K , I ))/dI },i i i i i i i i i K i i iD D D
budget constraints are hard under fiscal decentralization but soft under fiscal centralization.
To conclude, our result in comparing centralization and decentralization continues to hold,
independent of the tax rate t.
Second, consider the interpretation of K as domestic non-state capital. The objective function
government in region i becomes:
W = x(K , I ) + (1-t)K f (K , I ) + y + u(z )i i i i K i i i i
where t is the tax on non-state capital.
When t = 0, it is easy to see that our results go through, because in all the proofs we simply replace
x(K , I ) by f(K , I ). For any general t>0, we show that our analysis still goes through. Under centralization,i i i i
the central government,
max x(K , I ) + (1-t)K f (K , I ) + y + u(z )i i i K i i i i
s.t. I + z = E + tK f (K , I ).i i i K i i
The first order conditions become
29
(A4) Mx(K , I )/MI + (1-t)K f (K , I ) = u'(z )[1 - tK f (K , I )],i i i i KI i i i i KI i i
I + z = E + tK f (K , I ).i i i K i i
Under decentralization, with the same tax rate t, the first order conditions for local governments are
changed to
(A5) Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) + (1-t)d(K f (K , I ))/dIi i i i i i i i i K i i i
= u'(z )[1 - td(K f (K , I ))/dI ],i i K i i i
I + z = E + tK f (K , I ).i i i K i i
Comparing (A4) and (A5) under assumption (A3), starting with the optimal solution under
centralization, then under decentralization, the left-hand side becomes bigger, and the right-hand side
becomes smaller. Therefore, our results on the hardening of budget constraints under decentralization remain
valid.
30
Appendix B
Proof of Proposition 1: Because the cost of not bailing out m (m$1) projects is mB but the benefit is lesss
than mu'(z ), "no bailout" is not a worthwhile deviation under the specified condition. Comparing (1) andiC
(3), E > E together with concavity of u(z ) implies that I < I and z < z . Concavity of x(K , I ) withH S C FB C FBi i i i i i i
respect to I ensures thati
B > Mx(K , I )/MI > Mx(K , I )/MI .s i i i i i iC FB
Hence there cannot be a hard budget equilibrium (which has to be I = I ).�i iFB
Proof of Proposition 2: The condition implies that bailout is not worthwhile. If there were a soft budget
constraint equilibrium with I , we would have, considering (5) and (6) and E >E ,i* H S
Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) = u'(E - I ) > u'(E - I ) > B ,i i i i i i i i i i S* * S * H D
then bailout is not preferred, a contradiction. Comparing (3) and (5), we have u'(z ) < u'(z ), hence z > z . i i i iC D C D
Finally, E > E implies that I < I .�H S C Di i
Proof of Proposition 3: When (7) holds with equality, comparing (5) and (7), dz /dI > 0 implies for thei iG
same budget E = z + G = z + z < z . Hence, u'(z + z ) > u'(z ) > B by the condition of Proposition 2. H P P G D P G Di i i i i i i s
Then neither the central government nor local governments have incentives for bailout. When (7) holds with
inequality, if z + z = G < z , then the left hand side of (7) is greater than u'(z + z ), which is greater thani i i i iP G D P G
u'(z ) and B . If z + z = G > z , we must have I < I , then the left hand side of (7) is greater thani s i i i i iD P G D P D
Mx(K , I )/MI +(Mx(K , I )/MK)(dK /dI ),i i i i i i i iD D
which is in turn greater than B . In both cases, the local governments have no incentives for bailout. Unders
the condition G < z, u'(G) > B , the central government has no incentives for bailout either.s
31
To show there is no soft budget equilibrium, use (7) and apply the proof of proposition 2.�
Proof of Proposition 4: If R < R , E +R /N < E + R /N as E < E . The smaller budget would implyCC FB S CC H FB S H
u'(z ) = 1 + aR > u'(z ) = 1 + aR , or R > R .�i iCC CC FB FB CC FB
Proof of Proposition 5: Take a high enough so that R > 0 is arbitrarily small. This implies that (15) holdsDA
with equality since z > 0. Suppose z > z . Since I + z = I + z + R /N and R is small, theni i i i i i i i iDA DA D DA DA D D DA DA
I < I . This would imply that (15) holds with inequality, a contradiction. Hence z # z < z and z +i i i i iDA D DA D DA
R /N < z. Furthermore, under a hard budget constraint, u'(z + z ) > B > u'(z ), using (11) and (13). DA DA G CCi i s
This implies R > R .�DA CC
Proof of Proposition 6: z > z would imply u'(z ) < u'(z ), the budget constraint would remain soft. i i i iDN CC DN CC
By (17), we would obtain Mx(K , I )/MI < u'(z ) < u'(z ). Using dI /dR + dz /dR = 1, we derivei i i i i i iDN DN CC DN DN
1 + aR = (Mx(K , I )/MI )(dI /dR) + u'(z )(dz /dR) < u'(z ) = 1 + aR .DN DN DN DN DN CC CCi i i i i i i
Therefore, R < R , which would imply z # z , a contradiction. Therefore, z # z , that is, theDN CC DN CC DN CCi i i i
budget constraint can only be made harder. If u'(z ) > B > u'(z ), the budget is hard.i s iDN CC
Given u'(z ) > u'(z ), we establish, using dI /dR + dz /dR = 1, (17) and (18),i i i iDN CC DN DN
R < RDN CC
if and only if
[Mx(K/N, I )/MI - u'(z )](dI /dR) < u'(z ) - u'(z )i i i i i iDN DN DN CC DN
if and only if
dI /dR > {u'(z ) - u'(z )}/[(Mx(K/N, I )/MK)(dK /dI )].�i i i i i iDN DN CC DN
Proof of Proposition 7: R > R would imply 1 + aR > (1 + aR )/N, thus u'(z ) > u'(z ) and z <CC DD CC DD CC DD CCi i i
z . As B > u'(z ) > u'(z ), budget constraints are always soft. But R > R and z > z imply I >i s i i i i iDD CC DD CC DD DD CC CC
I , which gives iDD
Mx(K , I )/MI + (Mx(K , I )/MK)(dK /dI ) > Mx(K , I )/MI , i i i i i i i i i i iDD DD CC
32
that is, u'(z ) > u'(z ), a contradiction.i iDD CC
By (11) and (19), R < NR + (N - 1)/a if and only if u'(z ) < u'(z ). Then the budget constraintDD CC DD CCi i
is soft if R < NR + (N - 1)/a.�DD CC
33
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1997b.
Weingast, Barry R., "The Economic Role of Political Institutions: Market-Preserving Federalism and
Economic Growth," Journal of Law, Economics and Organization, 1995, 11, 1-31.
World Bank, The Chinese Economy: Fighting Inflation, Deepening Reforms, A World Bank Country Study,
1996.
35
1 Subsidization of loss-making enterprises is often an indicator of soft budget constraints. However,
subsidies are not identical to soft budget constraints. There are cases in which firms receive subsidies but do
not expect to be bailed out in cases of bad financial performance.
2 In a recent paper, David Wildasin (1997a) studied the issue of hard vs. soft federal grants to local
governments. He argues that, due to an externality of local public goods, large local jurisdictions are likely to
face softer budget constraints than small jurisdictions. This is because the failure to bail out the former
would have far more severe consequences for the economy as a whole, leading to a "too big to fail" effect.
3 Both the models of Andrei Shleifer and Robert Vishny (1994) and Ilya Segal (1993) on soft budget
constraints are based on the difference in objectives between the government and the private sector. In the
former, the government cares about employment and in the latter about the total social surplus.
4 By focusing on a two-period model we leave aside the role of reputation in sustaining hard budget
constraints. As is known from the theory of repeated games, reputation is an effective mechanism only if
there is a long enough time horizon and a low enough discount rate. In this paper, we prefer to focus on the
role of institutions in hardening budget constraints.
5 In this regard, it is useful to make a comparison between China and some other newly industrializing
countries such as Mexico, Thailand, Malaysia, Indonesia, and South Korea, which have experienced financial
crises recently. Unlike those countries, foreign capital is not allowed to go into China freely, and thus foreign
investors are not able to respond to China's higher domestic interest rate in the same way as they do in those
countries. Indeed, short-term and portfolio investment opportunities in China are not available to foreign
Footnotes
* Qian: Department of Economics, Stanford University, Stanford, CA 94305-6072; and Roland: ECARE,
Université Libre de Bruxelles and CEPR. The authors are grateful to Erik Berglöf, Patrick Bolton, Jiahua
Che, Mathias Dewatripont, David D. Li, Eric Maskin, Ronald McKinnon, Barry Naughton, Yijiang Wang,
Barry Weingast, David Wildasin, Chenggang Xu, three referees, and seminar participants in Brussels,
Stanford, Gerzensee and the CEPR annual workshop in macroeconomics in Tarragona for helpful discussions
and comments.
36
investors. Such restrictions on foreign capital are responsible, in part, for China's ability to avoid financial
crises like those as in Mexico and Southeast Asian countries.
6 The difference between z and I is that the choice of the latter exerts an externality on other regions whilei i
the former does not. Whether z is a form of public investment or consumption is irrelevant for our results.i
7 The "first best" is in reference to domestic welfare.
8 We assume that u'(z ) is greater than 1. This ensures that at the optimum J = 0, which simplifies ouri iFB
analysis. The model can, however, be accommodated to the case where u'(z ) = 1 and J > 0.i iFB
9 In our model soft budget constraints are a consequence of a distortionary taxation (all verifiable revenues
are taxed away). If enterprises were allowed to keep (R - 1) of their verifiable revenues, then enterprisesq
with type 2 projects would get (R - 1) + B under e and only B under e . However, because the two types ofq q h s l
projects are indistinguishable, in order to induce e from type 2 projects, the government would have toh
concede B - B to all enterprises. If B - B > (1 - ")(R + 1), this leads to a fall in tax revenues and thus to as q s q q
lower welfare level as compared to a soft budget constraint equilibrium. In such a case, the government
prefers to tax away all verifiable revenues.
10 The fact that local governments do not receive grants from the central government (i.e., the budget
constraints of local governments are hard) is not really relevant here. Indeed, under centralization, the fiscal
budget of the central government is also hard but enterprises have soft budget constraints as shown in
Proposition 1.
11 For this first order condition to make sense, we assume that the left-hand side, i.e., the marginal value of
infrastructure investment to region i, is decreasing in I . One can verify that this will be the case if f(K , I )i i i
takes the form of a Cobb-Douglas function.
12 The general case where the central government can also earmark grants for infrastructure investment is
technically more complicated and does not yield additional economic insight in the current set-up, given that
local governments already overspend in infrastructure investment.
13 Yijiang Wang (1991) demonstrates similar distortionary effects in a model with a Cobb-Douglas
production function (with fixed investment and circulating capital as two inputs).
37
14 A pathological case of hard budget constraints under very high inflation may prevail when R > NR +DD CC
(N-1)/a. In that case, there will be both very high inflation and a high marginal utility of local public goods.
This is a case where the marginal value of infrastructure investment is very high and decreases slowly so that
the local public goods provision is always very small for any budget size.
"
1-"
eh
el
(Rq, Bq)
(Rq, Bq)
(0, 0)
(Rs, Bs)
date 0 date 1 date 2
termination
bailout
type 1
type 2
38
Figure 1.
The Mechanism of the Soft and Hard Budget Constraint
0 ES EH
I i
zi
( I , z )FB FB
( I , z )C C
( I , z )D D_z
39
Figure 2.
Comparison among the First-Best Optimum, the Soft Budget Constraint Equilibrium under FiscalCentralization, and the Hard Budget Constraint Equilibrium under Fiscal Decentralization