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Publicado en: Tesis Doctorado

Essays on Soft Budget Constraint in Fiscal Federal Systems

María José Catalán

Tesis, Doctorado en Economía, IE-PUC, 2012

Abstract: This paper evaluates the trade-off between efficiency and regional risk sharing, generated by two observable facts in any federal country. First, central governments provide ex-post bailouts to regions experiencing financial difficulties (soft budget constraint) and in this way generate negative externalities among sub-national governments. Second, regions face imperfectly correlated income shocks. Thus, the softer are the budget constraints of local governments, the greater the negative externalities and the lower the aggregate efficiency. On the other hand, the softer is the restriction, the greater the capacity of regional governments to soften the provision of public goods, which increases efficiency. I find that when regional cycles are important, while the degree of substitution between private and public consumption is low and consumers’ risk aversion is high, the (positive) insurance effect may be greater than the effect of negative externalities between regions, and hence the policy recommendation for the central government may be to impose a soft budget
constraint. There are also cases in a certain range of parameters, where it is optimal to have some degree of hardness in the central government policy


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