Federalism and the Soft Budget Constraint ⑧ Yingyi Qian; Gerard Roland The American Economic Review, Vol. 88 No.(Dec., 1998), 1143-1162 Stable URL: http: //links. jstor.org/sici?sici=0002-8282%28199812%2988%3A5%3C1143%3AFATSBC%3E2.0.%3B2-7 The American Economic Review is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http: //www.jstor.org/about/terms. html. jstor's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the JSTOR archive only for your personal, non-commercial use. P Please contact the publisher regarding any further use of this work Publisher contact information may be obtained at http: //www. jstor.org/journals/aea. html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to creating and preserving digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org. http: //www.jstor.org/ Sat May2211:50:282004
Federalism and the soft budget constraint By YINGYI QIAN AND GERARD ROLAND The government's incentives to bail out inefficient projects are determined by the trade-off 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 ncreases the opportunity costs of bailout and thus serves as a commitment device(the"com- tition effect). Second, monetary centralization, together with fiscal decen ralization, induces a confict of interests and thus may harden budget constraints and reduce infation( 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 in- In reality, soft budget constraints mostly in- centive problem. They were a key character- volve a government, through the bailout of en istic of socialist economies and remain an terprises and banks(public and private )or of important concern in transition economies. lower-level governments. This paper studies There are also instances of soft budget con- the relationship between forms of federalism, straints in market economies such as bailouts that is, organizations of government involving of banks(e.g, the s&ls) and corporations some fiscal decentralization, and the degree of (e.g, Chrysler ). Following Janos Kornai the soft budget constraint Based on the trade (1980, 1986), an enterprise or any organiza- off between political benefits and(endoge- tion is said to have a soft budget constraint nous)economic costs, it analyzes how the when it expects to be bailed out in case of fi- government 's incentive to soften budget con- nancial trouble. This creates an incentive prob- straints depends on the extent of decentral lem because the manager of the organization zation of fiscal and/or monetary authority cording to Mathias Dewatripont and Eric Chinese experience where devolution of au- Maskin (1995), the fundamental reason for thority from the central to local governments the soft budget constraint problem is the in is a major feature of reform, the theme of the ability of rescuers to commit to no bailout ex paper is more general. Indeed, in the United and transition economies, there is a growing nterest in studying the relationship between federalism and government incentives 品三 Department of Economics, Stanford Univer We build a model of the soft budget con straint in a three-tier hierarchy with a"central lof. Patrick bolton. Jiahua Che. Mathias government'at the top, multiple"local gov MeKinnpont, Patrick bolto Eric Maskin, Ronald ernments"in the middle, and"enterprises Tng ngast, David Wildasin, Chenggang Xu, three referee has the following features. First, the soft and the cepr annual workshop in macroeconomics in budget constraint game between government Tarragona for helpful discu d comments bodies and ente Subsidization of loss-making enterprises is often an ment bodies face sequential bail-out decisions indicator of soft budget constraints. However, subsidies in the presence of sunk costs and enterprises are not identical to soft budget constraints. There are cases behave strategically in securing subsidies in which firms receive subsidies but do not expect to be bailed out in cases of bad financial performance. Second, the local governments compet 1143
THE AMERICAN ECONOMIC REVIEW cach other in allocating their own budgets to has no discretionary powers in the allocation attract mobile factors and grants from the cen- of seigniorage revenue between local govern- tral government in a simultaneous-move ments, inflation will be lower than under fiscal game. And third, the central government plays centralization. The reason is that the difference a sequential game against local governments in spending preferences between the central in deciding on the allocation of grants and, if and local governments due to fiscal competi monetary financing is possible, on total money tion induces endogenously a conflict of inter supply. The study of incentive problems in a ests, which may achieve both harder budget three-tier hierarchy is generally complicated constraints and monetary restraint( the and difficult, and this difficulty is only rein-checks and balance effect) forced by the introduction of fiscal competi In the extreme case of monetary decentral ion and factor mobility. Nevertheless, we are ization, with the externality of inflation, each able to derive several results on the effect of local government receives the full benefits federalism in hardening budget constraints from its monetary creation but shares the costs We first show that decentralization of fiscal of inflation with other regions. This creates authority to local governments together with high inflation and generally softens budget obility of nonstate capital across regions constraints may be effective in hardening the budget con Our analysis can be used to interpret the in traints of enterprises under local govern- teresting features of China's transition process ments'control. This is because competition to markets. In Eastern Europe and Russia, pri- among local governments in attracting capital vatization is the main focus of transition. In to their region creates an externality which contrast China's transition was first and fore- reases the opportunity cost of subsidizing in- most associated with the devolution of gov efficient enterprises, which in turn reduces the ernment authority from the central to local incentives for bailouts. Fiscal competition can level. Recently, local governments in China thus be viewed as a commitment device(the took the initiative to lay off excess workers competition effect). However, this comes and even privatize the enterprises under their at the cost of distortions such as excessive in- supervision. This happened at a time when frastructure investment monetary authority was recentralized and in- When fiscal decentralization is not complete fation was lowered. According to our analy and the central government has the power to sis, decentralization together with competition allocate part of the fiscal revenues, local gov- has a profound impact on the incentives of ernments will also compete for grants. Inter- local governments. It induces harder budget estingly, if the central government earmarks constraints because it increases the local gov- grants for local public goods and subsidies, ernments'costs of subsidies and, furthermore, strategic distortions by local governments fur- this effect requires the support of monetary ther increase the opportunity cost of bailout, centralization. From this perspective, reform thus achieving harder budget constraints, pro- of government organization, such as fiscal de- grant size is not too lar centralization, is an important dimension of We then consider the possibility of mone- the transition from a plan to a market tary financing with the central government cre- economy ting money and allocating seigniorage Our paper presents the first macroeconomic revenue while local governments continue to model of the soft budget constraint viewed as have full authority over their expenditures. a dynamic commitment problem in the frame- Fiscal competition together with competition work of a federal government. Even though for monetary grants works in a similar way towards hardening the budget constraint of terprises. However, inflation will be higher than under fiscal centralization if the centra 2 In a recent paper, David E. wildasin(1997a)studied government allocates earmarked grants hoping rd v. soft federal grants to local gov to" distortionary decisions by local He argues that, due to an externality of local public oods, large local jurisdictions are likely to face softer governments. But if the central government budget constraints than small jurisdictions.This is because
VO. 88 NO 5 QIAN AND ROLAND: FEDERALISM AND THE SOFT BUDGET CONSTRAINT our concept of the soft budget constraint is the The paper is organized as follows. Section same as that of Dewatripont and Maskin I presents a three-tier hierarchy model involv- 995), there are a number of important dis- ing the soft budget constraint in a macroeco- tinctions between our model and theirs. First, nomic context. Section Il demonstrates the in their model, firms are bailed out by profit- role of fiscal competition among local govern maximizing banks, and in ours by a govern- ments as a commitment device to harden the ment which also cares about employment budget constraints of enterprises. Section Ill rents. Second, our model endogenizes sources introduces monetary creation as an additional of revenue for bailouts. This allows us to en- source of financing and analyzes the implica dogenize the opportunity cost of bailouts tions of alternative monetary arrangements un which depends on the organization of govern- der fiscal decentralization on the budget ment. Finally, crucial conditions leading to constraints and inflation. Section IV uses our hard budget constraints in their model are the erpret the reform exp of limited liquidity of the bank and the costly in- China. Section V concludes with some general formation transfer between banks. In our implications of our analysis. model, the size of the budget matters less than its allocation among various expenditures. In L. The Model fact, g larger whe get constraints are hard since a higher ef- We consider an economy with N identical ficiency yields more tax revenues regions In each region, there are state enter This paper contributes to the literature on prises and new nonstate enterprises. The econ local public finance and fiscal federalism(e. g, omy can be viewed as a three-tier hierarchy Charles Tiebout, 1956; Wallace Oates, 1972: composed of a central government at the top. Roger H. Gordon, 1983; Wildasin, 1988)by N local governments in the middle, and enter- he link between fiscal competition rises at the bottom. Although the setup of the and government incentives for bailouts. Thus, model is tailored to the situation of the Chinese it adds to the growing literature on incentive economy, the logic of the model can be ap- problems in the context of the organization of plied to other federal states. The model has government. For example, Jean-Jacques three dates. Laffont and David Martimort(1994) investi- gate the role of duplication of regulators in State Enterprises preventing collusion, and Torsten Persson et At date 0, there are n (n is large)state en (1997)study the role of separation of terprises, each having one project in place. The powers in the organization of government in return on a project has two components: a ver improving the accountability of government. ifiable(taxable )return R and a nonverifiable Our results are also in accordance with recent (nontaxable )private benefit b(net of effort) historical analysis(e.g, Barry R. Weingast, accruing to employees(workers and manag 1995)and studies on transition economies ers). a type l project, present in proportion a (e. g, Qian and Weingast, 1996, 1997) yields(Ra, Ba) at date l independent of emphasizing the commitment effects of worker/manager effort(Figure 1). A type 2 federalism project, present in proportion(1-a), yields (Rg, B,)at date 1 only if the enterprise chooses action(effort)en, which can be interpreted the failure to bail out the former would have far more to a too big uences for the economy as a whole, leading Both the models of llya Segal(1993) the role of reputation in sustaining hard budget constraints s an effective mechanism only if there is a he government and the private sector. In the e prefer to focus on the role of institutions in hardening about the total social surplu budget constraints
THE AMERICAN ECONOMIC REVIEW DECEMBER /998 type 1 type 2 0,0) date 0 date 1 date 2 FIGURE 1. THE MECHANISM OF THE SOFT AND HARD BUDGET CONSTRAINT restructuring"or "privatization. If, how- Thus, public infrastructure investment ever,action(effort)e, is chosen, which means the marginal productivity of nonstate maintaining the"status quo, then the project For analytical simplicity, we assume that the ields(0, 0)at date 1. In the latter case, the total amount of nonstate capital is fixed government and the enterprise can engage in (2i K=K) and nonstate capital is perfectly efficient renegotiation: if 1 unit of funds is in- mobile across regions. All we really need for jected(i.e, bailout ), a type 2 project will yield our qualitative conclusions, however, is the as (R, Bs)at date 2. For the sake of simplicity, sumption that nonstate capital is less mobile ye assume no discounting and R, =0. We across countries than across regions within a assume further that the private benefits are country ranked such that Bs B.>0. This implies We offer two interpretations of nonstate that if all verifiable revenues are taxed away, capital. The first interpretation is domestic the manager with a type 2 project prefers e, to nonstate or private capital. with this interpre en if and only if bailout is expected tation, the assumption of inelastic supply of nonstate capital is realistic because formally Nonstate Enterprises domestic capital in China is not allowed to Nonstate enterprises emerge at date I and leave the country(even though some capital their activities in region i are described by a flight is inevitable in practice). On the other production function f(Ki, I), where K; rep- hand, despite the fact that allocation of state resents nonstate capital and I, represents pub- capital remains under state control, domestic lic infrastructure investment which is financed nonstate capital in China has a considerable from the government budget at date 1. We degree of mobility across provinces The second interpretation is foreign capit In such a c fk(K1,l)>0,f(K,l)>0 capital is less mobile across countries than across regions within a country can be justified fkx(K;,)0 ential paper by Martin Feldstein and Charles
VOL &8 NO 5 OIAN AND ROLAND: FEDERALISM AND THE SOFT BUDGET CONSTRAINT 1147 Horioka(1980), extensive evidence has ac- The Go cumulated indicating substantial capital im- We consider the government budget at date mobility across countries in general (e. g 1. In each region, on the revenue side, Ti-Ti Gordon and A Lans Bovenberg, 1996). This is the net tax revenue exclusively from state includes a high correlation between domestic enterprises, where T, is total taxes and Ti is vings and investment, real interest differen- transfers to state employees. On the expendi tials across countries, and a lack of interna- ture side, the budget is used for three purposes: tional portfolio diversification. In contrast, subsidies (or bailout)S: for type 2 projects, xample, Tamim A Bayoumi and Andrew K. public goods provision 4, ent Ii, and local capital mobility within countries is high. For public infrastructure investm Rose(1993)found strong evidence of capital mobility across regions in the United Kingdom T-T;=S+1;+z using the Feldstein-Horioka methodology But international capital mobility to China Actual tax revenues and expenditures will is particularly imperfect for idiosyncratic rea- depend on whether the budget constraints of sons. Unlike most Organization for Economic enterprises are hard(action en and no bailout ooperation and Development(OECD )and of type 2 projects)or soft(action e; and bailout newly industrializing countries, China has of type 2 projects). We can rewrite the gov- maintained formal control over its capital ac- ernment budget as count. Officially, capital is not free or out of China: Capital inflow to China is con- Ti+l+z=T-s=e, trolled as well as repatriation of profits. In fact, it was not until December 1996 that the Chi- where E= EH= nR, or E=ES= anR nese government announced the current ac-(1-a)n, depending on whether budget con count convertibility of its currency, but it has straints are hard or soft no plans to make capital accounts convertible We assume no tax on returns to nonstate in the near future. These imperfections inin- capital This can be justified by the difficulty ternational capital mobility need to be con- of such taxation in practice. It is difficult to tax tal domestic nonst apital in transition econe mobility within China. Once a foreign firm mies due to the lack of good tax institutions manages to invest in China, it can freely Indeed, the great majority of taxes in China hoose its location. The only consideration is were collected from the state sector. It is also profitability. Moreover, international investors well known that foreign firms are able to evade must incur some costs before investing in income taxes in host countries by transfer pric China to overcome language barriers and ac- ing schemes. This is true in developed coun- quire knowledge of Chinese laws, etc. Once tries and more so in developing countries like these costs are sunk, it is much less costly to China. However, in Appendix a we show that move capital from, say, Guangdong to our analysis goes through and our results con tinue to hold even with taxation of returns to nonstate capital In this regard, it is useful to make a comparison be The Government's Objective Function We assume a welfare-maximizing tries such as Mexico, Thailand, Malaysia, Indonesia, and ment: The local government in region imizes w and the central gover ently. Unlike those countries, foreign capital is not al- maximizes w=2 w. We assume that the wed to go into China freel short-term and portfolio investment opportunities in China re not available to foreign investors. Such restrictions on eign capital are responsi the latter exerts an extemality on other regions to avoid financial crises like those in Mexico and Asian former does not. whether z or consumption is irrelevant for our res
148 THE AMERICAN ECONOMIC REVIEW DECEMBER /998 population in region i consists of two groups: er and the government chooses bailout, and employees in state enterprises and in nonstate hard budget constraint equilibria as equilibria firms. Let the total private benefits of the em- in which enterprises with type 2 projects ployees in nonstate firms be choose e and the government chooses x;=x(K, l)=f(Ki, l)-Ki(Ki, Ii), The Interaction Among Local Govern where x, is assumed to be an increasing and ments -Except for the case of complete cen- concave function of I,. The total private ben- tralization, there is a competition between efits of the employees in state enterprises are local governments at date 1 to attract foreign yu,where y =nBa Ti under hard budget capital and grants from the central govern- constraints and y; =anBa +(1-a)nB, + Ti ment. Local governments move simulta under soft budget constraints. The total utility neously and make choices of budget of the two groups derived from local public allocation. The equilibrium is a Nash equilib goods is u(z), which is assumed to be con- rium in which each local government takes the cave in budget allocation of other local governments Under the interpretation of K as domestic as given nonstate capital, the objective function of local government in region i is expressed as The interaction between the central and Local Governments.-The interaction between W;=f(K,)+y;+u(z;) the central and local governments at date I con- cerns allocation of grants and monetary creation assuming the government puts an equal weight (except for the cases of complete centralization between rents to nonstate employees and returns and complete decentralization). This is a se. to nonstate capital Under the interpretation of K quential interaction between the central govern as foreign capital, the objective function of local ment and local governments. We will consider government in region i becomes the case in which the central government makes decisions(such as allocating grants and creatin W=x(K,l)+y2+(x) money ) after the local governments'decisions which reflects the fact that the central govern- because the government is not concerned with ment often accommodates the local govern returns to foreign capital. The two specifica- ments'needs. We will also consider the case of tions will give qualitatively similar results; for no accommodation in which the central govern- concreteness we will use the interpretation of ment moves before local governments foreign capital We define an equilibrium of the above ga as strategy profiles of state enterprises, local equilibrium overnments, and the central government We define the game played under federal such that none of the parties has incentives to institutions as follows deviate unilaterally. Our analysis is consider ably simplified because whether an enterprise The Interaction between governments and has a soft or a hard budget constraint is deter- State Enterprises.In this sequential interac- mined by a simple comparison between the tion an equilibrium is defined by: (i)a choice benefits of bailout (Bs)and the opportunit of action e of state enterprises at date O to max- cost of doing so. Soft budget constraints are imize private benefits given the expected obtained when the benefits exceed the cost of choice of Ti, Si, I,, and zi by the government; doing the best alternative. Hard budget con- and (ii) the governments choice of Ti, Si, I straints are obtained otherwise nd z, at date 1 in order to maximize social en the choice of action by state Il. Fiscal Competition as a Commitment Device enterprises. We define soft budget constraint game-perfect equilibria in This section demonstrates a main theme of which enterprises with type 2 projects choose our paper: Fiscal competition among local
VOL 8& NO 5 QIAN AND ROLAND: FEDERALISM AND THE SOFT BUDGET CONSTRAINT governments may serve as a commitment de- ment in infrastructure /; E, hard social welfare W=Ei w. The first-best op- budget constraints would yield more tax rev timum(1 zfa)satisfies enues and thus would allow a higher welfare level. Thus, the government would prefer a (1) ax(K, 1F)/81,=u'(ziB commitment to no bailout Comparative statics on a, the proportion of type l projects, yield interesting results which IFB+Z/=e provide a reason for the increased number of bailouts after the reforms of expanding en prise autonomy in China and other transition Fiscal centralization economies. To see this, assume that the gov ernment monitors enterprises with probability In the benchmark case of fiscal centralia- P, thereby forcing enterprises with type 2 pro- tion, the central government is entitled to all jects to choose eh. Because monitored enter- tax revenues, has full authority over its budget, prises with type 2 projects behave as if the and has control rights over public investment had type 1 projects, the effective proportion of and subsidies. Here the three-tier hierarchy de- type l projects becomes a=a+p(I-a) generates into a two-tier one in which local which increases with p Reforms for expand governments play no role. Define (If, zi)as ing enterprise autonomy reduce government a solution to monitoring and have the effect of reducing c a decrease in a worsens the average quality (3) ax(ki, Ii/aI =u'(z of the projects and thus increases the number of bailouts under a soft budget constraint equilib 1 +z=e. C. Fiscal decentralization The following proposition provides a con examine the effect of fiscal com- Proofs of all propositions are in Appendix b decentralization. each local PROPOSITioN 1: Under fiscal centralize ion, there exists a soft budget constraint equi- librium with If and zf but no hard budget quence of a distortionary taxation(all verifiable revenues onstraint equilibrium, provided Bs ax(Ki, are taxed away). If enterprises were allowed to keep(r, 2 projects would get(Rg-1)+B, under e and only B, under e However, because the two types of projects are indistinguishable, in order to induce en from type 2 proj ects, the government would have to concede B, -B in reference to domestic welfare ises. If B to a fall in tax revenues and thus to a lower welfare level a soft budget constraint equilibrium, In analysis. The model can, however, be accommodated case. the case where u(zf")=I and Ti >0 fiable revenues
50 THE AMERICAN ECONOMIC REVIEW DECEMBER 1998 government is entitled to all tax revenues gen- LEMMA I: IffKK(K, 1) erated in its region. Moreover, it has full au- 0, then dK /d, >0 and dK /dl, If and zi<zi Given any choices(I1,., IN), perfect mobil The intuition is as follows. Competition ity of foreign capital implies that among local govemments in our model gener- ates externalities under intranational capital mo- fx(K,, 1)=fr(K, i) bility: It increases the marginal regional value of infrastructure investment above its marginal for all i and j. This, together with equation 2i social value. This creates an allocative distortion K,=K, determines foreign capital allocation with too much infrastructure investment and too (K1(l1,…,l),…,KN(l IN)) for any few local public goods for a given budget. This g Since all regions are identical, we will loo cal public goods provision and thus increases the at symmetric Nash equilibria. Complementar- opportunity cost of subsidizing type 2 projects between infrastructure investment and for- in the state sector. When this cost outweighs the eign capital inflow gives the following benefit of bailout(Bs), terminating type 2 proj standard result ects becomes credible. To the extent that underprovision of local public goods is a general feature of fiscal competition, our results about fiscal competition hardening budget constraints should be robust Io The fact that local governments do not receive grants from the central gove t (i. e, the budget constraints is first-order condition to make sense, we as- f local governments are hard )is not really relevant here Indeed under centralization, the fiscal budget of the cen- i, is decreasing in /, tral government is also hard but enterprises have soft budget constraints as shown in Proposition 1 Cobb-Dougl
VOL. 88 NO 5 QIAN AND ROLAND: FEDERALISM AND THE SOFT BUDGET CONSTRAINT (IC,z g GURE 2. COMPARISON AMONG THE FIRST-BEST OPTIMUM, THE SOFT BUDGET ONSTRAINT EQUILIBRIUM UNDER FISCAL CENTRALIZATION, AND THE HARD BUDGET CONSTRAINT EQUILIBRIUM UNDER FISCAL DECENTRALIZATION The above results depend crucially on the under fiscal centralization, and the hard budget difference between international and intrana- constraint equilibrium under fiscal decentraliza- tional mobility of capital. Without this differ- tion. If the income effect from hard budges ne ence, there would be no difference between straints dominates the distortionary effect in the centralization and decentralization because the choice of lf and zi, fiscal decentralization yield central and local governments would compete a higher total utility from infrastructure invest- world.On the y for capital from the rest of the ment and local public goods compared to fiscal in the same other hand, our results do not centralizatio ption that foreign capital It is important to note the difference be- is not taxed. We show in Appendix a that the tween commitment to hard budget constraints results continue to hold for any given tax rate and commitment to decentralization. Interest on foreign capital (or domestic nonstate cap- ingly, they differ for the same reason--irre- ital). Indeed, taxation of foreign capital will versibility of earlier decisions, The lack of reinforce the governments incentive to in- commitment to hard budget constraints is due crease infrastructure investment because an in- to the irreversibility of effort decisions of en- crease in foreign capital not only increases the terprises at date 0, which gives rise to a bailout employment benefits in the nonstate sector but possibility at date 1. In contrast, because of the also increases tax revenue irreversibility of expenditure decisions of local Hard budget constraints under decentraliza- governments, commitment to fiscal decentral tion yield more tax revenues but the cost of ob- ization is self-enforced. Indeed, after observ taining commitment is an underprovision of ing the allocative choices of local governments public goods, not only compared to the first-best at date 1, the central government would find it solution but even compared to fiscal centralia- impossible to bail out enterprises since reve- tion. Figure 2 shows a possible welfare nues would have already been spent. But the comparison(in terms of the total utility derived central government would have no incentives from infrastructure investment and local public for recentralization before date 1 if the total goods, excluding the private benefits of the em- welfare is higher under fiscal decentralization ployees in state enterprises)among the first-best Recentralization is then either ineffective ex ptimum, the soft budget constraint equilibrium post, or undesirable ex ante