Fiscal Competition, Collusion and Soft Budget Constraints in a Federal Setup
Open AccessThere is a very close relationship between fiscal outcomes and politics. Politically motivated fiscal transfers routinely lead to bailouts creating soft budget constraints in a federation. This dissertation contributes to the literature by developing an analytical framework to model the endogenous formation of coalitions through collusion among government entities in both unbiased and biased contests, under either a hard or soft budget constraint of the central government.Three separate models are developed to analyze the competitive and collusive forces that lead to the raiding of the fiscal commons. Chapter 3 develops a model of collusion among sub-national regional entities in a federation (called horizontal coalitions) in a simultaneous choice open membership game, and Chapter 4 develops a model of collusion between the central government and a group of states (called vertical coalitions) in a dominant cartel formation game of d'Aspremont. Chapter 5 extends this analysis in a competitive general equilibrium model to incorporate collusion and moral hazard. When regional governments collude to raid the commons, it is found that in a game without bias, the grand coalition is the equilibrium outcome of the game. However, if there is political bias in contests, there are decreasing returns to coalition size. The rent seeking behavior of sub-national governments in a federation leads to fiscal congestion and macroeconomic instability. When this happens, sub-national governments may decide to form coalitions to ensure fiscal responsibility so as to move the economy from a bad to a good equilibrium. The underlying complex dynamics in a federal setup result in coalition formation generating both positive and negative externalities. The net effect of these externalities depends on three factors: the degree of political bias for the coalition, the effectiveness of the coalition and the idiosyncratic characteristics of dominant non-members. It is also seen that central fiscal transfers to rebalance and redistribute incomes among sub-national units creates moral hazard. Moral hazard is greater for low income states, where the degree of vertical imbalance is greater, as compared to high income states. Hence, in federal states, there is a tradeoff between equity and allocative efficiency that invariably creates difficult policy choices.
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