arrangement in which the public good is only locally consumed, the federal government is con-
cerned about the allocation of public consumption across states, and both levels of government
levy distortionary taxes.
The analysis also adds to the literature on soft budget constraints - see Kornai et al. (2003)
for a review.12 Formally elaborated by Dewatripont and Maskin (1995), a missing commitment
ability by the government lies at the root of the soft budget constraint phenomenon. Enterprises
form expectations that they will be bailed-out in case of insolvency which results in sub-optimal
investment choices. Wildasin (1997) shows that when applied to fiscal federalism, bail-out ex-
pectations equally distort local policy. In order to qualify for a bail-out local government may
sub-optimally choose local expenditures.13 The current paper demonstrates that such strategic
local incentives may well improve the efficiency of public good provision. The expectation of
qualifying for federal funds in response to local taxation serves as a countervailing incentive to
engage in a “race to the bottom” in tax competition.
3 The Model
We consider a model with 2 identical states. State i (i = 1, 2) consists of a representative
household and a representative firm. The former derives utility from a private good ci , leisure
`i , and a local public good gi . Preferences are
U ( ci,ti,gi ) = ci + h ( ' )+ b ( g ),
et al. (2004) but in contrast to this paper, the federal government does not have access to a tax instrument. The
federal transfer scheme is required to be self-financing.
12See Akai and Sato (2005) for a synthesis of the largely disconnected strands of literature on common agency
(alternatively referred to as decentralized leadership) and soft-budget constraints.
13Qian and Roland (1998) analyze how soft local budget constraints affect incentives to bail-out failing enter-
prises. In line with Wildasin (1997) they find local governments to spend less on local public consumption out
of own resources in an attempt to lure more transfers to their budget. Deducing the impact on overall welfare,
the disincentive effect needs to be weighted against the potential benefit of providing less (ex-ante) inefficient
bail-outs.