Abstract
Earmarked federal grants are ubiquitous and significant. Traditional fiscal federalism is unable to explain these grants’ widespread utilization. Recent arguments focusing on the potential benefits of centralized earmarking in reducing incentives for the creation of soft budgets at subcentral government levels merit formalization. I show that universal earmarking improves the efficiency of a federation in which regional governments are able to commit to provision of all regional public goods. However, efficient earmarking need not be universal: It should only involve private consumption and fiscal budgets for public goods subject to decentralized fiscal commitments.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Source: OECD Fiscal Decentralization database.
This is clearly explained in Oates (2005), which provides an excellent review of the fiscal federalism literature. It includes an overview of the traditional viewpoints that emerged from the first-generation theory of fiscal federalism and the new viewpoints that have been emerging with the second-generation theory of fiscal federalism. The literature that studies the incentives that create soft budget constraints is one of the branches that advance new thinking on fiscal federalism.
Lotz (2013) also makes a similar observation based on cost-efficiency terms.
The analysis here assumes complete information and does not consider political economy issues. Furthermore, the model assumes that regional public goods do not produce interregional spillovers. Hence, earmarked grants cannot possibly be justified in terms of Pigouvian correction incentives.
It is straightforward to show that the subgame perfect equilibrium for the sequential game in which the center is the Stackelberg leader and the regional governments are the Stackelberg followers is isomorphic to the simultaneous Nash equilibrium considered in the text.
As correctly pointed out by a reviewer, the redistributive constraints (4e) and (4f) are a particular case of a federal redistributive grant system in which the federal government faces the following constraint on federal grants: \({\sum \nolimits _{j=1}^{J}} {s_{c,j} } ={\sum \nolimits _{j=1}^{J}} {{\sum \nolimits _{l=1}^{L}} {s_{l,j} } } \). Under this federal system, the federal government would have the ability to allocate dollars across all programs (private consumption and public consumption) that are controlled by the federal government for equalization purposes. We rule out this grandiose federal system in the analysis for the following two reasons: (i) the grandiose system implies that the federal government is ultimately able to not only equalize expenditure levels per program but also determine the level of final expenditures in each program; and (ii) the restrictive system implied by conditions (4e) and (4f) is the one in which the federal government plays the most limited role in inducing the regional governments to behave efficiently.
In principle, different regional governments may have different abilities to commit to provision of regional public goods. It is, therefore, possible that some regional governments are able to commit more credibly to the provision of some public goods than some other regional governments. For simplicity and to keep the model as symmetric as possible, the case examined in this paper is restricted to a situation in which all regional governments face the same constraint on the ability of making credible commitments.
References
Akai, N., & Sato, M. (2008). Too big or too small? A synthetic view of the commitment problem of interregional transfers. Journal of Urban Economics, 64, 551–559.
Baskaran, T. (2012). Soft budget constraints and strategic interactions in subnational borrowing: Evidence from the German states, 1975–2005. Journal of Urban Economics, 71, 114–127.
Bird, R. M., Ebel, R. D., & Wallich, C. I. (1995). Fiscal decentralization: From command to market. In R. M. Bird, R. D. Ebel, & C. I. Wallich (Eds.), Decentralization of the socialist state: Intergovernmental finance in transition economies (pp. 1–68). Washington, DC: The World Bank.
Blöchliger, H. (2013). Measuring decentralization: The OECD fiscal decentralization database. In J. Kim, J. Lotz, & H. Blöchliger (Eds.), Measuring fiscal decentralisation: Concepts and policies. Paris: OECD Publishing.
Boadway, R. (2004). The theory and practice of equalization. CESIfo Economic Studies, 50, 211–254.
Breuillé, M.-L., Madiès, T., & Taugourdeau, E. (2006). Does tax competition soften regional budget constraint? Economics Letters, 90, 230–236.
Breuillé, M.-L., Madiès, T., & Taugourdeau, E. (2010). Gross versus net equalization scheme in a federation with decentralized leadership. Journal of Urban Economics, 68, 205–214.
Breuillé, M.-L., & Vigneault, M. (2010). Overlapping soft budget constraints. Journal of Urban Economics, 67, 259–269.
Buettner, T., & Wildasin, D. E. (2006). The dynamics of municipal fiscal adjustment. Journal of Public Economics, 90, 1115–1132.
Caplan, A., Cornes, R., & Silva, E. C. D. (2000). Pure public goods and income redistribution in a federation with decentralized leadership and imperfect labor mobility. Journal of Public Economics, 77, 265–284.
Council of Europe, (1985). European charter of local self government. European Treaty Series No. 122. Strasbourg.
Crivelli, E., & Staal, K. (2013). Size, spillovers and soft budget constraints. International Tax and Public Finance, 20, 338–356.
Goodspeed, T. J. (2002). Bailouts in a federation. International Tax and Public Finance, 9, 409–421.
Kornai, J., Maskin, E., & Roland, G. (2003). Understanding the soft budget constraint. Journal of Economic Literature, 41, 1095–1136.
Lotz, J. (2013). On grant policy and the OECD-taxonomy of grants. In J. Kim, J. Lotz, & H. Blöchliger (Eds.), Measuring fiscal decentralisation: Concepts and policies. Paris: OECD Publishing.
Oates, W. E. (2005). Toward a second-generation theory of fiscal federalism. International Tax and Public Finance, 12, 349–373.
Pettersson-Lidbom, P. (2009). Dynamic commitment and the soft budget constraint: An empirical test. American Economic Journal: Economic Policy, 2, 154–179.
Prud’homme, R. (1995). The dangers of decentralization. The World Bank Research Observer, 10, 201–220.
Qian, Y., & Roland, G. (1998). Federalism and the soft budget constraint. American Economic Review, 88, 1143–1162.
Robinson, J. A., & Torvik, R. (2009). A political economy theory of the soft budget constraint. European Economic Review, 53, 786–798.
Rodden, J., Eskeland, G. S., & Litvack, J. (2003). Fiscal decentralization and the challenge of hard budget constraints. Cambridge, MA: MIT Press.
Silva, E. C. D. (2014). Selective decentralized leadership. Journal of Urban Economics, 83, 1–5.
Silva, E. C. D., & Caplan, A. J. (1997). Transboundary pollution control in federal systems. Journal of Environmental Economics and Management, 34, 173–186.
Silva, E. C. D., & Yamaguchi, C. (2010). Interregional competition, spillovers and attachment in a federation. Journal of Urban Economics, 67, 219–225.
Smart, M., & Bird, R. M. (2009). Earmarked grants and accountability in government. In J. Kim, J. Lotz, & N. J. Mau (Eds.), General grants versus earmarked grants. Copenhagen: Korea Institute of Public Finance and Danish Ministry of Interior and Health.
Tanzi, V. (1996). Fiscal federalism and decentralization: A review of some efficiency and macroeconomic aspects. In M. Bruno & B. Pleskovic (Eds.), Annual World Bank conference on development economics (pp. 295–316). Washington, DC: The World Bank.
Wildasin, D. E. (1997). Externalities and bailouts: Hard and soft budget constraints in intergovernmental fiscal relations (vol. 1843). Working paper. Washington, DC: The World Bank.
Acknowledgments
I would like to thank two referees that provided excellent comments and suggestions for improvement and also thank to those who provided comments during my presentation at the IIPF 2014 conference. Any error, however, is solely my own.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Silva, E.C.D. Efficient earmarking under decentralized fiscal commitments. Int Tax Public Finance 22, 683–701 (2015). https://doi.org/10.1007/s10797-015-9365-0
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10797-015-9365-0