Decentralization and Overborrowing in a Fiscal Federation

Si Guo, Yun Pei, and Zoe Xie
Working Paper 2018-9
August 2018

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We build an infinite horizon equilibrium model of fiscal federation, where anticipation of transfers from the central government creates incentives for local governments to overborrow. Absent commitment, the central government over-transfers, which distorts the central-local distribution of resources. Applying the model to fiscal decentralization, we find when decentralization widens local governments’ fiscal gap, borrowings by both local and central governments rise. Quantitatively, fiscal decentralization accounts for from 19 percent to 40 percent of changes in general government debt in Spain during 1988–2006. A macroprudential tax on local borrowing that implements Pareto optimal allocation would reduce debt by 27 percent and raise welfare by 3.75 percent.

JEL classification: E61, E62, H74

Key words: fiscal federalism, time-consistent policy, decentralization, public debt

The authors thank Luc Eyraud and Lusine Lusinyan for sharing their data set. This paper was previously titled "Fiscal Decentralization, Intergovernmental Transfer, and Overborrowing." This paper has benefited from discussions with Jinhui Bai, Toni Braun, Yongsung Chang, Lei Fang, Galina Hale, Juan Carlos Hatchondo, Jonathan Heathcote, Roozbeh Hosseini, Zhen Huo, Anastasios Karantounias, Karen Kopecky, Federico Mandelman, Fernando Martin, Toshihiko Mukoyama, and Juan Rubio-Ramirez. They also thank seminar and conference participants and discussants at the Atlanta Fed, Fed Research Scrum (San Francisco), Tsinghua Macro Workshop 2018, Econometric Society Summer Meetings (Davis), and the Society of Economic Dynamics (Mexico City). The views expressed here are the authors’ and not necessarily those of the International Monetary Fund (IMF), its executive board, IMF management, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Si Guo, International Monetary Fund, 700 19th Street NW, Washington DC 20431,; Yun Pei, Department of Economics, University at Buffalo, 415 Fronczak Hall, Buffalo, NY 14260,; or Zoe Xie, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470,
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