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Decentralization and Overborrowing in a Fiscal Federation

Si Guo, Yun Pei () and Zoe Xie
Additional contact information
Si Guo: International Monetary Fund
Zoe Xie: Federal Reserve Bank of Atlanta

No 1229, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: 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 government’s fiscal gap, borrowings by both local and central governments rise. Quantitatively, fiscal decentralization accounts for 19–40% 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% and raise welfare by 3.75%.

Date: 2019
New Economics Papers: this item is included in nep-dge, nep-mac and nep-ure
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