Size, spillovers and soft budget constraints

In 1992, ordinary regions spent 71 % of their total resources on health services. Almost 96 % of their revenues came from central government (matching) grants (Von Hagen et al. 2000).

This relief program was not part of a regular intergovernmental transfer scheme (Von Hagen et al. 2000).

Bailout episodes during the 1990s include the provinces of Jujuy, La Rioja, Tucuman, Catamarca, Corrientes, Santiago del Estero, and Rio Negro that are the smallest in terms of population if we exclude the extremely sparsely populated and oil producing provinces in Patagonia in the south of the country. Moreover, these provinces together represent less than 13 % of the total population and less than 10 % of national GDP.

It is important to point out that we are not interested in episodes of generalized bailouts like, for example, the rescue operation implemented by the federal government in Mexico early after the financial crisis in December 1994 which included extraordinary transfers to all state governments. Another example is Brazil, where the federal government assumed all state and municipal debt in 1993 and 1997 (Dillinger and Webb 1999). Moreover, note that the recent fiscal crisis faced by the city of Philadelphia in the US in 1990 cannot be considered as a case of bailout since the fiscal cost of the crisis was mainly internalized by its residents living with reduced public services, additional sales tax, and city workers facing a wage freeze and a reduction in employee benefits (Inman 1995).

This decision making process is similar to the one studied by Caplan et al. (2000) when they look at a federation with centralized leadership and immobile residents.

Recent literature on soft budget constraints and bailouts also include: Qian and Roland (1998), Inman (2001), Sanguinetti and Tommasi (2004) and Breuille et al. (2006). See also Kornai (1986), who introduces the discussion on soft budget constraints in the study of state-owned enterprises, Dewatripont and Maskin (1995) for soft budget constraints in a credit model and Maskin (1999) for a survey.

In another related paper, Goodspeed (2002) writes that it is not clear whether small districts are more likely to induce bailouts.

See, for example, Besley and Coate (2003) who work with a model in which individuals differ in their preferences over public good provision. Feidler and Staal (2012) show that district size can be seen as a proxy for this heterogeneity in preferences.

That is, individuals in jurisdiction k≠i would solve