Too big or too small? A synthetic view of the commitment problem of interregional transfers

Abstract

There is a growing body of literature on the commitment problem of interregional transfers. The problem occurs because of an ex post bailout by a central government leading to ex ante adverse incentive consequences for a local government. However, different models have yielded different economic consequences. The local government may be too large, overspending and/or overborrowing, or it may be too small, raising less of its own revenue. In the presence of interregional spillovers, the equilibrium may yield a Pareto-efficient outcome. The present paper aims to synthesize these models, developing a simple decentralized leadership model. A critical question concerns what decision is made ex ante by the local government--namely public expenditure or tax collection--with the remaining policy instrument being residual adjusted by ex post transfers. We discuss how different scenarios affect the equilibrium outcome.