Bailouts in a Federation Revisited: Budget Pooling, Rather Than Soft Budgets, Causes Inefficiency

Abstract This study revisits bailouts in a federation by investigating whether soft budget constraints cause inefficient bailouts. Many studies have examined bailouts in public finance, wherein a federal government provides excessive financial support to regional governments after the need for loss compensation arises. We show that, within the framework of Goodspeed (2002, International Tax and Public Finance, 9(4), 409--421), inefficient bailouts arise from budget pooling rather than the lack of commitment associated with intertemporal inconsistency. Specifically, under budget pooling, the federal government balances aggregate revenues and expenditures across regional governments rather than separately balancing each regional government's budget. If the tax revenue from the regional government is spent only on the public goods in the region, no bailouts occur. As such, distinguishing between soft budget constraints and budget pooling improves our understanding of the mechanisms generating inefficient federal bailouts. JEL Classification: H72 , H74 , H77 , O23