A dynamic model of fiscal decentralization and public debt accumulation

Keywords Fiscal decentralization; Public debt; Time-consistent policy; Soft budget constraint Highlights * A dynamic infinite-horizon model of fiscal federation is developed. * Relationships between transfer, debt, and fiscal decentralization are analyzed. * Framework is applied to study decentralization and debt in Spain during 1988-2006. Abstract This paper develops a dynamic infinite-horizon model with two layers of governments to study theoretically and quantitatively how fiscal decentralization affects local and central government debt accumulation and spending. In the model, the central government makes transfers to local governments to offset vertical and horizontal fiscal imbalances. But the anticipation of transfers lowers local governments' expected cost of borrowing and leads to overborrowing ex ante. Absent commitment, the central government over-transfers to reduce local governments' future need to borrow, and in the equilibrium both local and central debts are inefficiently high. Consistent with empirical evidence, when fiscal decentralization widens vertical fiscal imbalances, local governments become more reliant on transfers, and both local and central debts rise. Applied to Spain, the model explains 39 percent of the rise in total government debt when the vertical fiscal imbalances widened during 1988--1996, and 18 percent of the fall in debt when the imbalances narrowed during 1996--2006. Author Affiliation: (a) International Monetary Fund, United States (b) University at Buffalo, United States (c) World Bank and Federal Reserve Bank of Atlanta, United States * Corresponding author at: World Bank, 1818 H Street, NW Washington, DC 20433, United States. Article History: Received 14 January 2021; Revised 30 May 2022; Accepted 2 June 2022 (footnote)[white star] The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, IMF management, the Federal Reserve System, the Federal Reserve Banks, the IBRD/World Bank or its executive directors. Byline: Si Guo [sguo@imf.org] (a), Yun Pei [yunpei@buffalo.edu] (b), Zoe Xie [lxie@worldbank.org] (c,*)