Dynamic Commitment and the Soft Budget Constraint: An Empirical Test
23 Pages Posted: 25 May 2007
Date Written: May 3, 2007
This paper empirically tests whether the soft budget constraint is caused by a dynamic commitment problem, i.e., the inability of a supporting organization to commit itself not to extend more resources ex post to a budget-constrained organization than it was prepared to provide ex ante. It uses Swedish local governments as a testing ground since the central government provided 1,414 discretionary intergovernmental fiscal transfers over the period 1979-1992. The estimated soft-budget effect is substantial, on average; a local government increases its debt by 20 percent of going from a hard to a soft budget constraint.
Keywords: Dynamic commitment, credibility, rational expectations, intergovernmental fiscal transfers, instrumental variable strategies
JEL Classification: D78, D84, D99, H74, H77
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