Externalities and Bailouts: Hard and Soft Budget Constraints in Intergovernmental Fiscal Relations

Central government matching grants can, in principle, induce socially- efficient provision of local public goods that produce spillover benefits. Local underprovision of public goods may however elicit direct central-government provision and finance (a ``bailout") that makes local residents better off than under grant-subsidized local provision; local underprovision that induces bailouts reveals the local budget constraint to be ``soft." Simulations suggest that the ability of a locality to extract a welfare-improving bailout depends positively on its size: budget constraints are more likely to be ``hard" for small localities.