Restricted Bailouts and the Commitment Problem in Federations

Standard models of soft budget constraints consider bailouts as pure monetary transfers. However, in practice often additional obligations or restrictions, such as savings goals, are linked to monetary bailouts. This paper analyzes in a model of a federation if such restrictions change economic outcomes in an soft budget constraint environment and under what circumstances they can increase welfare as compared to pure soft budget and hard budget regimes. We find that restrictions generally harden budget constraints, but not necessarily increase welfare. The evaluation crucially depends on the tax endowment of the central government and on the shape of preferences.