Soft Budget constraint in Local Public Expenditure

Focusing on the fact that there exist many inefficient public projects that go into a deficit, we construct the model in which inefficiency is created endogenously from the centralized fiscal system in the local public finance. The model has the following two characteristics; incomplete information between the central government and the local government with respect to the cost of the public project and incomplete contract between the central government and the local government. Incomplete contract creates the soft budget of the local government, that is, when the local government faces the deficit from the public project, it is ex post efficient for the central government to bail the local government out and supply the subsidy to cover the deficit. Under this situation, we derive the following two results. First, incomplete information and incomplete contract between the central government and the local government creates the adverse selection problem, which is related to inefficiency, through the soft budget of the local government. This represents the reason why the inefficient excessive project with the deficit appears. Second, we show that if the incentive scheme is not designed under the existence of incomplete information and incomplete contract, the second best policy leads to the uniform public expenditure among local regions, which corresponds to the realistic situation.