Scandinavian Working Papers in Economics

Working Paper Series,
Uppsala University, Department of Economics

No 2006:5: Soft Budget Constraints as a Risk Sharing Arrangement in an Economic Federation

Erica Lindahl () and Andreas Westermark ()
Additional contact information
Erica Lindahl: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden
Andreas Westermark: Department of Economics, Postal: Department of Economics, Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden

Abstract: We analyze a model where the federal government provides risk sharing arrangements to municipalities investing in a local public good. The risk sharing arrangements are an income equalization system and a system allowing for a soft budget constraint, i.e., a bailout. Our main result is that a bailout system in combination with income equalization can be a more efficient risk sharing arrangement than an income equalization system only. Thus, the introduction of a bailout system is welfare improving.

Keywords: Bailout; Fiscal federalism

JEL-codes: H72; H77

22 pages, January 26, 2006

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