Fiscal Competition, Collusion and Soft Budget Constraints in a Federal Setup

There is a very close relationship between fiscal outcomes and politics. Politically motivated fiscal transfers routinely lead to bailouts creating soft budget constraints in a federation. This dissertation contributes to the literature by developing an analytical framework to model the endogenous formation of coalitions through collusion among government entities in both unbiased and biased contests, under either hard or soft budget constraints of the central government.;Three separate models are developed to analyze the competitive and collusive forces that lead to the raiding of the fiscal commons. Chapter 3 develops a model of collusion among sub-national regional entities in a federation (called horizontal coalitions) in a simultaneous choice open membership game, and Chapter 4 develops a model of collusion between the central government and a group of states (called vertical coalitions) in a dominant cartel formation game of d'Aspremont. Chapter 5 extends this analysis in a competitive general equilibrium model to incorporate collusion and moral hazard.;When regional governments collude to raid the commons, it is found that in a game without bias, the more concentrated the coalition structure, the greater are the payoffs. However, in politically biased contests, if the central government's budget constraint is hard, there are decreasing returns to coalition size. It is also found that poor fiscal incentives like a soft budget constraint of the central government or shorter time horizons (due to elections) of state governments lead to the formation of larger coalitions and greater fiscal raiding. This rent seeking behavior of sub-national governments in a federation leads to fiscal congestion and macroeconomic instability. In this situation, sub-national governments may decide to form coalitions to ensure fiscal responsibility so as to move the economy from a bad to a good equilibrium.;The underlying complex dynamics in a federal setup result in coalition formation generating both positive and negative externalities. The net effect of these externalities depends on three factors: the degree of political bias for the coalition, the effectiveness of the coalition and the idiosyncratic characteristics of dominant non-members. This also explains "Olsen's paradox", where despite seeing decreasing returns to coalition size, we still see the formation of coalitions in a federation as they are able to exploit externalities due to political bias.;It is also found that rebalance and redistribution considerations involving the use of lump sum non-discretionary fiscal transfers to sub-national governments create moral hazard. However, moral hazard is not universal. It is found that in low income states, greater fiscal transfers (greater "vertical imbalance") leads to greater fiscal profligacy and lower growth, while high income states use the increased resources to further capital accumulation and economic growth. Hence, in federal states, there is a tradeoff between equity and allocative efficiency that invariably creates difficult policy choices.