The impact of fiscal decentralization and the soft budget constraint on the local government debt

Essay, 2019

27 Pages, Grade: A


Table of contents

1. Research Objective

2. Literature review
2.1 Definition of basic concepts
2.1.1 Local government debt
2.1.2 Fiscal decentralization
2.1.3 Soft budget constraint
2.2 The scale of local government debt
2.3 Fiscal decentralization and the scale of local government debt

3. Research Gaps

4. Short statement listing other planned sections within the literature review chapter

5. Methodology
5.1 Variable definition
5.1.1 Size of local government debt (DEBT).
5.1.2 Financial decentralization indicators (FD).
5.1.3 SBC.
5.1.4 Control variables.

4.2 Data sources
4.3 Dynamic panel model
4.3.1 Model setting
4.4 Panel threshold model
4.4.1 Model settings Settings for the model
4..4.1.2 Model estimation method

8. References

1. Research Objective

Due to the linkage between economic growth and the fiscal decentralization, the expansion in the local government debt is closely related to the fiscal decentralization and the SBC – the expectation that the local governments would be bailed out by the central government if they face debt challenges. Based on the literature fiscal decentralization is linked to local government debts as literature indicates that fiscal decentralization leads to the decentralization of the expenditure without the revenue collection powers. The Chinese local governments have increased expenditure budgets on public services but the powers of taxation are centralized. To bridge the revenue gaps, the local governments take up debts that are sunk into infrastructure and other low revenue generating investments. Soft budget constraints are thus a product of fiscal decentralization as they are based on the principal – agent relationship between the politicians and the voters, central government and local government and the local governments and the SOEs within the local jurisdictions. The paper explores two main research objects. They are shown below:

RQ 1: To study the impacts of fiscal decentralization and soft budget constraint on the scale of local government debts

In exploring the research question two main research hypothesis will be tested.

Hypothesis 1: fiscal decentralization has a positive impacts on the scale of local government debt

Hypothesis 2: soft budget constraint has a positive impacts on the scale of local government debt

Research question 2: Study the effect of soft budget constraint on the scale of local government debt under the different extent of fiscal decentralization.

2. Literature review

2.1 Definition of basic concepts

2.1.1 Local government debt

Local government debt has a broad meaning in the existing literature. The local government debts are defined as the debts by the government, public utilities, financing platforms as well as the debts incurred by the government departments and institutions including the state owned enterprises (SOEs). Local government debt can be divided into four main classes; the explicit direct debts, the explicit contingent debts, explicit contingent debts and the implicit direct debts. The local government debts are shown in the Table 1 below.

Table 2.1: Explanations and definitions of debtors

Abbildung in dieser Leseprobe nicht enthalten

Source: author generated.

2.1.2 Fiscal decentralization

Fiscal decentralization is a concept that has been adopted by many nations as a means of enhancing the efficiency of economic growth. Fiscal decentralization first generation definition is considered to be a positive and active role taken by the government as a means of correcting the existing market failures, establishing frameworks for the equitable income distribution and the stabilization of the macro-economy (Oates, 2014). The main assumption is that the government agencies who are the custodians of the interest of the public will focus on the maximization of the social welfare through forces such as their benevolence (in autocratic nations) or electoral pressure in the nations that follow democratic principles. The other assumption in the definition is that political stability in the nation-state would provide the appropriate context for the application of the theory (Quian and Weingast, 1997). Based on the above premises Oates (2005) defined fiscal decentralization as the transfer of responsibility and authority for various public functions from the central government (federal government) to the quasi-independent or subordinate organizations as well as to the private sector.

The second generation of the definition on the other hand focus on the politics and history as opposed to economics. As indicted by Oates (2005), the second generation fiscal decentralization focus on the workings of fiscal and political institutions in a setting with imperfect control and information. The view is that majority of the fiscal decentralization efforts have shifted the financial resources to the lower government levels but have failed to decentralize the local government’s discretion to manage the decentralized resources. In this perspective, decentralization is closely tied to the poverty reduction and governance as reflection in the definition by Bahl and Martinez-Vazquez (2013) who stated that fiscal decentralization entails empowering the people through the empowerment of the local governments.

2.1.3 Soft budget constraint

Soft budget constraint is an economic concept that was first conceived by Kornai (1979) in offering an explanation to the phenomenon where the government is engaged in continuous rescues of the state owned enterprises (SOEs) that rare facing losses under the planned economic systems of socialist governments. Park (2016) in a review of the soft budget constraints in South Korea noted that soft budget constraints is a concept that reflects on the existing social relationship between the organization that expects the assistance and the organization that is willing to help. Soft budget constraints are thus based on the principal – agent relationship between the politicians and the voters. Kornai (1979) noted that the term alludes to the situation where a firm that is loss making is assisted or bailed out by another institution, bank or the government. The expectation of the manager of the firm is that a rescue will be forthcoming when there are signs of trouble; thus such an expectation is a critical factor that affect the behavior of the firm. Vahabi (2011) noted that soft budget constraint a concept first developed by Janos Kornai was aimed at explaining the micro-foundation of the shortage economics as being a normal occurrence in socialist economic systems. Vahabi (2011, p. 1) noted that the concept refers to “ex-port bailout” of firms in paternalistic state which are loss making. Scholars have explored the concept especially beginning in the 1970’s to explore whether SBC should remain to be considered as a macroeconomic concept or it is a form of redistribute policy in macroeconomics aimed at ensuring wage and job security. In Anti-equilibrium, the explanation of soft-budget constraint offered by Kornai (1971 as cited in Vahabi, 2011) was based on the macroeconomic policy of the state as opposed to the firm’s socialist behavior. However, the view by Kornai radically changed as the seminal paper of Kornai (1979) indicated a movement of the explanation of SBC that appeared to favor the microeconomic explanation as opposed to macroeconomics as a means of aligning his thoughts with the dominant economics trends of the late 70s and 80s. Even though the concept of SBC was not accepted in the standard microeconomics standards at the time, the concept has gained significant growth in the last couple of years; particularly the 1990s. Dewatripont and Maskin (1995) time inconsistency game theoretical model, was one of the first indicators of the movement, as they explored the concept in the first formal study. Based on the endogenous explanations such as that of Dewatripont and Maskin (1995), where SBC was analyzed as being an outcome of the softening institutions internal interests. From such a perspective, the budget constraint degree is based on rational choices made by the maximizing agent. However, researchers such as Vahabi (2011) have explored what happens when the SBC concept is reformulated in the new microeconomics terms by exploring whether the concept aligns with the disequilibrium or non-Walrasian macroeconomics. In the previous work by Kornai (1979), the concept of SBC is discussed in terms of the markets generate state thus invalidating the Walra’s Law. This can explain why the eminent proponents of institutional (exogenous) and formal (endogenous) theories of soft budget constraints have remained silent on the various macro-economic implications of SBC’s particularly with regards to the Walra’s Law (Kornai, Maskin, and Roland, 2003).

Despite the great progress made over the last few decades with regards to the theoretical explanation of the soft budget constraint syndrome, the empirical research on the various SBC determinants is still not well explored (Bignebat and Gouret, 2008).

2.2 The scale of local government debt

A significant amount of literature has explored the scale of local government debt in China. Breslin (2014) noted that the reappearance of substantial debt in China after the global financial crisis (GFC) of 2008 has brought to the fore the concerns about the re-emergence of bank-centered debt in the country. Before the GFC, China has spent significant amounts of resources in the clearing up of the non-performing loans as well as bad debts accrued by the local governments. Despite the fact that the public finances of the national government have been in a strong position, the local government finances have faced massive stress in the last couple of years. The rise in the local government debt can be traced to the mismatch between the local expenditure and responsibilities with the revenues. The fiscal decentralization in China decentralized expenditure but did not effectively decentralize the revenue collection especially the power to collect taxes. The local governments in China massively rely on the central government transfers as well as local charges and fees. Based on the Budget Law passed in 1994, the local governments were prohibited from borrowing. However, the ability to borrow was returned in late 2014 due to the passage of the new Budget Law. In practice, the local governments have been engaged in significant borrowing through the SEOs and other off-budget mechanisms. In the past, the government ignored the clandestine borrowing by the local governments but also encouraged it as a means of ensuring infrastructure development. Two investigations have been undertaken by the National Audit Office (NAO) in 2011 and then in 2013 (Breslin, 2014). Between the audits by NAO, there was an experimentation period where the central government allowed 4 city governments to issue their own bonds.

In the recent years, the composition, size, as well as the utilization of local government debts have gained significant attention worldwide (Ma, 2013). The majority of the research has focused on the local government debt sizes and the various macroeconomic risks that such debts carry.

Even though the Budget Law of 1994 and the Guarantee Law of 1995 both forbid the local governments from taking debt, the NAO (2011) reported that at the end of 1996, 86 per cent of the county governments, 90 per cent of the prefecture governments and all the provincial governments had acquired new debts (Breslin, 2014). As at 2010, 46 per cent of all the counties in China had been involved in the borrowing of debt. As at 1998, the local government debts stood at 6 per cent of the China’s GDP (Breslin, 2014). The onset of the global financial crisis in 2008 also led to the introduction of massive fiscal stimulus packages that led to the increase of the local government debt. The local government debt increased from 6 per cent of the GDP in 1998 to 27 per cent of the GDP in 2010 and to 35 per cent in 2012. However, the estimation by some scholars is that the local government debt as at 2012 was approximately 55 per cent of the GDP. Based on the findings of the National Audit Office in 2011, the local government debt stood at RMB 10.717 trillion. By 2013, the NAO noted that the local government debt had risen to RMB 17.9 trillion (Niu, 2013). Further, the research by Ma (2013) noted that due to the differences in the financial transfers to the regions, some regions experience greater local government debts as compared to others.

2.3 Fiscal decentralization and the scale of local government debt

Fiscal decentralization main feature is the competition between local governments. The extant literature on the local government completion under fiscal decentralization consists of both the completion between the local government and the central (federal) government and the competition between the local governments. The literature on the former consists of various aspects such as the effects of the competition of the local governments on the economic development. Research undertaken by Edmark and Agren (2008) concluded that the local government competition promotes economic growth. However, an earlier research undertaken by Fleischmann and Green (1991) argued that the local government competition for economic development would have negative impacts on the economic development; partly due to the consequence on the resource allocation efficiency unless all the local governments adopt a similar economic development trajectory. In such a case, the competition between the local governments will lead to a zero-sum game.


Excerpt out of 27 pages


The impact of fiscal decentralization and the soft budget constraint on the local government debt
University of Nairobi  (School of Business)
PhD Economics
Catalog Number
ISBN (eBook)
ISBN (Book)
SBC, Fiscal Decentralization, local government debt, Chin
Quote paper
David Onditi (Author), 2019, The impact of fiscal decentralization and the soft budget constraint on the local government debt, Munich, GRIN Verlag,


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