Hamilton's Paradox: The Promise and Peril of Fiscal Federalism

Cambridge Studies in Comparative Politics

by Jonathan A. Rodden

As new federations take shape and old ones are revived around the world, a difficult challenge is to create incentives for fiscal discipline. A key question is whether a politically-motivated central government can credibly commit not to bail out subnational governments in times of crisis if it funds most of their expenditures. By combining theory, quantitative analysis, and historical and contemporary case studies, this book provides a new perspective on why different countries have had dramatically different experiences with subnational fiscal discipline.

Genres: Economics, Political Science, Politics

336 pages, Paperback

First published January 1, 2005

Reviews

[Henry Schlechta · Rating 5 out of 5]

An extremely enlightening book that discusses the problems that federal countries face in decentralizing borrowing responsibility to the states when the center is expected to carry the burden of a default on the debt by bailing the state out. Rodden argues that federations can either place heavy limits on the ability of states to borrow, or refuse to bail out states which cannot pay their debts: however, the former may be difficult to do in the context of a federal system where powers are entrenched at the state level, while the latter requires the federal government to credibly commit to not bail out states, even when they face heavy electoral pressure to. He also mentions the role that political parties play: disciplined political parties may be more effective at discouraging states from requesting bailouts when doing so would create a cost for all members of the said political party. This topic is somewhat underdeveloped in the section dealing with policy reccomendations, which is unfortunate given the seemingly important role it plays and the ability those designing constitutions have to influence party systems.

[Kevin_Raccoon · Rating 4 out of 5]

Although published in 2005 (with the quantitative regression analysis indeed not good), the book’s problem framing, analytical perspective, and policy insights remain entirely relevant today. One takeaway after reading it is that the classical solutions to the soft budget constraint problem in state-owned enterprises are difficult to apply to the issue of local government debt. As the book points out, even in most federal systems, local government debt typically carries an implicit guarantee from the central government. Cases such as Canada, Switzerland, and the United States—where the market partially recognizes a genuinely divided fiscal sovereignty—are exceedingly rare.
"A quick read of the dominant literature on fiscal federalism flowing from the optimistic legacy of The Federalist can lead to a mistaken notion that fiscal decentralization – especially when federal contracts and strong upper legislative chambers limit the center’s discretion – will lead to rapid improvements in the efficiency, accountability, and prudence of government. These notions implicitly assume American-style subnational tax autonomy and divided sovereignty."

[Christian]

Just started this comparative study of fiscal dynamics and institutional development in federal states, focusing on postwar Germany, Brazil, and the US.