Two-Instrument Screening under Soft Budget Constraints

TL;DR

This paper develops a unified theoretical framework for understanding soft budget constraints in multi-tier public finance, focusing on the use of two instruments and their implications for policy and mechanism design.

Contribution

It introduces a one-dimensional screening model with a single allocation index, providing a comprehensive rule that encompasses various bailout regimes and offers testable policy implications.

Findings

The model simplifies to a single index: the cap on realized rescue.

A hazard-based rule characterizes different bailout regimes.

Greater curvature tightens caps and shifts transfers toward front loading.

Abstract

We study soft budget constraints in multi-tier public finance when an upper-tier government uses two instruments: an ex-ante grant schedule and an ex-post rescue. Under convex rescue costs and standard primitives, the three-stage leader-follower problem collapses to one dimensional screening with a single allocation index: the cap on realized rescue. A hazard-based characterization delivers a unified rule that nests (i) no rescue, (ii) a threshold-cap with commitment, and (iii) a threshold--linear--cap without commitment. The knife-edge for eliminating bailouts compares the marginal cost at the origin to the supremum of a virtual weight, and the comparative statics show how greater curvature tightens caps while discretion shifts transfers toward front loading by lowering the effective grant weight. The framework provides a portable benchmark for mechanism design and yields testable implications for policy and empirical work on intergovernmental finance.