CIRJE-F-391. Akai, Nobuo and Motohiro Sato, "Decentralized leadership meets soft budget", December 2005.

The objectives of the present paper are twofold. First, we aim to synthesize the two strands of the literature on the incentive effect of intergovernmental transfers, the decentralized leadership and the soft budget problem both of which address the discretionary nature of the central transfer policy. We develop a simple decentralized leadership model in which the local governments move first and the central government transfer scheme is decided ex post. The ex post discretion of transfer by the central government pursuing social welfare distorts the ex ante incentive of the local governments, inducing the strategic action of the latter government. This paper also shows that the direction of the ex ante distortion moral hazard problem relies on what decision is made ex ante by type of authority is given to the local government, namely public expenditure or tax collection ex ante. Second we examine the robustness of the incentive problem. The benchmark model incorporates spillovers and is extended in several directions, including tax competition and distortionary taxes, and two period setting. The essence of the incentive problem remains the same.