This paper investigates how the soft-budget constraint with grants from the central government to local governments tends to internalize the vertical externality of local public investment by stimulating local expenditure when both the central and local governments impose taxes on the same economic activities financed by public investment. The model incorporates the local governments' rent-seeking activities in a multi-government setting. The soft-budget constraint is welfare deteriorating because it stimulates rent-seeking activities, although a soft-budget game may attain the first-best level of public investment.