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Rodden. 2002. The dilemma of fiscal federalism: Grant and fiscal performance around the world. American journal of political science 46 (July): 670-687.

In Brief

Roughly, this is the general problem Rodden deals with: If the central government transfers lots of grants/subsidies to the regions 'and' the regions can take on external debt on their own, then the regions will take out loans to effectively force the center to increase its payout to that region--because, if the center doesn't doesn't send more money to the region, the region goes bankrupt (as a result of the loans) and won't be able to continue providing schools and other services, which would result in unrest and anger at the central government. Thus, having just one of these two variables (transfers from the centers or regions that can independently take on external debt), you're fine (because having no transfers but freedom to take on debt means that the region's voters will hold their regional leaders accountable for bad fiscal policy; and having transfers but no loans keeps region from going into debt in the first place), but having both creates the problem. Federations are more likely than nonfederations to have both these variables.

Variables

• X: "fiscal and political institutions": whether regions depend on center for revenue (instead of imposing regional taxes) and whether regions can take on external debt
• Y: "fiscal performance of subnational governments"

Hypotheses

'Y' is balanced in the long term when either

• "the center imposes borrowing restrictions"
• or "subnational governments have both wide-ranging taxing and borrowing autonomy."

'Y' will be persistent deficits when "subnational govts are simultaneously dependent on intergovernmental transfers and free to borrow--a combination found most frequently among constituent units in federations."

Policy Implications

You could either stop transfers or stop external debt. But since the center can't credibly commit to stop transferring money (cutting off services), you're more likely to see the center trying to limit regions from taking on external debt.