Central Control of Regional Budgets : Theory with Applications to Russia

Motivated by the Russian experience, this paper examines the implications of imposing central control on the budgetary activities of a subnational government. In a multi-task principal-agent model, the center cannot monitor directly the informal budgetary operations of a region, but it can exert control over a formal regional budget and impose limited costs on informal behavior. Imperfect control of subnational budgets may increase social welfare but only at the expense of higher taxation, lower output, and a strong orientation of regional policies toward rent-seeking. Imposing costs on regions may be counterproductive, particularly in the presence of corruption