Soft Budget Constraints as a Risk Sharing Arrangement in an Economic Federation

We analyze a model where the federal government provides risk sharing arrangements to municipalities investing in a local public good. The risk sharing arrangements are an income equalization system and a system allowing for a soft budget constraint, i.e., a bailout. Our main result is that a bailout system in combination with income equalization can be a more efficient risk sharing arrangement than an income equalization system only. Thus, the introduction of a bailout system is welfare improving.