A Political Economy Theory of the
Soft Budget Constraint
(Preliminary - comments appreciated)
James A. Robinson∗and Ragnar Torvik†
October 18, 2004
Why do soft budget constraints exist and persist? The central ar-
gument in the literature is that soft budget constraints arise because
politicians cannot recognize bad projects ex ante, and cannot com-
mit not to refinance them ex post. In this paper we argue that the
prevalence of the soft budget constraint phenomenon can be best ex-
plained by the political desirability of softness. We develop a political
economy model of the soft budget constraint where politicians can-
not commit to policies that are not ex post optimal. We show that
because of the dynamic commitment problem inherent in the soft bud-
get constraint, politicians can in essence commit to make transfers to
entrepreneurs which other wise they would not be able to do. This en-
courages such entrepreneurs to vote for them. Though the soft budget
constraint may induce economic inefficiency, it may be politically ra-
tional because it influences the outcomes of elections. In consequence,
even when information is complete, politicians may fund bad projects
which they anticipate they will have to bail out in the future.
Keywords: Political Economy. Investment. Development.
JEL: H20, H50,O20
∗Harvard University, Department of Government, Littauer, 1875 Cambridge St., Cam-
bridge MA02138. E-mail: firstname.lastname@example.org.
†Norwegian University of Science and Technology, Department of Economics, Dragvoll,
N-7491 Trondheim, Norway. E-mail: email@example.com
Traditional policy analysis in the tradition of Pigou (1920) and Samuelson
(1954) saw policymakers as designing policies to solve market failures, or
satisfy normative criteria, subject only to the availability of resources and
the nature of preferences and technology. In the 1970’s economists began
to realize that even well intentioned planners were subject to other types of
constraints. Diamond and Mirrlees (1971) examined the nature of optimal
policies without lump-sum taxation, and Gibbard (1973) and Green and
Laffont (1979) argued that the incentive compatibility constraints generated
by private information had to be respected. Kydland and Prescott (1977)
also showed that optimal inter-temporal policies might be time inconsistent,
making it difficult for a planner to commit to even a second-best policy. In the
1980’s and 1990’s economists began to merge such ideas with models where
policymakers were self-interested and studied how the interaction between
such interests and social welfare led to further deviations from first or second-
These models have brought us much closer to an understanding of the
relationship between market failures and political failures. We have begun
to develop intuitions for the circumstances in which policy outcomes will
deviate from welfare optima and the types of phenomena that are typically
associated with political failure. For example, we now have well developed
political mechanisms which can account for why government’s redistribute
income using inefficient instruments.1
ideas about how political institutions help determine equilibrium policies.2
Yet many puzzles remain. A central, and fascinating one, is that of the
“soft budget constraint.” Originally introduced by Kornai (1979) in the con-
text of centrally planned economies, the basic notion is that governments and
policymakers are unable to impose a ‘hard’ budget constraint on government
owned enterprises or government agencies. In consequence such enterprises
or agencies have incentives to act in inefficient or profligate ways knowing
that they will be bailed out if things go wrong.
We also have carefully articulated
1See Coate and Morris (1995), Dixit, Grossman and Helpman (1997), Acemoglu and
Robinson (2001) and Drazen and (2004).
2See Persson, Roland and Tabellini (1997, 2000), Persson and Tabellini (2000, 2004).
Since its development, the problem of soft budget constraints has been
recognized to be endemic to all polities, though clearly being worse in de-
veloping economies. This recognition emerges from the fact that all scholars
note that soft budget constraints in Eastern Europe and the former Soviet
Republic proved more long lived that central planning. Maskin and Xu (2001,
p. 10) report that “considerable empirical work indicates that the soft budget
constraints syndrome continues to play an important role in virtually every
transition economy, even those that have already undergone many years of
reform”. Similarly, Kornai, Maskin and Roland (2003, p. 1114) note that
“Ironically, the transition experience suggests that soft budget constraints
have persisted amongst the economies of Eastern Europe in the initial phases
of transition, despite vigorous declarations on the need for hardening.”
Why do soft budget constraints exist and persist? The central argument
in the literature is that soft budget constraints arise because politicians can-
not commit not to refinance bad projects ex post and cannot distinguish bad
from good ex ante. Given that a project is launched, it will be refinanced as
long as benefits cover costs. Previous costs are sunk. Entrepreneurs know
this, and submit bad projects for financing in the first place. This is the
key argument in Dewatripont and Maskin (1995), which has become the
dominant model of soft budget constraints. This approach follows the liter-
ature which built on Kydland and Prescott (1977) where policymakers were
though of as well intentioned and thus downplays any political reason for
the existence of soft-budget constraints. Such an approach to understand-
ing the soft budget constraint is odd, because the overwhelming amount of
evidence strongly suggests the role of political motivations. For instance,
political scientists who have studied this topic, argue that the main reason
for soft budget constraints to persist is that soft budget constraints serve the
interests of politicians - this is precisely the reason they are not dismantled.
In this paper we develop a fully political economy model of the soft budget
constraint. Our starting point, following Alesina (1988), Osborne and Slivin-
ski (1996), and Besley and Coate (1997), is that politicians cannot commit
to policies that are not ex post optimal for them to adopt. This inability to
commit to arbitrary policies hampers the ability of politicians to exchange
policies for support, since voters do not necessarily believe election promises
(unlike in the basic Downsian model where perfect commitment is assumed).
Such a politically setting is the natural one if one accepts that the problem of
the soft-budget constraint is a problem of commitment. Instruments which
solve this credibility problem are therefore potentially attractive politically.
We argue that the key thing about the soft budget constraint is that, in ef-
fect, it is a credible way of transferring income to potential supporters. The
central observation is that because a policymaker cannot commit to enforce
a hard budget constraint, he can commit to make transfers to citizens.
Nevertheless, this in itself does not make a soft-budget constraint po-
litically rational. Instruments which allow all politicians to make credible
commitments to policy are not necessarily attractive unless they improve the
position of one politician relative to another. For example, politicians would
like to be able to offer income redistribution to groups to win their support.
In order for this offer to change the expected outcome of an election, such
redistribution has to satisfy two conditions (1) it must be optimal ex post for
politicians to enact, and (2) it must be something that all politicians cannot
Such asymmetries arise in many natural ways. Politicians differ in their
valuation of welfare of different groups, in their ability to undertake different
policies, in their regional attachment, and in their interaction with different
groups. We model such differences in the same way as Dixit and Londregan
(1996) who argue that (p. 1134) “Such differences can arise when each party
has its core support groups of constituents whom it understands well. This
greater understanding translates into greater efficiency in the allocation of
benefits: patronage dollars are spend more effectively”.
In this paper we argue that it is the combination of these two things that
leads to the prevalence of the soft-budget constraint. Politicians are happy
to finance projects which are known to be bad in the sense that revenues do
not cover costs and which they anticipate that they will find it optimal ex
post to ‘bail out’ in the future. This is because such ‘bail outs’ redistribute
3Consider the standard probabilistic voting model of political competition where two
political parties design credible policy platforms to maximize either the probability of
winning an election or expected utility. The usual outcome is that both parties win with
2. Because both parties have access to the same instruments, in equilibrium
these completely offset themselves and do not influence the expected election outcome.
resources to people or groups to whom they would otherwise find it difficult
to redistribute to credibly and to whom other politicians cannot credibly
redistribute resources. We refer to such groups as the core supporters of a
politician. We show that the key difference between such bad projects and
good projects is that all politicians can commit to refinance good projects ex
post and thus although they may redistribute resources to voters, they do so
symmetrically and therefore do not give any politician a strategic advantage.
The ability of incumbent politicians to lauch projects that only they can
credibly refinance in the future creates an incumbency bias. Moreover, it
introduces an interesting inter-temporal structure to the model. If an incum-
bent politician lauches a project today which only he can refinance tomorrow,
this encourages his core supporters to vote for him because they anticipate
that he will bail them out tomorrow, thus increasing their utility. In addition,
if such a politician gets re-elected then he can lauch further projects in the
next period which payoff in the period after that. This further increases the
benefit to core supporters from re-electing the politician. To capture these
inter-temporal effects we develop an infinite horizon election model.
While in Dewatripont and Maskin (1995) the soft budget constraint is
something politicians would want to escape if they credibly could, in our
model the soft budget constraint may arise as something politicians desire
even when information is complete. Many case studies point out that soft
budget constraints may serve political purposes. Treisman (1999, p. 52)
shows how in Russia “most soft credits previously handed out by the Cen-
tral bank were made part of the budget”. The strategy followed for budget
policy is coined ‘fiscal appeasement’, and consists of targeting public trans-
fers to regions to avoid loosing political support. Thus Treisman (p. 47)
argues that “a clear political logic underlay the pattern of central fiscal re-
distribution” and that (p.47) “this strategy of selective appeasement - messy,
nontransparent, economically inefficient though it was - did serve an impor-
tant political purpose”. Gimpelson and Treisman (2002) find that in Russia
(p. 172) “regional governments boost public employment by hiring parti-
sans and clients and extract greater federal aid” and that (p. 178) “Central
politicians responded with bailouts because they knew, too, that regional
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