This article studies the incentives for fiscal discipline faced by local governments (states) in a federalist system where revenue-sharing transfers are important sources of income for the states. Based on a market-discipline type of model of state-expenditure policy, it shows that the central government can use the transfers as a powerful mechanism to induce the states into choosing lower levels of fiscal deficits. This is accomplished by making the transfers contingent on an optimally chosen 'deficit targeting' rule, in such a way that the farther the state realized deficit from the targeted level, the lower the transfers from the central government. State debt-renegotiation process is shown to be a good opportunity for implementing such a rule by using an individually rational, incentive compatible contract between the states and the federal government.
