The Effects of Local Government Financial Distress: Evidence from Toxic Loans

By: Boris Vallee and Julien Sauvagnat

Format:Print
| Language:English

Abstract

We examine the response from both local governments and their voters to a sudden increase in public debt burden. We exploit plausibly exogenous variation in the ex post cost of toxic loans, a notorious ﬁnancial innovation adopted by a large number of local governments. A large increase in the debt burden of a local government results in a signiﬁcant reduction in its investments, but leaves expenses and taxes mostly unchanged. This eﬀect is dampened for local governments that are more politically contested. An increase in public debt reduces the likelihood of re-election for incumbent mayor and its political party. Overall, these ﬁndings support the existence of a public debt overhang eﬀect, which binds diﬀerently depending on the political context as contested mayors strive to maintain investments.