Tax Increases in Municipal Bankruptcies

Abstract

Chapter 9 of the Bankruptcy Code does not address the issue of whether a bankrupt municipality must increase taxes as a condition for confirming a reorganization plan that places losses on bondholders. The standard analysis of the issue has emphasized the moral hazard that would arise if such increases were not compulsory. This Article argues that the moral hazard-based argument for tax increases is misplaced because the legal and economic structure of municipal finance work to constrain municipal opportunism. Drawing from the literature on sovereign borrowing, it suggests that moral hazard in borrowing is limited by the potential for deterred investment and high-cost borrowing in the future. This result holds when we consider the incentives of municipal officials and the likely monitoring strategies of residents and investors. Moreover, some loss-shifting from residents to investors is sensible, because investors are better risk- bearers than residents. Due to the structure of Chapter 9, a presumption of regularity with respect to municipal reorganization proposals will act as a default rule, because states can condition the ability of their municipalities to seek Chapter 9 protection.

JEL Classification: G33, H79, K34