The Effects of Local Government Indebtedness: Evidence from Toxic Loans

Abstract

We examine the response from municipalities and their voters to a large and exogenous increase in municipal indebtedness. We show that municipalities with "toxic loans" on their balance sheet exhibit a large increase in their debt and interest expenses following the Great Financial Crisis. This large increase in indebtedness causes a twice-as-large reduction in municipal investments, whereas local taxes remain unaffected. The reduction in investments is particularly pronounced for municipalities that are politically contested. These empirical findings are consistent with a model of municipal investment in which electoral competition act as a disciplinary device for local politicians.

Keywords: Public debt, public investments, political contestation, toxic loans

JEL Classification: P16, H74, G11, G32