The impact of state intervention and bankruptcy authorization laws on local government deficits

Abstract

Local governments in the United States can file for bankruptcy to restructure their debt if allowed by state laws. While some states legislate an unconditional authorization, others conditionally permit local filings, do not give authorization, or intervene in local crises. This paper investigates the impact of state policy adoption on local governments’ revenue to expense ratio, a measure of deficit. While bankruptcy authorizations do not show an impact at the mean, a median locality decreases the revenue–expense ratio after the state adopts an authorization unconditional on state intervention, suggesting a moral hazard effect. Localities with conditionally high deficits, however, increase the ratio upon the adoption of a conditional authorization, possibly because they want to avoid being subjective to conditions placed by states.

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Notes

  1. 1.

    Liu et al. (2013) decompose state regulations of local fiscal distress to three parts: monitoring, crisis definition, and intervention. Fiscal institutions examined in this paper focus on the latter two.

  2. 2.

    Therefore, insolvency in this paper focuses on cash insolvency, which can be a consequence of budgetary insolvency or fiscal-year imbalance, long-run insolvency or lack of sustainability, and service-level insolvency or inability to meet community’s service demands (Lewis 1994).

  3. 3.

    Defaults are rare among rated municipal bonds but more common among unrated issuances. According to Appleson et al. (2012), there were 2,521 defaults among all municipal issuances from 1970 to 2011, as compared to 71 defaults among Moody-rated bonds.

  4. 4.

    The federal Bankruptcy Code define “municipality” to include cities, counties, villages, towns, school districts, special tax districts, and municipal utilities and enterprises as long as they are “instrumentalities or agencies of the state” (Spiotto 2013). Therefore, “municipal bankruptcy” is a conventional term used to refer to the bankruptcy of all local governmental entities.

  5. 5.

    Subnational government insolvency is intrinsically different from that of private entities. Continuing provision of public good and services is the key. For example, liquidation, an option available for distressed private corporates, is not accessible for local governments, leaving debt readjustment the only choice.

  6. 6.

    In 1994, the Congress amended the Bankruptcy Codes to change the previous requirement that a municipality be “generally authorized” to “specifically authorized,” because the general authorization clause had generated different interpretations in the court. What is consistent before and after 1994 is that without an explicit state authorization, localities face greater uncertainty in the court to even get the case accepted.

  7. 7.

    According to Spiotto (2008), from 1980 through 2006, there are 183 municipal bankruptcy filings, among which only 32 are from general purpose governments (cities, villages or counties). The most frequent filers are municipal utilities (75 filings) and special municipal district (38 filings).

  8. 8.

    Other factors, not related to the authorizations directly, decrease the attractiveness of bankruptcy filings to local governments and thus reduce moral hazard incentives. First, Chapter 9 includes stringent eligibility requirements for local governments to prove insolvency and negotiate in good faith, making it difficult to take advantage of creditors. The legal process for bankruptcy filing is complicated, often prolonged and expensive. Second, politically bankruptcy carries a negative connotation among voters (Allers 2015). Third, localities surviving a bankruptcy may return to the capital market, and the stigma association with prior bankruptcies increase their borrowing costs (De Angelis and Tian 2013).

  9. 9.

    States could also intervene in local fiscal crisis through an ad hoc approach, passing legislations and providing assistance for specific localities. Because such an approach is not standardized in law and might not be expected by local governments with certainty, it is not considered “institution” for analysis in this paper. Further, this paper defines intervention programs to be a system of procedures from declaring fiscal emergency to drafting and implementing corrective actions; thus, standalone grants and loans to local governments do not constitute an intervention program.

  10. 10.

    The Census dataset has the advantage in providing a comprehensive coverage of U.S. local government finance over the past decades. However, its limitations are multifold. First, the data are self-reported and thus may contain errors and differ from audited financial information. Second, the data are not detailed enough to separate out operating grants from capital grants and thus the amount of operating revenue is not available. In addition, due to varying bases of accounting, the difference between general expense and revenue may approximate but not equal to government-wide operating deficit.

  11. 11.

    Because some local governments are not surveyed in the non-census years, we obtain lagged value for variables from Census Survey of Government Finance based on a linear interpolation process.

  12. 12.

    The revenue diversification HHI is based on categories of total taxes, general charges excluding liquor store and utility, and miscellaneous general revenue including investment gains and intergovernmental revenue (thus n = 3 for the index). This broad categorization of revenue sources is preferred when local options for sales and income taxes are not allowed or strictly limited by the states, which is common for many localities.

  13. 13.

    This measure includes bankruptcy filings that are ultimately dismissed by the court as well as those leading to a debt restructure plan. However, obvious erroneous filings such as individuals filing under Chapter 9 are excluded.

  14. 14.

    Sample selection based on the dependent variable, that is, limiting the sample to observations with dependent variable value within a certain range, would lead to a nonzero expected error term conditional on the selection and independent variables, which violate the condition for consistent coefficient estimates.

  15. 15.

    Ideally, one would include all year dummies in the second step to control for common time trends. However, increased dimensions from the introduction of year dummies make the estimation of quantile regression computationally challenging. Following Bonilla et al. (2015), this paper includes a continuous year trend variable (with 1970 being year 0) and its square and cubic terms in the second step instead.

  16. 16.

    Codes for implementing the two-step estimator are available in R upon request. This paper extends the original code provided in Canay (2011), which works only on balanced panels, to more general cases of panel data.

  17. 17.

    Bootstrapped standard error or confidence interval is often used for complex estimation methods such as quantile regression where a direct expression of standard error is difficult to obtain mathematically.

  18. 18.

    Similar graphs on the trends in local government revenue and expenditure also show parallel trends between the states with and without a policy change during the period of analysis. These graphs are not presented here but are available upon request.

  19. 19.

    Quantile regression estimates for other covariates are not reported in the table due to space constraints, but are available upon request.

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Correspondence to Lang Yang.

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Yang, L. The impact of state intervention and bankruptcy authorization laws on local government deficits. Econ Gov 20, 305–328 (2019). https://doi.org/10.1007/s10101-019-00222-6

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Keywords

  • Fiscal rules
  • Fiscal federalism
  • Municipal bankruptcy
  • Fiscal sustainability

JEL Classification

  • D82
  • H71
  • H74
  • H77