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.
This is a preview of subscription content, log in to check access.
Buy single article
Instant access to the full article PDF.
Price includes VAT for USA
Subscribe to journal
Immediate online access to all issues from 2019. Subscription will auto renew annually.
This is the net price. Taxes to be calculated in checkout.
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.
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).
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.
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.
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.
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.
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).
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).
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Quantile regression estimates for other covariates are not reported in the table due to space constraints, but are available upon request.
Allers MA (2015) The Dutch local government bailout puzzle. Public Adm 93(2):451–470
Appleson J, Parsons E, Haughwout A (2012) The untold story of municipal bond defaults. Federal Reserve Bank of New York. http://libertystreeteconomics.newyorkfed.org/2012/08/the-untold-story-of-municipal-bond-defaults.html. Accessed 18 Jan 2019
Baker T (1996) On the genealogy of moral hazard. Tex Law Rev 75(20):237–292
Baskaran T (2017) Local fiscal polity after a bailout: austerity or soft budget constraints? Econ Gov 18:209–238
Becker T, Richards A, Thaicharoen Y (2003) Bond restructuring and moral hazard: are collective action clauses costly? J Int Econ 61(1):127–161
Bonilla L, Lopez E, McMillen D (2015) House prices and school choice: evidence from Chicago’s magnet schools proximity lottery. Working paper
Bunch B (1991) The effect of constitutional debt limits on state governments’ use of public authorities. Public Choice 68(1–3):57–69
Cabasés F, Pascual P, Vallés J (2007) The effectiveness of institutional borrowing restrictions: empirical evidence from Spanish municipalities. Public Choice 131(3):293–313
Cahill AG, James JA (1992) Responding to municipal fiscal distress: an emerging issue for state governments in the 1990s. Public Adm Rev 52(1):88
Canay IA (2011) A simple approach to quantile regression for panel data. Econom J 14(3):368–386
Carroll DA (2009) Diversifying municipal government revenue structures: fiscal illusion or instability? Public Budg Finance 29(1):27–48
De Angelis M, Tian X (2013) United States: Chapter 9 municipal bankruptcy: utilization, avoidance, and impact. In: Dos Santos C, Filho O, Liu L (eds) Until debt do us part: subnational debt, insolvency, and markets, pp 311–353. The World Bank, Washington
Dove JA (2016) Do fiscal constraints prevent default? Historical evidence from U.S. Municipalities. Econom Gov 17:185–209
Eichler S, Hofmann M (2013) Sovereign default risk and decentralization: evidence for emerging markets. Eur J Polit Econ 32:113–134
Freyberg DJ (1996) Municipal bankruptcy and express state authorization to be a Chapter 9 debtor: current state approaches to municipal insolvency and what will states do now? Ohio North Univ Law Rev 23:1001–1027
Gao P, Lee C, Murphy D (2017) Municipal borrowing costs and state policies for distressed municipalities. J Financ Econ. https://doi.org/10.1016/j.jfineco.2018.10.009
Gillette CP (2012) Fiscal federalism, political will, and strategic use of municipal bankruptcy. Univ Chic Law Rev 79:281–330
Goodspeed TJ (2002) Bailouts in a federation. Int Tax Public Finance 9(4):409–421
Grochulski B (2010) Optimal personal bankruptcy design under moral hazard. Rev Econ Dyn 13:350–378
Inman RP (2001) Transfers and bailouts: institutions for enforcing local fiscal discipline. Const Polit Econ 12(2):141–160
Inman R (2003) Transfers and bailouts: enforcing local fiscal discipline with lessons from U.S. Federalism. In: Rodden et al (eds) Fiscal decentralization and the challenge of hard budget constraints. MIT Press, Cambridge, pp 35–83
Johnson CL, Kioko SN, Hildreth WB (2012) Government-wide financial statements and credit risk. Public Budg Finance 32(1):80–104
Lewis CW (1994) Budgetary balance: the norm, concept, and practice in large U.S. cities. Public Admin Rev 54(6):515
Liu L, Tian X, Wallis JJ (2013) Caveat creditor: state systems of local government borrowing in the United States. In: Dos Santos C, Filho O, Liu L (eds) Until debt do us part: subnational debt, insolvency, and markets. The World Bank, Washington, pp 311–353
Moldogaziev TT, Kioko SN, Hildreth WB (2017) Impact of bankruptcy eligibility requirements and statutory liens on borrowing costs. Public Budg Finance 37(4):47–73
Moringiello JM (2014) Goals and governance in municipal bankruptcy. Wash Lee L Rev 71:403
Oates W (2005) Toward a second-generation theory of fiscal federalism. Int Tax Public Finance 12:349–373
Poterba JM (1994) State responses to fiscal crises: the effects of budgetary institutions and politics. J Polit Econ 102(4):799–821
Poterba JM (1996) Budget institutions and fiscal policy in the U.S. states. Am Econ Rev 86(2):395–400
Qian Y, Weingast BR (1997) Federalism as a commitment to preserving market incentives. J Econ Perspect 11(4):83–92
Rampini A (2005) Default and aggregate income. J Econ Theory 122:225–253
Rodden J (2006) Hamilton’s paradox: the promise and peril of fiscal federalism. Cambridge University Press, New York
Schroedter A (2014) Next Up: Illinois municipal bankruptcy? Better government association. http://www.bettergov.org/news/next-up-illinois-municipal-bankruptcy. Accessed 18 Jan 2019
Spiotto JE (2008) Chapter 9: the last resort for financially distressed municipalities. In: Feldstein S, Fabozzi F (eds) The handbook of municipal bonds. Wiley, Hoboken
Spiotto JE (2013) The role of the state in supervising and assisting municipalities, especially in times of financial distress. Munic Finance J 33(4):1–31
Suyderhoud JP (1994) State-local revenue diversification, balance, and fiscal performance. Public Finance Rev 22(2):168–194
Velasco A (2000) Debts and deficits with fragmented fiscal policymaking. J Public Econ 76:105–125
Wang X, Dennis L, Tu YSJ (2007) Measuring financial condition: a study of US states. Public Budg Finance 27(2):1–21
White MJ (2002) Sovereigns in distress: do they need bankruptcy? Brook Pap Econ Activity 2002(1):287–319
Wibbels E (2005) Federalism and the market: intergovernmental conflict and economic reform in the developing world. Cambridge University Press, Cambridge
Yang L (2018) Negative externality of fiscal problems: dissecting the contagion effect of municipal bankruptcy. Public Admin Rev. https://doi.org/10.1111/puar.12986
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
About this article
Cite this article
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
- Fiscal rules
- Fiscal federalism
- Municipal bankruptcy
- Fiscal sustainability