Amalgamation, free-rider behavior, and regulation

Abstract

Amalgamation incentivizes municipalities to increase public debt because it allows them to subrogate their repayment and interest burden on the entire municipality after amalgamation. Smaller municipalities, in particular, tend to accumulate public debt in order to free-ride. Previous studies have shown this kind of opportunistic behavior in countries where municipalities can issue bonds freely in the market. However, in Japan, municipalities cannot issue bonds freely by regulation. When such regulation controls debt accumulation by the merging municipality, the free-rider effect should be weak. This study examines the relationship between the regulation of local government borrowing and free-rider behavior of Japanese municipalities. The difference-in-difference regression results confirm the existence of a free-rider effect in this regard. Moreover, the debt expenditure ratio, the index of the regulation of local public bond issues, has the same effect that prevents local public debt from increasing for both merging and never-merged municipalities. This fact shows that a merging municipality with a free-rider incentive cannot increase local public debt to excess by using the regulation. Therefore, the average free-rider effect per capita is approximately 7 % of the average local public debt per capita for the end of the pre-treatment period. This result is considerably lower than the effects of the Swedish cases.

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Notes

  1. 1.

    Baqir (2002), Bradbury and Crain (2001), Bradbury and Stephenson (2003), and Gilligan and Matsusaka (1995, 2001) empirically analyzed the 1 / n effect.

  2. 2.

    “Permission from the upper-level government” was replaced by “consultation with the upper-level government” as the condition for public bond issues by municipalities from fiscal year (FY) 2006.

  3. 3.

    Mabuchi (2001) described the history of Japanese municipality amalgamation.

  4. 4.

    LAT is the inter-governmental subsidy that aims to adjust the uneven distribution of central government resources between local governments.

  5. 5.

    Rausch (2006) examined amalgamations in this period.

  6. 6.

    Special-purpose municipal amalgamation bonds were abolished by the new law after FY 2006.

  7. 7.

    For example, let us assume that municipalities A, B, and C merge into municipality D. Municipalities A to C have the same amount of local public debt (10,000) and populations of 200, 500, and 500, respectively (i.e., local public debt per capita is 50, 20, and 20, respectively). Therefore, the average local public debt per capita of the municipalities is 30, and the local public debt per capita of new municipality D is 25.

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Acknowledgments

This paper has greatly benefited from the comments of the editor-in-chief, Bob Chirinko, and three anonymous referees.

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Correspondence to Katsuyoshi Nakazawa.

Appendix: Statistical sources and definition of variables

Appendix: Statistical sources and definition of variables

Freeride is defined as \({1-N_i }/{N_j }\in \left[ {0,1}\right] \), where \(N_i \) is the population of municipality i, which participates in an amalgamation, and \(N_j\) is the total population of the post-amalgamation municipality, including municipality i. Source: Statistics Bureau, Ministry of Internal Affairs and Communications 1998.

Change in local public debt per capita (\(\Delta \hbox {Debt}\)) is considered in three settings: per capita debt in FY 2002 minus the debt level in FY 1998 (merged in FY 2003), per capita debt in FY 2003 minus the debt level in FY 1998 (merged in FY 2004), and per capita debt in FY 2004 minus the debt level in FY 1998 (merged in FY 2005). The post-treatment period of the control group has been adjusted to each treatment group. The per capita change in local public debt in the pre-treatment period is equal to the per capita debt in FY 1998 minus the debt in FY 1996. Source: Local Government Finance Settlement FY 1996, FY 1998, FY 2002, FY 2003, and FY 2004.

Debt per capita 1996 and debt per capita 1998 (Debt) refer to per capita local public debt. Source: Local Government Finance Settlement, FY 1996 and FY 1998.

Debt expenditure ratio (DER) is the average of the past 3 years’ ratios of a municipality’s debt expenditure to its stable revenues that are not use-specific. Source: Local Government Finance Settlement, FY 1996 and FY 1998.

Population is the municipality’s population (unit: 1000 people) in FY 1996 and FY 1998. Source: Statistics Bureau, Ministry of Internal Affairs and Communications, FY 1996 and FY 1998.

Ratio indicating financial resilience and soundness (r_FS) is the ratio of fixed expenditure (i.e., labor cost, repayment cost of local public debt, etc.) to fiscal resources that the municipality can freely use. A high ratio is considered to indicate financial stringency. Source: Local Government Finance Settlement, FY 1996 and FY 1998.

Ratio of LAT to a total revenue (r_LAT) is the ratio of the inter-governmental subsidy, called “local allocation tax grant,” to total revenue. Source: Local Government Finance Settlement, FY 1996 and FY 1998.

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Nakazawa, K. Amalgamation, free-rider behavior, and regulation. Int Tax Public Finance 23, 812–833 (2016). https://doi.org/10.1007/s10797-015-9381-0

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Keywords

  • Amalgamation
  • Free-rider behavior
  • Common pool
  • Difference-in-difference
  • Fiscal policy
  • Local public debt

JEL Classification

  • D72
  • H72
  • H73
  • H74
  • R51