The Effects of Local Government Financial Distress: Evidence from Toxic Loans

28 Pages Posted: 12 Mar 2021

See all articles by Julien Sauvagnat

Julien Sauvagnat

Bocconi University; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Boris Vallee

Harvard Business School - Finance Unit

Date Written: February 9, 2021

Abstract

We examine the response from both local governments and their voters to a sudden increase in public debt burden. We exploit plausibly exogenous variation in the ex post cost of toxic loans, a notorious financial innovation adopted by a large number of local governments. A large increase in the debt burden of a local government results in a significant reduction in its investments, but leaves expenses and taxes mostly unchanged. This effect is dampened for local governments that are more politically contested. An increase in public debt reduces the likelihood of re-election for incumbent mayor and its political party. Overall, these findings support the existence of a public debt overhang effect, which binds differently depending on the political context as contested mayors strive to maintain investments.

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

JEL Classification: P16, H74, G11, G32

Suggested Citation

Sauvagnat, Julien and Vallee, Boris, The Effects of Local Government Financial Distress: Evidence from Toxic Loans (February 9, 2021). Available at SSRN: https://ssrn.com/abstract=3782619 or http://dx.doi.org/10.2139/ssrn.3782619

Julien Sauvagnat

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

Boris Vallee (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

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