The Real 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, and a twice-as-large reduction in municipal investments. The reduction in investments is particularly pronounced for municipalities that are politically contested. Local taxes remain unaffected. These empirical findings are consistent with a model of municipal investment in which electoral competition act as a disciplinary device for local politicians, and highlight the economic and political nature of public indebtedness.