Do equalization payments affect subnational borrowing? Evidence from regression discontinuity

According to the fiscal federalism literature, subcentral budget constraints become softer when local governments are more dependent on revenues over which they have no discretion. As a consequence of ‘transfer dependency’, subcentral governments can expect to be bailed out by the central government and therefore tend to accumulate higher levels of debt. We test this conjecture with data from Austrian municipalities. In fiscal terms, Austria is a highly centralized federation in which tax autonomy at the municipal level is rather weak. Our identification strategy is based on a discontinuity caused by the unique regulation of population weights in the tax-sharing agreement between central government and the municipalities. Our results indicate that, in line with theoretical expectations, municipalities with higher revenue dependency are responsible for higher net borrowing per capita. The size of the additional borrowing effect equals to about 5% of average municipal debt. We also find that almost one half of the observed discontinuity works through an investment channel.