Financial Innovation And Local Governments Investment

Local public investment is a key driver of infrastructure provision and long-term growth. Hence, understanding investment financing choice is paramount. Unlike central governments, most local authorities face a narrow choice between debt and tax funding, subject to fiscal rules and financial market access constraints. To analyze this choice, we transpose Williamson (1988)'s corporate finance framework, which views financing as a governance decision aimed at minimizing transaction costs rather than as market neutral or an agency conflict. In this adaptation to public finance, debt corresponds to rules-based, market governance, while tax funding represents hierarchical, discretionary governance. In stable environments, debt dominates; under instability, the ranking reverses. We test these propositions using France's local public debt crisis that began in 2010, triggered by municipalities' exposure to toxic structured loans. Using a panel of 35,000 municipalities (2000–2018) and a distance-based instrumental-variable strategy, we find that before the crisis, structured loans did not alter investment behavior, but after the crisis, exposed municipalities sharply curtailed investment and re-ranked their financing choices away from borrowing toward higher self-financing. These results highlight the governance nature of local financing decisions and extend Williamson's corporate finance framework to public finance.