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Assist or desist? Conditional bailouts and fiscal discipline in local governments

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  • Jens Dietrichson
  • Lina Maria EllegÃ¥rd

Abstract

Whenever a central government faces a sub-unit in financial distress, the unpleasant question arises of whether to assist the unit or not. On the one hand, resisting to bail out the unit may lead to default or bankruptcy, which could be very costly both economically and politically. On the other hand, bailouts may increase problems of soft budget constraints: noting that the central government steps in in times of trouble, sub-units may come to expect that bailouts will be available when needed. Restricting attention to the relation between central and local governments, bailouts have been found to be followed by deteriorating fiscal discipline in case studies of several fiscally decentralized countries (e.g. Bordignon and Turati, 2009; Pettersson-Lidbom, 2010; Fink and Stratmann, 2011). Little is however known about whether such tendencies can be dampened if assistance is made conditional upon the local governments' own fiscal efforts. We examine a case in which the Swedish central government provided conditional grants to 36 financially troubled municipalities: to receive the grant, municipalities first had to cut costs and balance their budgets. There were also 23 municipalities that applied for the grant, but whose applications were rejected. We examine the program effect on fiscal discipline over the decade after the launch of the program. Two major identification problems are that the program effect may vary between municipalities, and that selection into the program was not random. We address these two problems by employing the synthetic control method, a case study method developed in Abadie and Gardeazabal (2003) and Abadie et al. (2010), and also combine this method with fixed effects estimations. Our results reveal substantial heterogeneity in the municipal responses to the program and also highlight the importance of the choice of comparison group. For the average effect on admitted municipalities, the main bulk of the evidence point to no increases in the level of per capita costs in the longer run. Fixed effects estimations show consistently better net revenues on average. Moreover, admitted municipalities do better on average than rejected municipalities, who arguably received a signal of hard budget constraints. We conclude that conditional bailouts need not erode fiscal discipline.

Suggested Citation

  • Jens Dietrichson & Lina Maria EllegÃ¥rd, 2013. "Assist or desist? Conditional bailouts and fiscal discipline in local governments," ERSA conference papers ersa13p598, European Regional Science Association.
  • Handle: RePEc:wiw:wiwrsa:ersa13p598
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    Cited by:

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    2. Christofzik, Désirée I. & Schneider, Benny, 2019. "Fiscal policy adjustments to budget shocks: Evidence from German municipalities," Working Papers 10/2019, German Council of Economic Experts / Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung.
    3. János Kornai, 2014. "The soft budget constraint," Acta Oeconomica, Akadémiai Kiadó, Hungary, vol. 64(supplemen), pages 25-79, November.
    4. Heiko T. Burret & Lars P. Feld, 2018. "Vertical effects of fiscal rules: the Swiss experience," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 25(3), pages 673-721, June.
    5. Ellegård, Lina Maria, 2013. "Divided We Fall. Conflicts of Interests Regarding Fiscal Discipline in Municipal Hierarchies," Working Papers 2013:42, Lund University, Department of Economics.
    6. Kornai, János, 2014. "Bevezetés A puha költségvetési korlát című kötethez [Introduction to the author s volume entitled Soft Budget Constraint]," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 845-897.
    7. Ben-Bassat, Avi & Dahan, Momi & Klor, Esteban F., 2016. "Is centralization a solution to the soft budget constraint problem?," European Journal of Political Economy, Elsevier, vol. 45(C), pages 57-75.
    8. Thushyanthan Baskaran, 2017. "Local fiscal policy after a bailout: austerity or soft budget constraints?," Economics of Governance, Springer, vol. 18(3), pages 209-238, August.
    9. Björn Falkenhall & Jonas Månsson & Sofia Tano, 2020. "Impact of VAT Reform on Swedish Restaurants: A Synthetic Control Group Approach," Scandinavian Journal of Economics, Wiley Blackwell, vol. 122(2), pages 824-850, April.
    10. Jochimsen, Beate & Raffer, Christian, 2020. "Local Government Fiscal Regulation in the EU: The Impact of Balanced Budget Rules," VfS Annual Conference 2020 (Virtual Conference): Gender Economics 224566, Verein für Socialpolitik / German Economic Association.
    11. Baskaran, Thushyanthan, 2014. "Bailouts and austerity," Center for European, Governance and Economic Development Research Discussion Papers 212, University of Goettingen, Department of Economics.

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    More about this item

    Keywords

    bailouts; local governments; fiscal performance; synthetic control method;
    All these keywords.

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • H61 - Public Economics - - National Budget, Deficit, and Debt - - - Budget; Budget Systems
    • H62 - Public Economics - - National Budget, Deficit, and Debt - - - Deficit; Surplus
    • H72 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Budget and Expenditures
    • H77 - Public Economics - - State and Local Government; Intergovernmental Relations - - - Intergovernmental Relations; Federalism

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