On Subnational Debt and Bailouts: Does Fiscal Decentralization Lead to Overborrowing?

The issue of subnational debt has received a growing attention by both researchers and policy makers in the light of the recent fiscal and economic crisis, which brought a number of subnational governments to the brink of default. The existing fiscal decentralization literature considers the accumulation of subnational debt the result of lax borrowing regulations and subnational governments’ dependence on fiscal transfers from the central government. In the case of this vertical fiscal dependence, central governments cannot credibly commit to ignoring the pleas fiscal problems of lower-level governments, which creates a moral hazard problem. My paper challenges this consensus on two grounds. First, I argue that “moral hazard” based explanations are overly focused on the institutions that incentivize subnational governments to overborrow, while overlooking the factors that have created the demand for increased subnational spending in the first place. I emphasize the increased demand for subnational spending, which seems to be due to institutional reforms that transferred considerable social welfare and healthcare responsibilities to regions. Second, this paper addresses the methodological shortcoming of existing comparative studies, which examine the subnational debt problem using national level data. My empirical analysis is based on a dataset that combines debt data at the level regions for a large set of OECD countries. The multi-level structure of the data allows analyzing both, the effect of macro-level structures and the effect of regional context factors.