Further Issues on Intergovernmental Finance
Local Public Debt
Central government may set a debt limit for local public debt. If the market is perfect, local public debt is evaluated in the market. A local government with poor fiscal resources cannot issue new public debt unless its interest rate is high. However, if the market is imperfect, a local government with poor fiscal revenue may issue too much public debt at a low rate of interest. If so, such a local government may well face financial difficulties regarding the redemption of public debt. Once the local government goes bankrupt, in order to alleviate the bad outcome of bankruptcy, central government, in a political economy, has to rescue the region. Considering this ex post response by central government, local governments have an incentive to issue public debt by too great an extent. This is an unwanted outcome of soft budget constraint. Thus, it may be desirable for central government to impose a debt limit so as to restrict the issuance of local public debt.
It is worth noting that local public debt has a unique feature. Residents may move away from a region before taxes are increased to redeem the public debt. Such residents may enjoy the benefit of public spending financed by local public debt and avoid the tax burden by moving to other regions. This behavior is called the runaway effect of local public debt.
However, such behavior may not work well. If residents intend to sell their land in order to move away, they cannot sell the land for a high price. Since the future tax burden is likely to rise, the land price is reduced by the amount of the present discount value of the future tax burden. The future tax may well be capitalized in the land price at once. Thus, a current resident effectively pays the future tax by selling the land at a low price. This means that the runaway effect does not easily occur.