Assist or Desist? Conditional Bailouts and Fiscal Discipline in Local Governments

Abstract

Central government bailouts of local governments are commonly viewed as a recipe for local fiscal indiscipline, as local governments learn that the center will come to the rescue in times of trouble. Little is known however about whether such tendencies can be dampened if assistance is conditional on 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 deal with the obvious selection problem related to participation in such a program, we use the synthetic control method (Abadie and Gardeazabal, 2003; Abadie et al., 2010) to identify suitable comparison units for each of the 36 municipalities. We then estimate fixed effects regressions on the resulting sample to compare the cost development of admitted municipalities to that of their most similar counterparts during the decade after the program. For most of the admitted municipalities, costs seem to be largely unaffected by the program. However, a non-negligible number are able to hold back costs more than expected, and the development of net revenues is favourable for the group as a whole. We conclude that participation in a conditional bailout program need not erode fiscal discipline, and may even induce a greater concern for fiscal discipline.