Local fiscal policy after a bailout: austerity or soft budget constraints?

Abstract

Do higher-level governments enforce austerity after bailing out indebted subnational governments or are bailouts a free lunch for the recipients? Analyzing this question empirically is difficult because bailouts are not granted randomly. This paper suggests a method to evaluate the fiscal consequences of subnational bailouts that does not rely on institutional details to obtain quasi-exogenous variation. The main idea is to combine matching and difference-in-differences designs. In a second step, I apply this method to study how bailouts affect the fiscal policy of recipient municipalities in the German federal state of Hesse. Combining disaggregated budget data with data on bailout payments over more than a decade, I find that municipalities consolidate their budgets after they receive a bailout from the state government. While this finding is specific to the German federal context, the proposed methodology can be used, due to its flexibility, to study the fiscal consequences of bailouts in various other settings.