Subnational Debt Renegotiation and Elections: Experimentation and Reputation in the Brazilian Fiscal Federalism

Abstract

The present paper analyzes the effect of elections on subnational fiscal policy after debt renegotiations between local (state) governments and the Federal government. First, a stylized model determines under which conditions a state will accept the debt renego- tiation requirements and highlights an incentive for the state to reduce tax effort after renegotiation. Next, a dynamic model shows that elections bring about new incentives for nonpayment of debt interests to the Federal government. The model’s solution yields two perfect Bayesian equilibria. In the first “experimentation equilibrium” new state governors decide to stop payment of debt interests in order to test the Federal govern- ment’s willingness to get involved in a politically costly confrontation. In the second “reputation equilibrium” the Federal government decides to withhold federal transfers to any defaulting state, in spite of the high political cost of that decision, in order to avoid defaulting by other states in the future.