Subnational public debt sustainability in Mexico: Is the new fiscal rule working?

Abstract

In 1997, after a costly bailout, the central government of Mexico passed legislation intending to improve subnational finances through fiscal decentralization. As a result, many states rapidly began to accumulate debt during the following decade. Subnational public debt grew threefold between 1996 and 2006. The global financial crisis only aggravated the debt accumulation problem, which increased by 320% between 2006 and 2016. In response, a new law with a set of fiscal rules for subnational governments was enacted in 2016, namely, the Law of Fiscal Discipline (LDF) for states and municipalities. This study evaluates the impact of the fiscal rule alert system on the levels of debt accumulation across Mexican states. Using a quarterly panel dataset comprising the period 2013–2020 and employing difference-in-differences techniques, we observe a significant reduction of 4% in public debt between treated and untreated states and 5.8% in debt per capita. Moreover, we document that even after the first wave of the COVID-19 pandemic, the new fiscal rule effectively reduced the pace of subnational public debt in Mexico.