The Impact of Debt Financing on the Level of Capital Spending

Abstract

This paper examines whether the debt illusion hypothesis holds at the local level. Generally, municipal bonds are issued to finance capital spending. However, capital costs could be funded by current revenues or borrowing. If taxpayers perceive debt financing to be less costly than current taxation, reliance on debt tends to incur larger public spending. By utilizing a sample of New Jersey municipalities in the U.S., this study found that municipalities relying on more debt spent more on capital investments than those relying on less debt.