Local Government Finances

In this paper, Luiz de Mello, using panel-based aggregate local government data from 13 OECD countries, examines the causal relationship between intergovernmental transfers and subnational jurisdictions’ net worth. He found a stable, inverse relationship between current transfer receipts and local government net worth, implying that local indebtedness increases with more transfers from the center. In terms of causality, the results are mixed. Using dynamic fixed-effects estimators, de Mello discovered that transfers cause indebtedness, which supports the deficit-bias hypothesis. Moreover, other evidence also suggests that a deterioration of net worth is due to increments in current transfers. He argues that soft-budget constraints may be a problem in some OECD countries and recommends introducing tighter fiscal rules.

This paper was presented at the Lincoln Institute’s annual Land Policy Conference in 2007 and is Chapter 10 of the book Fiscal Decentralization and Land Policies.