Political Will and Fiscal Federalism in Municipal Bankruptcy

Municipalities in fiscal distress may seek to adjust debts under Chapter 9 of the Bankruptcy Code either because they are truly destitute or because they lack the political will to adopt affordable tax increases. Local officials of municipalities that enter bankruptcy proceedings nevertheless retain political authority over municipal fiscal affairs. The decision to enter bankruptcy, however, may have significant financial consequences for other municipalities or for more centralized levels of government. Those externalities induce central governments to consider bailouts for distressed municipalities. In order to avoid moral hazard problems, central governments typically impose harsh restrictions on local officials as a condition of bailout. This dual system of rescue for distressed municipalities - bailouts and bankruptcy - permits local officials to threaten to file under Chapter 9, and thus to impose costs on central governments, unless the latter modify the conditions of bailouts. In this article, I suggest that allowing bankruptcy courts to impose tax increases serves to neutralize the strategic behavior of local officials, and thus encourages localities to internalize the costs of their activities in a manner more consistent with the tenets of fiscal federalism