Assist or Desist? Conditional Bailouts and Fiscal Discipline in Local Governments

Central government bailouts of local governments are commonly viewed as a recipe for local fiscal indiscipline, as local governments learn that the center will come to rescue in times of trouble. Little is however known about whether such tendencies can be dampened if assistance is made conditional upon the local governments' own fiscal efforts. We examine a case in which the Swedish central government provided conditional grants to 36 financially troubled municipalities: to receive the grant, municipalities first had to cut costs and balance their budgets. For each municipality, we estimate the long run program effect on per capita costs of services using the synthetic control method for case studies (Abadie and Gardeazabal, 2003; Abadie et al., 2010). The number of municipalities that substantially reduce their costs after the program is much larger than the number that substantially increase their costs, and there is a cost reducing effect on average. Fixed effects estimations with net revenues as measure of fiscal performance corroborate these findings for costs. Conditional bailouts need thus not erode fiscal responsibility and may even induce fiscal discipline. (Less)