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Municipalities provide infrastructure and essential services financed by taxes and debt. We develop a model of municipal capital structure, defined as the debt-to investment ratio, that rests on two primary economic forces: the elasticity of the tax base with respect to taxes and services, and the process for resolving financial distress. We show how municipalities determine optimal financing, highlighting legal structures governing financial distress, state-by-state variation in allowance of workouts under bankruptcy law, and the pro-creditor leaning of courts. We show that municipalities that issue safe debt, for either political or behavioural reasons, decrease overall welfare.
Presented by Ron Giammarino