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    Posts Tagged ‘Municipal bond’

    Political Will and Fiscal Federalism in Municipal Bankruptcy

    Tuesday, April 12th, 2011

    When a municipality faces municipal distress, who ultimately picks up the tab?  More importantly, who should pick up the tab?

    That’s the issue taken up by Clayton P. Gillette, NYU’s Max E. Greenberg Professor of Contract Law, in a recent paper titled “POLITICAL WILL AND FISCAL FEDERALISM IN MUNICIPAL BANKRUPTCY.”  Though the academic prose doesn’t read quite like the Economist, Professor Gillette’s discussion is a timely and important one for observers of US municipalities and their current financial troubles.

    Municipal governments

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    In essence, Professor Gillette argues that Chapter 9 of the Bankruptcy Code (municipal bankruptcy) is often perceived as a “dumping ground” for governmental entities who could raise taxes, but simply don’t have the political gumption to do so.  Historically, municipal debtors have attempted to utilize Chapter 9 as a means of shifting the burden of imprudent debt onto creditors.  But Gillette argues that in an age of government bailout and centralized governmental assistance for failing municipalities, Chapter 9 also effectively acts as a “bargaining chip” for municipal debtors dealing with federal and state agencies who would prefer to address municipal financial distress outside of bankruptcy – albeit at a moderate cost to local officials.

    In support of this argument, Gillette explains that the structure of Chapter 9 offers municipalities a shot at having it both ways:  They can run up a tab, then determine whom (other than themselves or their taxpayers – i.e., private creditors or states and federal agencies) they’d prefer to pick it up.

    What’s the answer to this perceived recipe for irresponsibility?  For Professor Gillette, it involves giving bankruptcy courts the power to impose affordable tax increases:

    As a general proposition, fiscal federalism requires each level of government to internalize both the costs and the benefits of its activities.  Centralized governments should, therefore, subsidize decentralized governments only to control negative spillovers of local activity or to induce activities that generate positive spillovers.  Concomitantly, decentralized governments should be discouraged from engaging in activities that impose adverse external effects. In at least some cases of fiscal distress, however, – primarily those involving localities that have substantial state or national importance – municipalities can externalize some costs of idiosyncratic choices or local public goods onto more centralized levels of government or creditors. As a result, municipalities have tendencies both to overgraze on the commons of more centralized budgets and to avoid the exercise of political will to satisfy the debts they incur. The current legal structure for addressing municipal fiscal distress may interfere with, rather than advance the objectives of fiscal federalism insofar as it insulates local decisions from centralized influence and reduces the need for distressed localities to internalize the consequences of fiscal decisions. The result is that while theories of federalism typically focus on the security that decentralization confers against an onerous centralized government, the capacity of sub-national governments to exploit the financial strength of more central governments raises the possibility that the latter requires protection from the former. The claim of this Article is that judicially imposed tax increases may be used as a means of providing such protection by reducing the incentives of municipalities to [strategically] exploit bankruptcy proceedings . . . .

    Whatever readers may think of the constitutionality of his idea, Professor Gillette’s article is an intriguing contribution to evolving thought on municipal distress.

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