This paper explores the effects of formal limits on US municipal debt policy. Based on a theoretical analysis of fiscal policy under uncertainty, we argue that forward looking governments facing a debt limit will take precautionary measures to preserve their budgetary flexibility in the event of adverse shocks. These include planning lower deficits or higher surpluses, but we also explore the role of alternative debt instruments. To test the predictions, we use a panel of US municipalities and exploit institutional variation with regard to state-imposed debt limits. Our results suggest that US municipalities follow a prudent debt policy and plan for lower levels of regular debt when facing debt limits. In addition, tight limits lead to substitution of regular debt with other more expensive, unrestricted debt instruments. In line with our theoretical prediction, heterogeneity analyses reveal that reactions to debt limits are more pronounced among municipalities exposed to higher risk.

While little is known about how a local government react to the fiscal shocks in advanced country, empirical evidence is lacking. This is because, in general, many fiscal shocks are endogenous. This paper examines the impact of donations via the Hometown Tax Donation system (HTD) on various local government expenditures. Under the HTD system, which is quite unique fiscal system, people can donate some portion of the tax payable to the place of residence to other municipalities. The most significant characteristic of the financial resources received by local governments through this fiscal system is their instability. It is difficult for the local governments to control the amount. According to our quantitative analysis (using panel data analysis with instrumental variables), the local governments may accumulate the donations in reserves for future needs while simultaneously increase specific expenditures such as welfare and sanitation costs.

We study how local governments respond to a very large and unexpected revenue windfall under uncertainty about its persistence. Exploiting quasi-experimental variation from BioNTech’s COVID-19 vaccine breakthrough, we show that German municipalities did not use unprecedented local business tax revenues to expand discretionary spending relative to a control group; current expenditure and public investment remained stable. Instead, they repaid debt, accumulated reserves, and temporarily reduced local business and property tax rates. The tax cuts reflected initially optimistic expectations and were reversed as revenues declined, highlighting how uncertainty and balanced-budget rules constrain intertemporal fiscal adjustment even amid exceptionally strong balance sheets.

Tax revenue fluctuations can threaten municipalities' fiscal stability, especially when shortfalls coincide with economic downturns. We study how exposure to tax revenue risk—the covariance between tax revenues and macroeconomic conditions—affects municipal borrowing costs and public investment. Municipalities with higher tax risk pay more to borrow: a one-standard-deviation increase in tax risk raises offering yields by 3 basis points and secondary-market yields by 7 basis points. These effects are robust to a border-discontinuity design and are strongest where alternative repayment capacity is limited. Greater tax risk, in turn, leads to sustained reductions in public investment.