This paper explores the effects of institutional debt limits on municipal borrowing in the United States. A theoretical analysis shows that forward-looking governments facing a debt limit take precautionary measures to preserve budgetary flexibility in the event of adverse shocks. Specifically, they plan lower deficits and rely on alternative debt instruments. We test these predictions using a panel of US municipalities, exploiting the design of state-imposed debt limits. Our results show that tight limits are reflected in lower levels of restricted debt and induce municipalities to shift borrowing toward unrestricted but more expensive debt instruments. These responses are concentrated among municipalities that have already exhausted a substantial share of their legal borrowing capacity; for these municipalities the limit also restrains total borrowing, indicating that substitution between restricted and unrestricted instruments is only partial.

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 large positive revenue shock when its persistence is uncertain. Exploiting quasi-experimental variation from BioNTech’s COVID-19 vaccine breakthrough, we show that German municipalities did not increase discretionary spending or public investment despite unprecedented business tax revenues. Instead, they reduced debt, accumulated reserves, and temporarily cut business and property tax rates. Firms hardly entered or relocated. Our results suggest that beliefs about persistence shaped policy and, together with fiscal oversight, led to reversal of tax cuts as revenues declined. Overall, tax policy is not only useful for attracting business but serves intertemporal expenditure smoothing.

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.