Excessive State Debt: A New Approach to a Growing Problem

Economists and political observers agree state governments defaulting on their debt obligations is a growing concern. How best to aid struggling states, however, is a point of contention. This Issue Brief makes a case against ex post restructuring measures, specifically bankruptcy modeled on Chapter 9 of the U.S. Bankruptcy Code, and in favor of ex ante debt mitigation action. In particular, it introduces tax-credit borrowing (TCB) as a potential commitment device for states that would allow for the creation of super-priority, risk-free debt. TCB ensures that states internalize the risk of default and avoids the moral hazard problem of states assuming that the federal government will, in a fiscal crisis, use taxpayer money to offer a bailout. It also incentivizes better monitoring of the borrowing decisions made by state officials, as the fiscal ramifications of excessive debt would move from state creditors to taxpayers and voters. Small changes to federal tax policy and likely a subsidy (relative to traditional debt) would be necessary to encourage tax-credit borrowing, but this new approach can solve the sticky problem of debt prioritization that continues to mystify states and municipalities.