Voter-Induced Municipal Credit Risk

Policy shocks that increase the costs of public goods should simultaneously reduce voter support for them. We study the extent to which this creates a corresponding voter-induced municipal credit risk. We exploit changes to state and local tax (SALT) deductions from the Tax Cut and Jobs Act as a policy shock to the costs of local public goods. In a difference-in-differences framework with repeated bond trades, we find that jurisdictions with a higher share of residents who ceased deducting SALT (and therefore, face a higher marginal cost of local public goods) experienced a significant increase in municipal bond yields, with an average treatment effect of 8.3 basis points or 3.0% of the unconditional average yield spread. This effect is concentrated in areas where residents have a direct impact on municipal financing decisions via ballot initiatives. This study thus demonstrates the importance of voters in the pricing of public debt and extends the discussion of political and policy uncertainty and therefore, coordination and agency problems to the municipal context.