Determinants of Fiscal Distress in Italian Municipalities

25 february 2016*

How important are specific categories of local spending in affecting municipalities' defaults? This study considers Italian municipalities and examines which of the main indicators (debt repayments, current budget balance, amount of residuals and personnel costs) affect their probability of default. Results suggest that a 10pp rise in the share of loan repayment over total spending leads to an average increase in default probability of 2.6%–2.9%. No significant role is found for other budget indicators


Fiscal coordination rules between government levels are crucial for guaranteeing sound public finances and the fiscal stability of national economies. Since 1999, the Italian government has been imposing a set of constraints – primarily through the Internal Stability Pact – in order to preserve financial and fiscal discipline not only at the national, but also at the local level. These limits include upper thresholds on subcategories of either current spending (personnel costs, advertising, etc.) or budget balances (such as ex-post equilibrium between current revenue and current spending). The main question this study will attempt to answer is whether any particular budget category is more effective in signalling future fiscal distress. The specific focus is on two local public spending items – personnel expenditure and loan repayments – that have been highlighted in the government’s policy actions, given that they have been charged with injecting too much rigidity into current spending. The former item has been tightened for 2016 (turnover has been reduced to 25%), while the latter was relaxed in 2015 (with the limit on interest payments being raised from 8% to 10% of total current spending). An inquiry into the main determinants of default probability may provide support to policymakers in their efforts to design rules that effectively address the ultimate causes of local defaults. In this respect, Italy represents an interesting case study: on the one hand, it is characterised by a huge variety of local governments; on the other, detailed data are available for each municipal budget. Moreover, recent policy measures have signalled the government's intention to redefine these limits on given spending categories. For instance, the budget bill for 2015 increased (from 8% to 10%) the ratio between interest spending and total current revenue that municipalities are allowed to maintain. 

This analysis focuses on municipalities that experienced a default event in the 2000–2012 period, and the final database relies on 32 cases of local default. A municipality is in financial distress when its council approves a default resolution, an event that is specifically disciplined by Italian law. [1]  The dependent variable is therefore a binary variable “Dit” (the local default indicator), calculated using data from the Ministry of the Interior. This variable assumes the value 1 when a municipality “i” experiences financial distress in year “t”. 

The independent variables are constructed using a Ministry of the Interior database that includes municipal budget data, and six indicators are implemented in order to take into account different features of local budgets, specifically: (i) principal index (i.e., loan repayments over total spending); (ii) current revenues index (i.e., the logarithm of current revenue per capita); (iii) current spending index (i.e., the ratio between current spending and total spending); (iv) autonomy index (i.e., tax revenue over current spending); (v) residual index (i.e., positive residuals over total revenue); (vi) personnel index (i.e., the ratio between personnel spending and current spending). In order to control for time-varying effects, the dataset includes a set of regional macroeconomic variables: unemployment rate, per-capita GDP and inflation rate. 

Table 1 shows the main empirical findings. [2] Firstly, a bivariate regression (column 1) is carried out, and then each independent variable is added one by one to the regressors. In all specifications, the debt indicator (annual loan repayments over total spending) is significant in affecting the default probability: ceteris paribus, a 10pp increase in the principal index increases the default probability by a percentage ranging from 2.6% to 2.9% when both macroeconomic control variables and year dummies are included (column 8). Our results confirm on a local level what economic literature  has recently been pointing out at national and international level – an economy hits its “fiscal limit” when the debt level rises to the point  where current spending is too constrained and the government loses the ability to finance it by increasing taxes. In this analysis, this issue is even more relevant because, unlike at national level, current revenue must cover not only the interest payments but also the principal component (i.e., debt rollover is not permitted). Other than the debt indicator, still considering a 10pp increase in the other independent variables, there is weak evidence (column 6) of statistical significance for the current spending index (with a positive average marginal effect of 1.2%) and for the current revenue index (-0.7%). This last effect is also confirmed in the most complete specification (column 8), with both a higher coefficient and a stronger statistical significance. It should be noted that the personnel index is never statistically significant; thus, there is no evidence that this indicator has increased default probability in the sample.

In other words, the results do not point to a loss of control over current spending (in relation to revenue) as the main determinant of defaults, nor to the share of personnel costs over total spending. Instead, municipalities seem to be more at risk of default when they are incapable of fully internalising the effects on the future budget balance of issuing new debt today. This evidence supports the view that keeping local debt under control should be a primary goal for both local and national policymakers so as to avoid local default episodes that generate economic and social instability. At the same time, the effectiveness of budget constraints other than the usual balanced budget (such as limitations on specific spending subcategories) in providing insurance against future default may be questioned. 

Table 1 - Probability of default, marginal effects, panel logit model
Notes: The explanatory variables are lagged (t-1) to avoid simultaneity. *** (**, *) indicates statistical significance at the 1 (5, 10) percent level. Marginal effects are calculated at the sample means of the explanatory variables.

(*) Joint research with Luigi Marattin (  The full paper (Working Paper DSE No. 1024) can be downloaded at the following link:

[1]  Legislation on local defaults was introduced for the first time in 1989 (Decree Law 66, converted into Law 144/1989) but only entered into systematic use eleven years later with the Consolidated Text of Local Governments (Decree Law 267/2000), where default is defined as a contingency in which municipalities have definite and liquid liabilities they cannot cope with. The procedure is the following: first, the city council approves the default resolution, which includes the report by the audit committee. Within five days, these documents are officially transmitted to the Ministry of the Interior and to the local section of the accounting judiciary; they are subsequently published in the Italian Official Journal (which announces new laws and administrative acts).

[2] The goal of this study is to investigate the probability of a local default and to this end a model able to deal with a binary dependent variable is required, where the interest lies primarily in the response probability of the covariates included in the specification. Thus, a logit model is implemented.


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