Subnational fiscal behavior under the expectation of federal bailouts

This paper analyzes how subnational governments allocate own resources between current spending and infrastructure investment and decide on borrowing under the expectation of federal bailouts. It is assumed that states' borrowing possibilities increase with the expectation of such bailouts because the financial system is willing to fund a higher amount of public investment projects. As a result, state governments engage in an opportunistic behavior: they allocate a higher (lower) than optimal amount of own resources to current spending (infrastructure investment) and over-borrow.