In this paper, we investigate how tightening fiscal constraints (e.g., through intergovernmental transfer cuts) can lead local governments to postpone investment payments. We first provide a simple model showing how local governments can use arrears to relax their short-run financial constraints. We then empirically assess our theoretical prediction using information from accounting and financial reports from all Italian municipalities for the period 2003-2010. Exploiting the long-lasting effect of the 1979 structural reform of Italian local public finance, we employ an instrumental variable approach to face endogeneity concerns. We find robust empirical evidence that the tighter the local government's fiscal and financial conditions, the larger the arrears in public investment expenditures.
Available at: http://works.bepress.com/paola_valbonesi/44/