THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN

Bernardino Benito; Francisco Bastida

Journal ofPublic Budgeting, Accounting & Financial Management; Winter 2004; 16, 4; ABI/INFORM Global pg. 492

J, OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 16(4),

492-525 WINTER 2004

THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN

SPAIN

Bernardino Benito and Francisco Bastida*

ABSTRACT. This paper analyzes the impact of economic, social and political factors on
municipal debt behavior. With this aim, we have obtained a stratified random sample of
130 cities during a five-year period. These data have been used to configure a micro panel
to obtain accurate estimates and to control for problems such as unobserved
heterogeneity. The main conclusion obtained from this process is that non-financial
surplus/deficit, financial independence, capital expenditures, and capital revenues are the
variables that best explain the indebtedness of this type of entities.

INTRODUCTION

There are three government levels in Spain: central government (Parliament and the
Cabinet), regional government (17 autonomous communities), and local government (50
provinces and 8,102 municipalities). Municipalities are grouped by provinces, and the
latter are grouped by autonomous communities. Each level is multi-functional, within its
jurisdiction, on different issues and activities.

Each municipality has a mayor, a cabinet, and a professional administration. The

mayor is the head of the executive, and is elected indirectly by the citizens. The citizens
elect the members of the cabinet, and these in turn, elect the mayor. Municipalities are
allowed to both raise local taxes and charge tariffs for the services they provide. 1

* Bernardino Benito, PhD., is a Professor of Accounting at the University of Murcia

(Spain). Francisco Bastida, Ph.D., is an Assistant Professor at the Technical University of
Cartagena (Spain). Their teaching and research interests are in public sector accounting,
public financial analysis, and public finance and budgeting.

Copyright 2004 by PrAcademics Press

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN

Municipalities have always played a crucial role with regard to two aspects of the
Spanish public sector: first, in relation to political representation and second, because they
must provide key services such as day-care nurseries, public transport, waste disposal,
sewage, construction and management of sports centers and public green areas. 2

LIMITS ON LOCAL GOVERNMENT INDEBTEDNESS IN SPAIN

During the last few years, interest has grown to limit the indebtedness of the Public
Administration in Spain and in the rest of the European Union. The efforts have been aimed
particularly at sub-central governments. The different reasons that justify the establishment
of these limits can be summed up as follows (Monasterio, 1996):

a) To promote inter-generational equity, in order to avoid having today's population

issue debt to enjoy services whose financial cost will be transferred to future
taxpayers;
b) To sustain financial balance, i.e., revenues must cover expenses; and
c) To meet the economic stabilization objectives imposed by the Central Government.

Different types of instruments can be used to establish these limitations. They range
from trusting market mechanisms to establishing some internal control at the center of the
public sector (Ter-Minassian & Craig, 1997). In this latter option, the control instruments
can be the establishment of rules limiting indebtedness, the introduction of coordination
mechanisms, or finally, the use of direct control means by the Central Government.

In the case of the Spanish Local Governments, the Central Government opted for the
establishment of a series of limitations. These limitations vary according to the type of

TABLE 1 Limitations on Indebtedness

indebtedness: short or long term (see Table 1).

Aside from these limitations, Parliament passed in December 2001 the Law of
Budgetary Stability to implement the Pact of Stability and Growth, which was agreed upon
in the pact of Amsterdam of June 1997. This Pact limits the use of the public deficit as an
instrument of
economic policy in the European Economic and Monetary Union. In accordance with that Law
(effective January 1, 2003), the Public Administrations will not be able to have a non-financial deficit
(see Table 3). This means that the non-financial revenues will have to cover, at least, the non-financial
expenditures. Therefore, in practice, this implies the impossibility of getting into debt, unless very
special situations occur.

Table 2 analyzes the extent to which municipalities are complying with these debt limits. We
have subdivided the municipalities into two subsets (population less than or exceeding 20,000
inhabitants) in order to test if there are differences due to size. The conclusion reached is (see Table 2)
that the requirement stipulating the concretion of a non-financial surplus (as established in the
General Law of Budgetary Stability) is the one least met. Although this legal limitation was not in

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 BENITO & BASTIDA

effect during the period studied, we have considered it convenient to include seeing what is the
starting point for municipalities in relation to this issue. Finally, no differences based on population
were found.
TABLE 2
Non-compliance with Legal Debt Limits (In %)
In relation to Table 2, it is worth mentioning the existence of empirical literature that both
confirms and rejects the effectiveness of debt limits on sub-national governments.4 On the other hand,
we observe that as the electoral year approached (1995, 1999) municipalities
exceeded the limits in higher percentages. 5 However, dealing with these two issues in more detail
would exceed the purpose of this paper, and therefore, they will be addressed in future works.

BALANCE OF REVENUES AND EXPENDITURES IN LOCAL GOVERNMENTS

TABLE 3
Financial Balance of Revenues and Expenditures
In order to describe properly the variables considered in this work, it would be useful to analyze
the optimal financial balance situation for this kind of entity (Table 3). According to this, and
referring to a financial year (calendar year), operating expenditures must be funded by operating
revenues, reaching a surplus (primary operating balance) that should be assigned to the annual
repayment of debt (debt service). If the primary operating balance were negative (deficit), the current
level of the entity's expenditures would be beyond its own means. This situation would force
the municipality to reduce expenditures, increase current revenues, or search for new revenues.
Finally, if this situation persists, the only solution would be short-term debt, whose service
needs new operations to be
financed, meaning that in reality, it would be covering up real long-term debt operations.
Once the debt service has been repaid, we obtain the net operating balance, which
measures the ability of the entity to finance its current expenditures with current revenues,
including the charge of those past expenditures financed by loans. This net operating
balance, when positive, together with the capital revenues, will allow capital expenditures
to be financed without having to get into debt. In the same manner, its positive value will be
the maximum level the debt service can be increased while keeping a constant level of
expenditures and revenues. Table 3 shows the balance situation referred to in previous
paragraphs.

PURPOSE OF THE PAPER

In Spain, as well as in the USA, there have been several events that have contributed to
reduce the amount of resources available to the cities; consequently, municipalities have
been forced to issue debt to finance their policies. As Cropf and Wendel (1998) indicate, the
issue of local indebtedness warrants attention and analysis. Furthermore, whereas twenty
years ago no one spoke of excessive indebtedness, now it is a concern for both American
cities and the cities of other countries (Clark, 1994).

On the other hand, municipal debt management is influenced by a number of

economic, social and political forces, some of which are internal, but most of which are
external to cities. As cities rely more on debt for development, it is important to understand
the effects of these forces on municipal debt patterns and their impact on the policy of the
cities. Using this approach, in the following pages we analyze the determinants of
municipal indebtedness in Spain.
For the purpose of empirical analysis, we have obtained the financial data from a
stratified random sample taken from 130 municipalities, part of the Autonomous
Community of Valencia6 during a five-year period (1994-1998). In addition, we have
considered other non-financial variables, such as political tendency (conservative or
progressive) of the governing party, the economic level of the municipality, the number of
inhabitants, and the geographical location (coastal or not).

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN

The studies focused on municipal finances dealing with cross-sectional and time-
series data were conducted using the corresponding panel data methodology. Examples of
this kind of works are Metcalf (1991); Kiewiet and Szalaky (1996); Dickson and Yu
(1997); Dahlberg and Johansson (1998); Brown (2000); and Holtz-Eakin (2001). In
Spain, this methodology had not been applied to the analysis of the indebtedness of local
governments. In fact, Spanish works had been based only on cross-sectional data, and,
consequently, they were under the limitations pointed out by Wei-Te (1995).

In order to fill this gap, we have obtained the necessary data and have carried out the
appropriate steps to test our hypotheses. These hypotheses are supported by both previous
empirical and theoretical literature, and the methodology used is homogeneous to that
literature. Therefore, the results obtained can be compared with those from works
performed in other countries. Finally, this survey could be the starting point of future
research in Spain.

Moreover, an important feature of the analysis of local governments is that the panel
data provide samples large enough that permit the study of other key characteristics
without problems of degrees of freedom and insufficient variation of important variables.
We must bear in mind that national level studies consider time series for a single element,
reducing, consequently, the possibilities of the research. On the other hand, these latter
works deal with aggregated data, and consequently suffer from the problems pointed out
by Farnham (1985).

To sum up, the interest of the paper lies in obtaining results that can be compared to
the works of other countries. We think that this will contribute to enrich similar
international literature on this matter.

REVIEW OF PREVIOUS WORKS

There are many theoretical and empirical works analyzing different issues related to
municipal indebtedness. There are three groups of studies: (1) effectiveness of limits
imposed to indebtedness7 (2) rating of municipal debt and (3) factors influencing the
volume of indebtedness. The aim of this article is to concentrate on the last of these.

The rest of this section is organized as follows. First, a description of general works
regarding municipal indebtedness is provided. Second, we review those studies dealing
with financial variables, i.e., factors directly connected to the management of the
municipality. Finally, a summary of the literature related to external socioeconomic factors
is provided.8

General Works
From a theoretical point of view, we can highlight, among others, the work of Zehms
(1991), who proposed 13 ratios for the financial analysis of local governments depending
on the needs of the three user groups identified by Jones, Scott, Kimbro and Ingram (1985):
(1) citizens, (2) legislative and overseeing bodies, and (3) lenders and creditors.

Metcalf (1991) carried out an empirical survey to determine in which way the fiscal
policies of the federal government affected the level of acquisition of financial assets and
financial liabilities of the municipalities. 9 The main conclusion reached was that fiscal
policy influences municipal indebtedness.

In view of financial problems faced by cities such as New York and Cleveland during
the 1970s, Groves, Godsey and Shulman (1981) proposed a technique called "indicators
analysis" {Financial Trend Monitoring System, FTMS). This technique consisted of several
ratios that explained the financial situation, among them: population, per capita income, and
capital expenditures divided by operating expenditures. These indicators are used as
independent variables in our model. On the other hand, Mercer and Gilbert (1996) also
considered the variable 'per capita income' as a good gauge of the indebtedness of the
municipality.

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 BENITO & BASTIDA

Benito and Vela (1998) discussed some ratios in order to check the financial situation
of municipalities. We highlight the investment ratio (capital expenditures/total
expenditures), the self-financing ratio (taxation revenues/operating revenues), and the net
operating balance ratio (net operating balance/operating revenues).

Financial Variables
Oates (1972) and King (1984) stated that sub-national governments must follow two
rules when financing expenditures: current expenditures should be financed with taxes,
whereas long-term debt should finance capital ones. 10 Mceachern (1978), Cropf and Wendel
(1998), and Holtz-
Eakin (2001) also argued theoretically that the municipal debt should fund local capital
projects.

On the other hand, as pointed out by Ter-Minassian and Craig (1997), according to
Spanish laws, long-term loans are generally restricted to investment needs, thus
conditioning the financial management of municipalities.

We can also quote the outstanding work by Musgrave and Musgrave (1989),
regarding the "intergenerational equity" theory, i.e., capital projects must be financed
through long-term debt, so that the people enjoying these capital goods repay the
corresponding incurred debt.

Brusca and Labrador (1998) proposed a linear regression model aimed at explaining
local indebtedness in a sample of Spanish municipalities. They considered the stock of
per-capita debt as the dependent variable. The number of inhabitants, the annual revenues
per inhabitant, the annual expenditures per inhabitant, the net operating balance, the gross
operating balance and the budgetary surplus per inhabitant were used as the independent
variables.11 They found out that the annual expenditure per inhabitant and the gross
operating balance influenced per capita debt level, with the expected sign in both
regressions, i.e., the higher expenditures are and the lower the gross operating balance is,
the larger indebtedness is.

Brusca and Condor (2001) stated theoretically that the non-financial surplus was a
key issue necessary to explain the indebtedness of local governments.

Balaguer (2001) discussed the indebtedness of Spanish municipalities from 1992 to

1996. She considered the annual increase of the indebtedness and carried out an ordinary
least squares regression, step by step, including all years. The results indicate that capital
expenditures, population and the non-financial surplus explain the dependent variable. At
a lower significance level, the net operating balance also influenced the dependent
variable. In general, these conclusions are similar to those obtained by Brusca and
Labrador (1998); that is to say, the higher the level of expenditures and the lower the level
of savings are, the higher indebtedness becomes.

Brown (1996) stated that a high percentage figure in direct and indirect taxes out of
total revenues is recommended, since it is a good indicator of the financial independence
of the Local Government. If this ratio is low, local governments are unable to mobilize
resources within their own jurisdictions to finance an increasing volume of expenditures.
This situation leads to larger deficits and growing sub national indebtedness (De Mello,
2001). However, Farnham (1985) stated that a higher percent of revenue from own
resources, indicating lesser dependence on aid from state government, may have a
positive effect on a locality's borrowing.

Socioeconomic Factors
Political theory (Tusell Gomez, 1996) has stated that left wing governments allow a
higher laxity regarding governmental financial discipline. These progressive parties, thus,
defend a bigger public sector with a wider scope of responsibilities than right wing
governments. Accordingly, the latter become less indebted than the former. Blais and

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN

Nadeau (1992), among others, verified empirically this theoretical assumption. However,
works such as Abizadeh and Gray (1993) did not find a significant relationship.
Dickson and Yu (1997) investigated the spending of local governments. They
concluded that the left wing governments spend more than right wing governments, and
that spending increases with increases in per capita income. This latter idea was also
discussed by Foot (1977) and Hulten and Peterson (1984). Also, Farnham (1985) stated that
the per capita income variable could pick up the influence of a positive income elasticity
of demand for capital goods, in which case its sign would be positive, as we have
hypothesized. However, Adams (1977) argued that the per capita income of a municipality
was negatively related to its debt level. Consequently, the empirical findings of Farnham
refuted the arguments of Adams (1977).
Kiewiet and Szalaky (1996) tried to test the determinants of public debt. With this
aim, they applied the panel data methodology, with cross-sectional (49 American States)
and time-series (1961-1990) data.12 The relevant conclusion emphasized in their work is
that per capita personal income and the ruling party's ideology (left wing) had a positive
effect on the level of indebtedness. Mceachern (1978) also proved that the per capita
income influenced positively the level of local debt.
On the other hand, Bunch (1991) proved that the fact that the same party
(conservative or progressive) controlled the government for many years led to a higher
creation of public authorities that issued revenue bonds (not subject to debt limits) in
order to circumvent debt limits.

Hempel (1973), Hulten and Peterson (1984), and Rivers and Yates (1997) argued
theoretically that population growth caused a rise in the requirement for municipal
services and capital stock. As a result, this situation led to a higher debt burden. The same
relationship was empirically proved by and Farnham (1985).

Mitchell (1967) concluded that debt limits provoke the "devolution phenomenon"
and also that higher population and wealth suggested higher levels of indebtedness. Pogue
(1970) found that, while per capita income did not significantly affect the level of
municipal indebtedness, the increase in population did affect it.

Wei-Te (1995) suggested that tourist municipalities had a higher economic growth,
and consequently, they had to meet the demand for municipal services such as economic
infrastructures and public services. This situation increased the debt burden of the
municipality.

METHODOLOGY
Description of the Sample

As stated above, the financial data of municipalities has been obtained from the
Annual Accounts,13 during a five-year period (19941998), of 130 municipalities. In
addition, other variables have been taken into account: political tendency, economic level,
population, and geographical location (tourist). All variables are described in the next
section (selection of variables).

The availability of information allowed us to apply the proportional stratified random

method to define the components of the sample. Thus, by using statistical tests over
sample data, we could accurately infer population behavior (Ryan, Scapens & Theobald,
1992). The parameters considered in order to typify the population were (1) municipal
size14 and (2) geographical situation (province), as shown in Table 4.

With regard to this sample structure, a micro panel of data has been created. There
were 7,150 total possible observations, including crosssectional information (11 variables
per year in 130 municipalities) and temporal (5 years: 1994-1998). However, we could
only use 6,316 effective observations; therefore, we had 834 missing values. The level of
missing observations is similar to that obtained by Metcalf (1991).

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 BENITO & BASTIDA

TABLE 4 Sample and

Population
Population Sample
Province Province
Castellon

Castellon
Alicante

Alicante

Valencia
Inhabitants Valencia Total Total

1-5,000 89 120 195 404 21 29 47 97

5,001-20,000 36 10 49 95 9 2 12 23
20,001-50,000 10 4 17 31 2 1 4 7
Over 50,000 6 1 4 11 1 1 1 3
Total 141 135 265 541 33 33 64 130
The Autonomous Community of Valencia is composed of three provinces: Alicante,
Castellon, and Valencia. Proportional stratified random sample, considering the worst
case p=q=0.5. N (population) = 541; error: 7.5%.

The existence of missing observations conforms an incomplete panel. However, it

does not reduce the accuracy of the model, since those missing observations occur
randomly. In relation to the temporal gap of the financial information, it is comparable to
previous studies (Brown, 1996; Brusca & Labrador, 1998).

Selection of Variables
Taking into account the variables considered in previous works, we have selected the
variables shown in Table 5 for our model. In addition, we have tried not to include an
excessive number of regressors and consequently we have focused only on the most
relevant.15

The statistical description of the dependent and independent variables, including all
years, is summarized in Table 6.

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN 8

TABLE 5 Selected Variables

(see Table 6) makes the number of valid cases for regression decrease down to 177 and,
therefore, the sample fails to be representative of the population. Accordingly, we have
excluded this variable from the regression. Nevertheless, in order to check the results
obtained in previous papers, a univariate test will be used to check if this socioeconomic
factor influences the indebtedness of the municipality.

Specification of the Model

As stated above, the same 130 municipalities compose our sample during five years. It is
important to distinguish the panel data from the time series obtained from different cross-
sections. In the latter, a different random sample of elements is drawn each time. Therefore,

TABLE 6 Descriptive Statistics of

Variables
Variable S t a t i s t i c Real
Mean Median Min Max St. Dev. Observa-
tions N (n-
T)
Dependent vnpf .0215 -.0010 -.1489 .5124 .0803 568
Variable
dcostero .1000 0 0 1 .3002 650
Dummy dnivelec .2439 0 0 1 .4305 205
dpobl .7462 1 0 1 .4355 650
dpob2 .1769 0 0 1 .3819 650
independent dpob3 .0538 0 0j 1 .2259 650
dsp .3752 0 0 1 .4845 645
variables
Rest of gkgtos .3363 .3088 0 .9231 .1845 576
independent iking .2208 .1581 0 .8711 .1922 574
inding .2984 .2896 .0105 .7324 .1386 574
variables
rping .0111 .0194 -.6593 .5803 .1438 574

The variable dnivelec applies only to municipalities with more than 1,000 inhabitants
(La Caixa, 2000). Also, intermediate case (dnivelec = 5) has been eliminated in order to
stress the differences between the two subgroups of municipalities. Consequently, we are
faced with the problem of a low number of valid observations (N = 205). This situation

All observations included (i = 1....130; t = 1994,... 1998).

N = 130 and T = 5; maximum number of elements of a variable = 650 (130*5).
Total valid elements for regression (N):
- Including variable dnivelec: 177.
- Excluding variable dnivelec: 564.
depending on the structure of our data, we must apply the corresponding panel data
methodology. In relation to the number of cross-sections (T = 5), we are dealing with a
micro panel. Taking into account the number of cross-sections, econometric literature
(Arellano y Bover, 1990) justifies panel data regressions as the right methodology to use,
since T = 5 is a reasonable number of cross-sections when N>100 (in our case, N = 130).
This methodology allows us to control for unobserved heterogeneity. This issue will be dealt
with in detail later on.

The general specification of the model corresponds to the following equation:

vnpfj, = f(dcosterOjt, dpoblu, dpob2it, dpob3it, dspit, gkgtosn, iking,,,

indingu, rping,,) (i)

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 9 BENITO ft BASTIDA

Where i = 1, ...130; and t =

1994, ...1998.

In relation to variable dnivelec:

I I
E[vnpfi, dnivelecu = 0] < E[vnpf,t dnivelecu =1] (ii)
Where i=
1....130; and t=
1994,...1998.

According to the theoretical and empirical literature available, the following hypotheses
will be tested:

H0-i: dcostero>0

Coastal municipalities must face higher expenditures on tourism infrastructures than

non-coastal ones. Taking into account that there is no specific State funding for these
purposes, the former will hold higher levels of indebtedness than the latter. This proxy
variable controls for the local governments of tourist areas, as suggested by Wei-Te (1995).

I
H0-2: E[vnpfii dnivelec=0] <E[vnpfit \ dnivelec it=\]

The economic level (measured by disposable family income) causes a higher demand for
infrastructures and other kinds of expenditures, and, consequently, a larger debt burden for
local governments (Hulten & Peterson, 1984). 19 This assumption was empirically proved by
Mitchell (1967), Dickson and Yu (1997), Mceachern (1978), Kiewiet and Szalaky (1996), and
Foot (1977). Farnham (1985) also stated theoretically and tested empirically this hypothesis.
On the other hand, Mercer and Gilbert (1996) and Groves et al. (1981) stated
theoretically that this variable explained municipal indebtedness.
This hypothesis, in accordance with the previously given reasons, will be tested by
means of a univariate analysis.

Ho-3a: dpobl < 0

Ho-3t,: dpobl < 0

H0.3c: dpob3 < 020

Municipalities with larger populations have larger debt burdens because of the higher
level of urban infrastructures and services they must provide. Furthermore, this assumption is
reaffirmed by the fact that small municipalities tend to become less indebted and face more
difficulties when trying to access credit than larger municipalities (Farnham, 1985; Hulten &
Peterson, 1984; Rivers & Yates, 1997). Variables for this test are dpobl, dpob2, dpob3, and
the omitted category is {dpobl = dpob2 = dpob3 = 0), applicable to municipalities with more
than 50,000 inhabitants.
Furthermore, Hempel (1973) stated previously this hypothesis theoretically. On the
other hand, Mitchell (1967), Pogue (1970), and Balaguer (2001) proved it empirically.
Finally, we can refer to Groves et al. (1981), who suggested the use of this parameter
(population) in local financial analysis.

H0-4: dsp < 0

Left wing governments, in line with the political theory (Tusell Gomez, 1996) and with
the empirical literature (Blais & Nadeau, 1992; Kiewiet & Szalaky, 1996; Dickson & Yu,
1997) become more indebted than right wing ones. Therefore, according to the definition of
the dummy variable dsp, we expect a negative sign.

H0-5: gkgtos > 0

According to theoretical assumptions (Oates, 1972; Mceachern, 1978; King, 1984;
Musgrave & Musgrave, 1989; Cropf & Wendel, 1998; Benito & Vela, 1998; Holtz-Eakin,
2001) indebtedness must finance investment in capital goods. 21 The empirical work by

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN 10

Balaguer (2001) also proved this hypothesis. On the other hand, this premise is included in
Spanish laws (Ter-Minassian & Craig, 1997). Finally, we can refer to Groves et al. (1981)
and Zehms (1991) in order to justify the relevance of the variable. They pointed out that it
was a good indicator of the investment activity of the municipality. 22

H0.6: iking < 0

In accordance with the Spanish legislation, this sort of revenues is dedicated to

financing new capital investments and, therefore, the higher these revenues are, the lower the
need for municipal indebtedness is, in order to complement the financing of those
investments.

H0-7: inding < 0

From a fiscal point of view, the more autonomous the municipalities are, the less they
get into debt (De Mello, 2001; Mceachern, 1978). The level of autonomy is measured by the
percentage of direct and indirect taxes out of total revenues (excluding indebtedness).
Furthermore, as previously stated, according to Brown (1996), a high figure in this ratio is
recommended.

H0.8: rping < 0

A positive non-financial surplus allows municipalities to use those savings to reduce

their financial liabilities. Both Brusca and Condor (2001) theoretically, and Balaguer (2001)
empirically, considered this factor as a key issue in explaining the indebtedness of local
governments. This is one of the premises of the Pact of Stability and Growth agreed by the
European Union. We will test the effectiveness of this parameter to control the level of
indebtedness. On the other hand, it is worthy to mention that this parameter is the one local
governments most failed to sustain (see Table 2).

Once we have described our hypotheses, we will proceed to explain the estimation
procedure applied. First of all, we propose a traditional cross-sectional regression, estimated
by means of an ordinary least squares test (OLS), between-groups (BG) and within-groups
(WG) estimators. If the assumptions of cross-sectional data are correct, these three estimations
should yield quite similar results. On the other hand, if it does not happen, it implies that the
initial model was not well specified and did not reflect the real economic nature of the
phenomenon at issue. In this latter case, the panel data regression model should be applied.
Subsequently, within this model, we must test if individual-specific factors (unobserved
heterogeneity, Tji) are correlated with regressors (Arellano & Bover, 1990). If the correlation
exists, a fixed-effects model should be the appropriate (WG estimator); otherwise, a random-
effects regression (BG estimator) model should be used.

The initial cross-sectional regression considered is:

vnpfu = a + Xufi + Vu (iii)

Where:
- i = 1, ... 130;
- t = 1994, ..1998;
- vnpfu is the dependent variable, with the structure of a vector [(130x5)xl];
- a is a vector [(130x5)xl] that represents the intercept.
- X,t is the matrix of independent variables [(130x5)x9], [the number of rows is deduced
from(i)];
- p is the matrix of coefficients [9x1], [the number of rows is derived from (i)];
. v is a residual [(130x5)xl] matrix that is supposed to be iid~(0, o-v 2).
The OLS estimator starts with the assumption that regressors are uncorrelated with errors,
that is to say:

cov(^, vit) = 0; co\[Xu,(vnpfu - a -

Xu P)] = 0;
covCV;,, vnpfu)- /3cov(Xu,Xit) = 0 (iv)

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 11 BENITO ft BASTIDA

cov(X u , vnpfu)
Where: J3 =
cov(Xu,Xu)

On the other hand, if model (iii) is well specified, it follows that:

Zl vn
Pfn
vnpf) = a + pxi + v j ; where vnpf, = ----------- (v)

Where: i = 1,... 130; and

t = 1994,... 1998 (identical calculation for Xi and v,).

Applying the OLS estimator to the above expression we get the between-groups estimator
(BG):

T ( x i - x ) ( v n p f. - v n p f ) zzzz z
Z
$BG = ~-------------------- ------ =----------------- > &
BG =
vn
Pf ~ KG X (VI)

Where: VNPF = JL<---------------

NT
i=l,...130; and

t = 1994,... 1998 (identical calculation for x )

Finally, if model (iii) is correctly specified, we can also apply OLS to the following
expression:

V"Pfa - vnPf i - P{ x u - X i ) + u i t - U i (vii)

Where: i=1...130;
and t= 1994... 1998.
In this way we deduce the within-groups estimator (WG):
ZZ ~
Xl
X vnPf - vnPfi)
B = -l______>-_________________________ (viii)

Where: = vnpf - ftWG X

As stated above, if the proposed model is correct, the estimators OLS, WG, and BG
will produce similar coefficients. The coefficients obtained with the three estimators are
shown in Table 7. We have to make clear that coefficients that remain constant during all
periods (dcosteroj, , dpoblit , dpob2H , dpob3it) cannot be obtained through the WG
estimator, since, as we have seen above (viii), in the estimator, the average for each period
is subtracted from each observation (x,). Therefore, in the case of time-invariant regressors,
all observations become zero. Consequently, we calculate 5 (9-4) coefficients (see Table 7).
TABLE 7 Estimation of Coefficients
The coefficients obtained by applying the three estimators differ, meaning that model
(i) was not accurately specified. The error in the
specification of the model lies in the existence of unobserved heterogeneity, which, since it cannot be
measured, is included in the residuals. This heterogeneity has a similar behavior to model errors (u it),
since it is a random variable with a mean equal to zero and a variance different from zero (a n).
Nevertheless, whereas the residual (Ujt) includes completely random factors, the term r|j measures
unobserved inherent elements of the municipality, 23 and consequently they do not vary as time goes on.
Thus, the appropriate equation is:

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN 12

vnpfu = a + X j ,P + Z, y+ n, + u (ix)
Where:
- Xu is the matrix of time-variant regressors: dsp, gkgtos, iking, inding, rping;
- Z, is the matrix of time-invariant regressors: dcostero, dpobl, dpob2, dpob3;
- 77, stands
for unobserved heterogeneity;
- Uj,stands for the residuals, which given that they do not include unobserved heterogeneity, are
supposed to be iid,~(0, au2).
This equation represents the static panel data regression, and allows an estimation of individual
behavior models exploiting cross-sectional data (several observations) and time-series (several
periods).24 As stated earlier, almost all previous papers in Spain considered several periods in their
samples; however, they did not apply the panel data methodology, and therefore obtained a biased and
less accurate estimation of the population parameters. The key point is that these studies did not test the
existence of unobserved heterogeneity, which, as we have seen previously, may exist in cross-sectional
data observed in different periods of time (Arellano & Honore, 2000).

At this point, we must check if the unobserved heterogeneity is correlated with

regressors. In order to do so, we apply the Hausman test (Arellano, 1993; Contoyannis &
Rice, 2001), whose null hypothesis is the uncorrelation between heterogeneity and
regressors:

H0: E(77, | Xlt) = 0; x2(5)=21.79; Prob. > %2 = 0.0006 (x)

We clearly reject the null hypothesis (significance 0%). This means that there is
correlation between 77, and Xu. Accordingly, the fixed effects model is the right one.
Nevertheless, the Hausman test is only valid if the GLS estimator is efficient in relation to
the WG estimator under the null hypothesis. In order to ratify the result, we have regressed
using OLS the system of equations proposed by Arellano and Bover (1990), and we have
calculated the following test that confirms again the correlation between 77, and Xit:

H0: 2 = 0; F(5,916) = 4.83; Prob. > F = 0.0002 (xi)

Null hypothesis of uncorrelation between regressors and unobserved heterogeneity is
rejected.

Accordingly, we will estimate the regression of vnpf on dsp, gkgtos, iking, inding and
rping using the WG estimator, and we will obtain /3 coefficients. On the other hand, the y
coefficients applicable to time-invariant regressors (dcostero, dpobl, dpob2, dpob3) which
the WG estimator is not able to calculate, will be estimated by means of the regression
proposed by Hsiao (1986):

fiu =v?tpfit- X i t f i => $ , = a ' + yzi (xii)

Where:
- ft,is the temporal mean of residuals estimated in the regression (ix).
- zi stands for the temporal mean of time-invariant regressors.
- This equation is estimated through OLS.
ANALYSIS OF RESULTS

Summary of the Regressions

The WG estimation of model (ix) presents the coefficients included in Table 8.

TABLE 8 Coefficients of the WG Model

Regressor Coefficient Expected sign Significance
a (constant) 0.10649 6? *
**
P dsp 0.01576 -
gkgtos 0.09319 + *

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 13 BENITO ft BASTIDA

*
iking -0.16954 - *
**
inding -0.27426 - *
**
rping -0.22200 - *
**
- Dependent variable: vnpf
- Number of valid observations for regression: 564.
- Significance: * 10%; ** 5%; *** 1%.

On the other hand, estimation of equation (xii) is summarized in Table 9.

In order to test the hypothesis related to the variable dnivelec (ii), the results obtained
from the test that compares the difference between means are shown in Table 10.
TABLE 9 Estimated Equation

-Dependent variable: tit.

-Number of valid observations for regression: 130.
-Significance: * 10%; ** 5%; *** 1%.

TABLE 10
Difference of Means in Variable dnivelec (ii)
Period Mean of vnpf whether... t-test for difference of means
dnivelec= 0 dnivelec=\ t P>|t| Significance
1994-1998 -0.0561 -0.0167 -1.242 0.
216
1994 -0.0310 -0.0057 -0.520 0.
607
1995 -0.0506 -0.0900 0.504 0.
618
1996 -0.0842 0.0232 -1.354 0.
185
1997 -0.0357 -0.0138 -0.442 0.
662
1998 -0.0770 0.0099 -1.054 0.
299
Variable whose means have been compared: vnpf. The results have been confirmed with
Mann-Whitney non-parametric test. After applying Levene test, we have assumed equal
variances in all tests.

Financial Variables
The results indicate that capital expenditures {gkgtos) have a positive influence on the
variation of debt stock (see Table 8). This feature confirms both the theoretical premises
(Oates, 1972; Mceachern, 1978; King, 1984; Benito & Vela, 1998; Holtz-Eakin, 2001) and
the empirical work of Balaguer (2001). Furthermore, this feature meets the

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN 14

"intergenerational equity" theory (Musgrave and Musgrave, 1989). Finally, the data show
the compliance with Spanish legal regulation (Ter-Minassian & Craig, 1997).

On the other hand, capital revenues (iking), as derived from legal arguments, cause a
lower need for financial indebtedness (see Table 8).

The non-financial surplus/deficit (rping) has the same effect because if it is positive,
it generates financial resources that can be applied to reduce indebtedness (see Table 8).
This result confirms again the conclusion reached by Balaguer (2001).
Finally, the independence ratio (inding) coefficient, which measures the ability to collect
own taxes and, therefore, a measurement of financial autonomy, has a negative sign,
corroborating our hypothesis (see Table 8). It also confirms the assumption of Mceachern
(1978) and De Mello (2001) regarding the outlay decisions made by local governments.
According to these authors, the municipalities decide the mix of taxes and debt needed to
finance public goods and therefore, the more autonomy they have in levying local taxes, the
less debt they are forced to issue.

Socioeconomic Variables

The result obtained using the geographical variable (dcostero) is, at least, interesting,
since it rejects the null hypothesis (significance 1%), and reveals that non-coastal
municipalities have a higher level of increase of borrowing than the coastal ones (see Table 9).
Therefore, we do not confirm the conclusions reached by Wei-Te (1995).

Both the economic level (dnivelec) and the population (dpobl, dpob2, dpob3) are not
significant (Tables 9 and 10). Thus it seems that these factors are not useful in order to explain
the level of indebtedness of local administrations in Spain. These findings are further discussed
below.

With regard to economic level (dnivelec), we confirm the conclusions reached by Pogue
(1970) and Balaguer (2001) (see Table 10). On the contrary, Mitchell (1967), Foot (1977),
Mceachern (1978), Hulten and Peterson (1984), Kiewiet and Szalaky (1996), and Dickson and
Yu (1997) found that this variable provoked a higher debt level. This feature also fails to
confirm the theory (Hulten & Peterson, 1984; Mercer & Gilbert, 1996; Groves et al., 1981).

Considering the population (see Table 9), Pogue (1970), Hempel (1973), Hulten and
Peterson (1984), and Mercer and Gilbert (1996) stated that population growth had a positive
effect on debt levels. Furthermore, our findings do not confirm previous empirical works, such
as Farnham (1985) and Balaguer (2001).

Taking into account both factors simultaneously, Mitchell (1967) stated that the higher
population and the economic level are, the higher the indebtedness is.
Finally, the variable political ideology (dsp), according to our findings, does not affect
local indebtedness (confirming the results of Abizadeh and Gray [1993]). This feature, as set
out above, contrasts with the theoretical assumptions. Further, it does not corroborate the
works of Blais and Nadeau (1992), Kiewiet and Szalaky (1996), and Dickson and Yu
(1997), who pointed out that right wing parties held lower levels of indebtedness.

CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH

The objective of this paper was to provide an empirical analysis of municipal debt
patterns based upon a proportional stratified random sample of 130 municipalities during a
five-year period (1994-1998).

The main conclusion reached is that the financial variables that better explain the issue
of debt in these entities are non-financial surplus/deficit, financial independence, capital
expenditures and capital revenues. These two latter variables are related to one of the limits
discussed earlier, i.e., long-term debt must finance capital expenditures. Another kind of
variables considered, such as political ideology, economic level, or population have not

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 15 BENITO ft BASTIDA

been found to be significant. On the other hand, geographical location (coastal or not)
influences indebtedness, but with the opposite sign than the one we originally expected.

Among the limitations of this study, there is a methodological aspect to the model. The
initial equation has been divided into two other models plus a test for medians difference.
Consequently, the whole variation of the dependent variable has not been represented by
one unique equation, and so, the R 2 of the two separate models is no longer relevant.
Therefore, it has not been included in the corresponding tables.

On the other hand, it would have been advisable to include organizational and
managerial factors, besides budgetary and financial variables, so that the behavior of the
dependent variable could be better described. However, such information was not available.
In the last few years, interrelations between financial and organizational variables are being
increasingly analyzed to:

a) Study causality situations, and

a) Understand the consequences of public decisions adopted by local governments.

With respect to future research works, the effectiveness of debt limits is worth
researching. In that sense, we would like to prove the conclusions of Mceachern (1978),
Kiewiet and Szalaky (1996) and Bunch (1991), which would allow us to test whether the
existence of municipal debt limits makes the local governments react by either:

- Circumventing legal debt limits by issuing debt that is not included in the limits
(circumvention hypothesis); or

- Shifting debt from the municipalities to other dependent entities. In Spain, it could be
towards companies or other kinds of entities created or owned by the local governments
(devolution hypothesis).

On the other hand, further research is needed to examine the electoral cycle shown in
table 2. Works such as Blais and Nadeau (1992) and Dickson and Yu (1997) have analyzed
this issue. In addition, future research should pay attention to new types of municipal
indebtedness (creative financing), which are currently being used to finance public
expenditures in Spain, as well as in the USA (Cropf & Wendel, 1998).

Finally, we intend to research in the future whether fiscal decentralization increases local
indebtedness as a result of lax debt management (De Mello, 2001). Because of its high degree
of decentralization, Spain appears to be the appropriate field for further research on this
matter.

ACKNOWLEDGMENTS
This work is part of the research project PPC/01491/03, funded by the Fundacion Seneca
of the Autonomous Community of the Region of Murcia (Spain). We also thank two
anonymous referees for their insightful comments.

NOTES

1. A large percentage of their inflows (31% on average in 1998) is still represented by

transfers from higher levels of government. Transfers are classified as "current" or
"capital" depending on whether they are intended to cover operating expenditures or to
finance investments respectively.
2. These services are provided partly free of charge and partly against the payment of a
price that is usually lower (sometimes much lower) than production cost.

3. We would like to point up that papers such as Swaroop (1995) have questioned the
merit of a balanced budget as a strict rule. This is particularly true in the case of
Germany, whose present economic crisis has forced the government to assume a
budgetary deficit as a measure to boost the economy.

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 THE DETERMINANTS OF THE MUNICIPAL DEBT POLICY IN SPAIN 16

4. E.g., Pogue (1970), Mceachern (1978), Farnham (1985) and Bunch (1991). On the
other hand, Kiewiet and Szalaky (1996) and Brown (2000) suggested that the success
of the limit depended on its nature.

5. This electoral cycle was proved, among others, by Blais and Nadeau (1992) and
Dickson and Yu (1997).

6. One of the 17 Regions of which Spain is composed.

7. Some of the studies focused on this issue have been discussed earlier.

8. As Cropf and Wendel (1998) pointed out, we have included these external factors in
the analysis because the municipal debt policy is strongly affected by them.

9. The sample included 185 entities from 1978 up to 1988; he applied a panel data
regression. After testing the correlation between unobserved heterogeneity and the
independent variables (p. 63) he applied the appropriate model: random or fixed
effects.

10. See Farnham (1985) for a detailed discussion about this issue.
11. After performing a univariate analysis (T-student test and confirming with U-Mann-
Whitney test) to verify the significance of the difference of the means, these authors
developed a multivariate test based on a logit model. This logit regression was
estimated twice, one for each year (1993 and 1994).

12. They proposed a random effects model by means of the Generalised Least Squares
(GLS) estimator.

13. Published by the Public Audit Office for Valencia.

14. Measured by means of the number of inhabitants according to 1998 census.
15. It is well known that the use of an excessive number of independent variables reduces the
parsimony of the model (Hair et al, 1998).

16. All the monetary amounts have been deflated according to the variation of the Consumer
Price Index for Autonomous Community of Valencia published by National Institute of
Statistics, and refer to thousands of constant pesetas as of December 31 st, 1994. All
variables, except dcostero, dnivelec and dsp have been drawn from Annual Accounts of
the municipalities for the period 1994-1998. The data for variable dnivelec were found in
the Spanish Trade Directory edited by La Caixa (classifies municipalities in 10 levels
according to familiar income). On the other hand, the General Sub department of
Electoral Processes (Area of Electoral Processes) of the Spanish Ministry of the Interior
sent us the necessary information to form dsp.

17. We have chosen this proxy variable because in our population almost 100% of the tourism
is located at the coast.

18. This dummy variable has been built as suggested by Erikson, Wright and Mclver(1993).
The two relevant election days in our study were: May 26 th 1991 and May 28th 1995.
According to previous studies (Blais & Nadeau, 1992 and Dickson and Yu, 1997), the
election year should be taken to fall in the current year if the election falls after June 30 th,
otherwise it should be taken to fall in the preceding year. However, in our survey, the local
election takes effect from the following year, i.e.:

- The election of 1991 forms the variable dsp for the years 19941995.

- The election of 1995 forms the variable dsp for the years 19961998.

We have chosen this approach because the politicians that win the local election in
May have to deal with the budget previously passed by the former government for the
whole year (local budgets are passed in December of each year and take effect from

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 17 BENITO ft BASTIDA

January to December of the following year). As a result, the ruling party in the
municipality cannot put its policy into practice by means of the budget until the following
year to the election year.
19. Adolf Wagner hypothesized a positive correlation between per capita real income
growth and government expenditure. This theory is known as Wagner's law and, to
some extent, supports our assumption. However, the literature regarding this theory is
far from being conclusive.

20. Several studies have analyzed the effects of population on other debt characteristics.
For example, Carleton and Lerner (1969) hypothesized that a large population should
have a positive effect on the municipal bond rating. Simonsen Robbins and Helgerson
(2001) tried to prove whether the population influenced the municipal bond interest
rates.

21. See Bonner (1972), Collins (1977) and Swaroop (1995) for an extensive research on
the municipal choice between debt and taxes.

22. Works such as Benito and Vela (1998) and Estevez (1995) can also be consulted.
23. These elements include both the preferences of the community regarding the optimal
debt level (Mceachern, 1978), and regional attitudes toward debt financing (Farnham,
1985).

24. We can place this technique on the dividing line between time series and cross-
sectional analysis.

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