Race to the debt trap? — Spatial econometric evidence on debt in German municipalities

•We derive the theoretical reaction of jurisdictions' debts to their neighbors' debts.•We estimate the spatial interdependence of public debt among German municipalities.•We find statistically and economically significant and robust interaction effects.•Tax interaction is stronger and spending interaction weaker than debt interaction.

Through an intertemporal budget constraint, jurisdictions may gain advantages in tax and spending competition by ‘competing’ on debt. While the existing spatial econometric literature focuses on tax and spending competition, very little is known about spatial interaction via public debt. If jurisdictions compete for mobile capital to finance public spending, they may compete in debt levels as well as taxes. We use a theoretical model to derive the reaction of jurisdictions' debt levels to their neighbors' debts. We then estimate the spatial interdependence of public debt among German municipalities using a panel on municipalities in the two largest German states from 1999 to 2006. We find significant and robust interaction effects between debt levels of neighboring municipalities, which we compare to spatial tax and spending interactions. The results indicate that a municipality increases its per capita debt by 16–33 Euro as a reaction to an increase of 100 Euro in neighboring municipalities.