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Public Financing Under Balanced Budget Rules

This paper analyzes the impact of a balanced budget rule (BBR) on government financing costs. We construct measures of BBR at the US state government level and find that states with tighter BBRs are associated with significantly lower state government bond spreads. Furthermore, the credit default swap (CDS) spreads are also significantly lower for states that impose tighter BBRs, indicating the importance of a default risk channel. We then build a simple sovereign default model with BBRs to illustrate the mechanism and conduct event analysis. Our quantitative analysis projects that the debt spreads for the state government of Illinois would reduce by 50% and its debt burden would decline by 33% in ten years if it imposed a BBR today.