Subnational governments are crucial actors in delivering public services and addressing structural challenges but are often overlooked in fiscal policy debates. This column analyses the macroeconomic pressures faced by subnational governments and their respective bond markets. It shows that persistent inflation and tight monetary conditions continue to weigh on growth and public finances in many countries. Varying debt profiles and borrowing modalities further differentiate the fiscal challenges of different jurisdictions. Structural responses aimed at long-term sustainability must emphasise improved transparency, credible fiscal rules, and strengthened frameworks that delineate subnational fiscal responsibilities and central government support limits.
Subnational governments account for nearly 40% of public investment and more than a quarter of public spending across OECD countries. They are critical actors in delivering public services and addressing long-term structural challenges, including ageing, climate adaptation, digital infrastructure, social cohesion, and housing. In many countries, subnational governments are also major employers and providers of health and education services.
Despite this central role, fiscal policy debates and macroeconomic discussions often overlook subnational governments – particularly in relation to debt sustainability and markets. The current macroeconomic environment, marked by elevated inflation, high borrowing costs, and limited fiscal space (Fornaro and Wolf 2025, Furceri et al. 2025), warrants more attention to be given to subnational debt and borrowing frameworks. At the same time, persistent market inefficiencies, such as central government bailout expectations, raise concerns that subnational bond debt is being mispriced, risks are underappreciated, and incentives misaligned.
In this column, we build on recent OECD work to examine how subnational governments are navigating this turbulent environment. We begin by exploring the macroeconomic pressures facing subnational governments, then draw lessons from recent crises, and focus on the structure and behaviour of subnational government bond markets. We conclude with a set of policy recommendations aimed at reinforcing market discipline, reducing bailout expectations, and modernising fiscal frameworks to ensure sustainability at all levels of government.
The Global Crisis illustrated the significant macroeconomic consequences of pro-cyclical fiscal policies adopted by subnational governments under fiscal distress. In both the US and the EU, limited fiscal autonomy and borrowing constraints forced local governments into severe spending cuts and investment retrenchments precisely at the moment economic stimulus was most needed. This pro-cyclicality not only deepened the recession but slowed the recovery, highlighting structural fragilities inherent in subnational financing systems.
Subnational governments and the macro-fiscal environment: Asymmetric pressures
Economic activity has weakened across many OECD countries, with persistent inflation and tight monetary conditions continuing to weigh on growth and public finances. Following a period of unprecedented monetary tightening, borrowing costs remain near their highest levels in 15 years, exacerbating fiscal pressures across government levels. Subnational governments have limited borrowing autonomy, rely on formula-based transfers, and are often subject to balanced-budget rules. At the same time, they face large spending responsibilities and reduced flexibility to respond to shocks.
The most recent subnational data available (Figure 1, Panel A) highlight notable deterioration in fiscal balances at the subnational level, particularly evident in countries such as Korea, Austria, Bulgaria, Sweden, Germany, and Finland. In Germany, the decline was primarily driven by a drop in revenues rather than increased expenditures. In the latest data for the US (NASBO 2025), subnational governments experienced a significant shift, moving from a strong surplus to a significant deficit, driven both by a decline in total revenues and an increase in total expenditures, with a strong impact from interest expenses. The OECD-wide data shows subnational governments facing negative aggregate fiscal balances for the first time since the post-Global Crisis recovery period (Panel B).
Figure 1 Recent evolution in fiscal balances of subnational governments in the OECD
Panel A) Changes over 2023-2022 (percentage points of national GDP)
Panel B) Balances over time (percentage points of total revenues)
Note: Panel A shows the change in percentage points of GDP. Panel B shows the balances in percentage of total revenues. EA = Euro area.
Source: OECD System of National Accounts, Table 12 – Net lending (+) / borrowing (-), in Brochado and Dougherty (2024).
The rise in interest payments has asymmetrically impacted subnational governments, depending significantly on their debt profiles and borrowing modalities. Jurisdictions predominantly borrowing from financial markets through bond issuance are exposed to market fluctuations, whereas others dependent on bank loans face variable rate increases and tighter credit conditions. The varying debt maturity structures further differentiate their immediate fiscal challenges.
Rising debt service costs can crowd out space for investment and social spending, especially as subnational governments have limited revenue and borrowing capacity. Moreover, these challenges come at a time when subnational governments are expected to scale up their contributions to energy transition, digital transformation, and housing initiatives.
Beyond budgetary stress, rising interest rates also pose political and institutional risks. Where local and regional authorities lack clear rules or credible backstops, markets may begin to question sustainability, leading to volatility or contagion. Conversely, in systems where subnational governments are seen as implicitly protected by central authorities, subnational debt may be systematically underpriced – raising the risk of moral hazard and distorted incentives.
Learning from the pandemic: Crisis as a stress test
The COVID-19 pandemic served as a real-time stress test for intergovernmental fiscal systems (Dougherty and de Biase 2021). While the severity and duration of the shock varied, most subnational governments experienced a dual squeeze – declining revenues and rising expenditure responsibilities, with little room to obtain new funding.
Due to the fragility of subnational governments’ fiscal positions, in most OECD countries, central governments intervened quickly and at scale, providing extraordinary transfers to stabilise local budgets. While this helped prevent pro-cyclical cutbacks and protected essential services, it also reinforced perceptions that central authorities will act as ‘lenders of last resort’ in future crises.
Many fiscal rules were suspended or softened during the crisis, and in some cases, debt ceilings were temporarily lifted. Yet relatively few countries used this opportunity to strengthen the long-term sustainability of their fiscal frameworks. As a result, many of the vulnerabilities exposed by COVID-19 remain unresolved.
With interest rates now significantly higher and public debt levels elevated, the next fiscal shock could be more difficult to absorb – particularly if market confidence in central government support begins to erode, with central governments in need of fiscal consolidation themselves. Recent analysis warns that ill-timed or poorly designed consolidation strategies – particularly those that freeze or reduce equalising transfers – risk weakening the stabilisation role of intergovernmental finance and widening regional disparities (Dougherty et al. 2025).
The structure of subnational bond markets: A case of quiet dysfunction
One of the more puzzling features of subnational government debt markets is the low dispersion in borrowing costs across jurisdictions. In some countries with developed subnational bond markets – such as China, India, and certain OECD countries – yields on subnational government bonds tend to cluster tightly across jurisdictions, despite clear differences in their fiscal performance, revenue capacity, and governance. Even in countries considered as benchmarks for subnational government bond markets, like Canada, Germany and the US, yields are closer to each other and to the risk-free borrowing rate than they would be in a purely competitive market (Figure 2).
Figure 2 Low dispersion of subnational government bond yields in selected countries
Individual subnational government bond yield variance across countries and time (monthly)
Notes: Only bonds issued in domestic currency. Monthly boxplots, no outliers. Periods with higher variance show a thicker area. The Y-axes are from -1% to 15% percentage points. The X-axes go from Apr/2008 to Jan/2024, for all countries.
Source: Brochado and Dougherty (2024), with LSEG data.
This phenomenon can be partly explained by market inefficiencies that are both structural and behavioural. First, in some countries, there is a widespread expectation that subnational governments will be bailed out in the event of distress. These expectations may be informal and, thus, have no legal basis. Still, investors often act on political instincts rather than legal rules, narrowing risk spreads and weakening credit signals.
Recent experiences during the COVID-19 pandemic reinforced these expectations of implicit central bailouts. Extraordinary central support provided to subnational governments – documented in our earlier VoxEU column (Dougherty and de Biase 2021) – has potentially deepened moral hazard. Investors, observing extensive central interventions, have limited incentives to price subnational fiscal risks adequately.
Second, fiscal transparency at the subnational level remains uneven. In many countries, subnational governments are not required to publish standardised budgetary and debt information on a timely basis. Audits may be irregular, and reporting standards vary widely. Without comparable, timely, and accessible fiscal data, investors struggle to price risk accurately – even when willing to do so.
These factors collectively create a paradox: while subnational borrowing is often constrained by law or institutional design, in practice, weak price signals and bailout expectations can encourage excessive or misaligned borrowing. The long-term consequences can be severe when macroeconomic conditions deteriorate or central government support wanes.
Failing to address subnational vulnerabilities could again trigger pro-cyclical adjustments during downturns. Rising borrowing costs and limited revenues could again force spending cuts and investment delays – just as stimulus is most needed, echoing post-Global Crisis outcomes.
Fiscal frameworks and the role of market discipline
In response to these challenges, many countries have sought to reform intergovernmental fiscal frameworks. The OECD’s Intergovernmental Fiscal Outlook (OECD 2025) and Fiscal Federalism 2022 (OECD 2021) respectively explore the fiscal situation of subnational governments and outline several principles for effective reform.
First, fiscal rules should be designed to provide both discipline and flexibility. Expenditure or debt ceilings should be linked to clear medium-term objectives, with well-defined escape clauses for exogenous shocks. Rules must also be enforceable – with transparent monitoring, credible sanctions, and independent oversight.
Second, frameworks should clarify the conditions and limits of central government support. This includes establishing transparent criteria for extraordinary transfers, setting up fiscal buffers or stabilisation funds, and creating resolution mechanisms for subnational fiscal crises. The aim is not to eliminate solidarity, but to ensure that it does not encourage imprudent behaviour.
Third, fiscal transparency is essential. Countries like Mexico and South Africa now use centralised debt registries and real-time reporting to monitor subnational liabilities — a model worth replicating.
Reforms should also be coordinated across levels of government. National investment strategies, including those related to energy transition, digital infrastructure, and housing, significantly rely on subnational government implementation. Fiscal frameworks must therefore facilitate – not constrain – sustainable investment, while still safeguarding long-term debt sustainability.
Conclusion: Fiscal sustainability requires local accountability
The era of cheap and abundant finance for governments is at an end. High borrowing costs, coupled with elevated debt levels and renewed global shocks, have brought fiscal sustainability back to the centre of economic debate. But too often, these debates focus only on “sovereign” or central government balance sheets, ignoring the complex, growing roles of subnational governments.
As we argue in this column, the risks facing subnational governments are distinct but interrelated: tighter borrowing conditions, increasing investment responsibilities, and market structures that often fail to price risk accurately. Left unaddressed, these dynamics could undermine both macroeconomic stability and the achievement of government priorities.
Addressing these fiscal risks requires distinguishing structural from junctural challenges. Structural responses, aimed at long-term sustainability, must emphasize improved transparency, credible fiscal rules, and strengthened frameworks that clearly delineate subnational fiscal responsibilities and central government support limits.
Key reforms include improving borrowing frameworks, better fiscal transparency and aligning subnational finance with long-term investment goals.
Finally, it is essential to recognise that fiscal sustainability is not just a national issue – it is a multilevel challenge. The weakening of automatic fiscal stabilisers observed in recent years (Auerbach and Yagan 2025) only reinforces the urgency of strengthening subnational fiscal governance. The current turbulence offers a window of opportunity. By strengthening the foundations of subnational finance now, countries can build more resilient, responsive, and sustainable fiscal systems for the future.
Source : VOXeu
