The recent recession has shone a very public spotlight on the perilous financial conditions of many American states. At the same time, it has renewed academic interest in the question of excessive state debt—its causes and possible cures. Scholars who see risk externalization as a primary driver of systematic overborrowing have proposed bankruptcy legislation for the states as one solution. Such advocates argue that a formal debt-adjustment mechanism could reduce the appeal of federal bailouts and thereby curtail the moral hazard leading to excessive debt. But given the states' unilateral power to set the terms of default, it is hard to see why an opportunistic state would be inclined voluntarily to invoke an ex post debt-adjustment mechanism—and indeed this Article shows that even under existing law states could effectively opt into the federal bankruptcy procedures of Chapter 9 if they so desired. An ex ante approach is needed.

This Article identifies one such ex ante approach, "tax-credit borrowing," and argues that with minimal changes to federal tax policy, this approach could reduce risk externalization more effectively than bankruptcy legislation can. The advantage of tax-credit borrowing in this context stems from its capacity to preclude default by toggling the plaintiff/defendant distinction that lies at the heart of modern sovereign-immunity doctrine. Without a credible threat of default, a state's leverage in bailout negotiations and the concomitant moral hazard would be greatly reduced. But tax-credit borrowing would have important implications for state fiscal policy even if agency problems (rather than risk externalization) better explain state borrowing habits. This Article shows how the availability of risk-free debt could reduce borrowing costs and improve the monitoring of state political actors.

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