| Summary: | This paper shows how the creation of ceilings on local public debt can increase economic activity. For identification, the paper exploits administrative micro data in conjunction with the introduction of a Mexican law limiting the amount of indebtedness of subnational governments. The analysis finds that states with ex-ante higher public debt have stronger economic growth after the implementation of the law, despite reducing public spending and increasing taxes, albeit at the expense of more extreme poverty. The mechanism for this result is a reduction in crowding out. In states with higher ex-ante public debt, banks reallocate credit away from local governments and into private firms, with strong positive firm-level real effects. The unwinding of this crowding out is stronger for more credit constrained firms and for firms borrowing from banks that are more exposed to local public debt. Furthermore, the impact of the law on economic growth is stronger in states allocating a larger share of public spending to non-infrastructure projects
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