Opinions expressed in this paper are those of the authors and do not constitute the official position of the Cabinet Office, the Japanese Government or the Economic and Social Research Institute. Toward Reform of Local Bond System in Japan September 2005 Takero Doi # and Tomoko Hayashi ## Abstract Outstanding of local government bonds in Japan has increased rapidly after the 1990s, and now reached the highest level. It is important to reduce and manage not only the outstanding amount of national government bonds but also local government bonds. We can find that the change of the management system of local government bonds in advanced countries because of decentralization and increasing of the government debt in recent years. This paper discusses the international comparison of fiscal discipline of local governments and the characteristics of local government bond systems in the United States and France studied through local survey. We also model economic institutions behind Japanese local government bond issues and more market-oriented system behind the US local government bond and draw welfare implications from the comparison of Japanese and the US systems. Japanese system requires the permission of issuing from the central government which determines the use of funds raised by local government bond issue and who should buy those bonds. (Ex post) subsides for interest and debt payment as well as the mechanism for the reconstruction of local government budget in the case of (near) default also characterize the Japanese system. Under such heavy protection by the central government, bond yields do not reflect credit risk of local government and therefore ex post burden is transferred to national, not local, tax payers. On the other hand, the US system make credit risk to be reflected in local government yields because of rating and other market oriented mechanism, so that risk are shared by market participants. Implications for improvement of the Japanese system are presented and discussed toward the end of the paper. As the suggestion in Japan, some points are clarified from the international comparison. In many countries except Japan, local governments face discipline through market mechanism in the market of local government bond. Various actors such as investors and banks in the market support the fiscal discipline. Furthermore, not only the market mechanism but also some fiscal rules play an important role for reduction of local government debt. # Keio University and Economic and Social Research Institute, Cabinet Office ## International Economic Affairs, Cabinet Office