Intergovernmental Transfers, Local Fiscal Policy, and the Flypaper Effect: Evidence from a German State

I study how rule-based general-purpose transfers from a higher tier of government affect municipalities' expenditures and taxation. The data set covers 319 municipalities in the German state of Hesse over the period 2001–2010. For identification, I rely on discontinuities in the allocation formula for general-purpose transfers that the state government of Hesse pays to its municipalities. Exploiting these discontinuities to implement an instrumenal-variable design, I find evidence that Hessian municipalities use transfers to increase expenditures but not to reduce taxes. These results are consistent with the existence of a flypaper effect in German local fiscal equalization.