How Do Local Governments Adjust to Changes in Equalization Transfers? Evidence from Argentina

We study the dynamic impact of intergovernmental transfers on local government budgets. Unlike the extensive literature that focuses primarily on developed countries, this paper shifts the focus to the developing world. Using Argentina as an ideal case of a multi-tiered government and employing dynamic analytical methods, we disentangle the nature of local fiscal adjustments following a shock in transfers from the intermediate level of government. In the short run, transfers lead to increases in both spending and own tax revenues. As the growth of spending outpaces that of own tax revenues, a deficit emerges. In the long run, local governments restore fiscal balance by adjusting both spending and taxation to levels consistent with a balanced budget. The steady-state equilibrium involves a higher level of public spending, driven by the endogenous growth of transfers. These findings are robust to a battery of robustness checks. We further extend the analysis by examining: the composition of spending and own tax revenues throughout the fiscal adjustment process; the role of local government size; and the influence of conditionality in certain types of transfers -an aspect often overlooked in the literature, but highly relevant for shaping results. Finally, we offer a comparative discussion that places our findings within the broader literature. Overall, the paper provides valuable insights for the design of local fiscal policy.