Fiscal Policy in Monetary Unions: State Partisanship and its Macroeconomic Effects

States have become an increasingly important agent of fiscal policy in the U.S. Motivated by the large literature that finds increases in partisanship among policymakers, we analyze whether partisanship affects state fiscal policy and what its macroeconomic effects are. Using data from close elections, we find strong partisanship effects in the passthrough of federal transfers to state: Republican governors spend less of federal funds and, instead, cut distortionary taxes. Transfers are an important vehicle of federal policies, with a share of 40% in the 2009 stimulus bill and funding the 2014 Medicaid expansion. We provide causal evidence that the passthrough of federal transfers by state governments varies between Republican and Democratic governors, using a regression-discontinuity design. To analyze the macroeconomic effects of this partisan behavior, we use a structural model of Republican and Democratic regions in a monetary union. The model delivers an aggregate transfer multiplier that is significantly lower with partisan differences. This is due to distortionary tax cuts that lower the initial aggregate demand effects, but make Republican states more competitive with a delay. Our model implies that the transfer multiplier varies over time with the partisan affiliation of governors and we find empirical support for this prediction using local-projection methods.