The flypaper effect: evidence from a natural experiment in Hesse

Theory suggests that transfers should have an effect on local fiscal policy that is similar to an equivalent increase in local incomes. Yet much of the empirical literature shows that local governments use transfers primarily to increase expenditures. Recent contributions have revisited this so called flypaper effect by using quasi-experimental methods, and some have found that the evidence for the flypaper effect dissipates once endogeneity of transfer receipts is accounted for. This paper contributes to the growing body of quasi-experimental research on the flypaper effect by exploiting a natural experiment in the German state of Hesse. Using discontinuities in the Hessian municipal transfer allocation formula to construct a set of instruments for municipal transfer receipts during the 2001-2010 period, it provides strong evidence in favor of the flypaper effect.