Housing booms and local spending

This paper examines how local governments adjust their spending in response to a temporary revenue windfall generated by a housing boom. We focus on Spanish local governments because of the intensity of the last housing boom-bust experienced there and the large share of construction-related revenues they obtain. We find that windfall revenues were mostly used to increase expenditures (above all, current). We seek to determine whether this behaviour was due to political myopia (incumbents in contested elections increasing expenditures to convince uninformed voters about their competence) or to extrapolation bias (leading to the overstatement of the persistence of revenue shocks). We find evidence for both mechanisms: the propensity to spend is higher where local incumbents were elected by a narrow vote margin and lower in places with past volatility experience. Finally, we also examine what happens during the bust, and find that governments enjoying large windfalls during the boom had to cut their spending abruptly (above all, capital) and raise taxes. The adjustment during the bust was actually greater in those places that overspent more during the crisis.