Intergovernmental transfers and dynamic adjustment of subnational budgets

We study the dynamic impact of intergovernmental transfers on subnational budgets. Using the ideal case of a multi-level government like Argentina, and methods for dynamic analysis, we disentangled the nature of subnational fiscal adjustments that follow a shock in federal transfers. The results indicate that in the short-run, transfers increase spending more than proportionally and own revenues also increase, although to a small extent. Thus, a deficit is reached in the short-run. In the long-run, provinces recover fiscal equilibrium by adjusting spending to a level consistent with a balanced budget. The steady-state equilibrium involves a higher level of spending, as transfers increase endogenously as a result of cross-regional spillover effects. This result is robust to variations in the definition of subnational budgets. We also provide a discussion on potential mechanisms that may guide the dynamic of fiscal adjustments, and a relevant set of extensions that consider regional disparities and different types of taxes and spending used to balance subnational fiscal accounts. As a whole, the paper provides relevant insights for the design of subnational fiscal policy.