Working Paper: NBER ID: w22304
Authors: Carlos A. Vegh; Guillermo Vuletin
Abstract: The flypaper effect is a widely-documented puzzle whereby the propensity of sub-national governmental units to spend out of unconditional transfers is higher than the propensity to spend out of private income. Building on previous insights in the literature that rationalize this puzzle using costly taxation, we develop a simple optimal fiscal policy model with distortionary taxation that generates two novel and testable implications: (i) there should be a positive association between the size of the flypaper effect and the level of the tax rate, and (ii) the flypaper effect should be larger the lower the elasticity of substitution between private and public spending and, in fact, should vanish for very high degrees of substitution. We show that these hypotheses hold for Argentinean provinces and Brazilian states.
Keywords: Flypaper Effect; Distortionary Taxation; Fiscal Policy
JEL Codes: H21; H22; H41; H42; H62; H77
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tax rate (H29) | Size of the flypaper effect (C54) |
| Elasticity of substitution between public and private spending (H30) | Size of the flypaper effect (C54) |