Housing booms and busts and local spending

Abstract

This paper examines how local governments adjust their spending in re-sponse to a temporary revenue windfall generated by a housing boom. We fo-cus on Spanish local governments because of the intensity of the last housing boom-bust experienced there and the large share of construction-related rev-enues they obtain. We find that windfall revenues were mostly used to in-crease expenditures (above all, current). We seek to determine whether this behaviour was due to political myopia (incumbents in contested elections in-creasing expenditures to convince uninformed voters about their compe-tence) or to extrapolation bias (leading to the overstatement of the persis-tence of revenue shocks). We find evidence for both mechanisms: the propen-sity 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.