The vertical fiscal externalities of a territorial reform: Evidence from Brazil

Abstract

Do fiscal shocks associated with a government’s territorial reform generate vertical fiscal externalities for local governments? This paper investigates how local governments responded in terms of public spending to the creation of the Brazilian state of Tocantins in 1988. Using a dynamic Difference-in-Differences approach, we find that municipalities affected by changes in the second-tier government experienced a sharp reduction in public spending in the years following the reform. This may have been partly driven by the reduction in intergovernmental central transfers to the affected municipalities after the reform, which constrained their fiscal capacity.