Fiscal Spillovers between Local Governments: Keeping up with the Joneses' School District

Abstract

While there is a rapidly growing literature concerning fiscal spillovers between local governments, it is challenging to empirically distinguish spillovers from common underlying trends. Using financial and geographic data for every school district in the U.S. from 1972 to 2002, this paper tests for fiscal spillovers using a new type of instrumental variable strategy that tests whether districts located near state borders respond to the predicted fiscal behavior of neighboring districts located in a different state. The fiscal behavior of the out-of-state neighboring districts will often be driven by changes in their states’ finance formulas or other state-specific shocks that are plausibly unrelated to factors affecting the in-state, border district. Additional specifications examine the extent to which local spillovers across state borders differ from in-state local spillovers. The results confirm that districts' revenues are influenced by exogenous shocks in their neighbors' revenues, especially for districts that were already outspending their neighbors. On average, a one dollar increase in the mean revenues per pupil of nearby districts leads to about a 22 cent increase in a district’s own revenues per pupil, which is smaller than estimates derived from ordinary least squares models or traditional instrumental variables models. Spillovers occur regardless of whether districts use direct or representative democracy to determine local tax revenue levels, and there is suggestive evidence that positive spillovers are mitigated by household mobility across districts in metropolitan areas. Based on these results, policymakers should consider that school finance policies targeted towards particular districts can change the equilibrium spending levels and residential composition of other districts.