We explore how spatial interaction affects the strategic use of municipal income when deciding between 1) an optimal long-run expenditure strategy versus 2) using the current income to finance current activities, a phenomenon known as the permanent income hypothesis. Even when this hypothesis is grounded in temporal logic, insufficient attention has been given to the impact of spatial dependence on this type of budget decision. Therefore, we present two reasons why spatial interaction adds new insight to this discussion. First, subnational governments located inside larger functional areas have lower average costs due to the population concentration, allowing for coordination between jurisdictions to achieve more power of negotiation and to potentially exploit economies of scale. Second, local government decision-making is not independent of other jurisdictions as municipalities would constantly evaluate the others’ actions regarding local tax effort, spending, and debt. While this spatial consideration remains a challenge for theoretical modeling, we offer empirical evidence to evaluate how robust the permanent income hypothesis is when geography is incorporated. Our empirical approach uses dynamic panel data with spatial dependence on debt, expenditure, and the error term. To evaluate our hypothesis, we exploit panel data from 320 Chilean municipalities between 2008 and 2020 and use two sources of income: non-matched grants via mining windfalls and horizontal fiscal transfers among cities. The evidence indicates that jurisdictions make backward-looking decisions regarding spending; that is, there are no significant differences between the short and long run. The results for debt, however, are not robust. Policy pertaining to the use of public resources should consider the spatial dependence between municipalities which should be a crucial factor in budgetary decision-making.
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