Identifying the Effect of Government Spending: Evidence from Political Variations in Federal Grants

Abstract

The debate regarding the effect of fiscal policy on the level of output is long and has not been settled yet. This paper suggests a new identification strategy as a mean to resolve the debate. I show that the distribution of federal grants is affected by whether state representatives in Congress are part of the majority party. States represented by Democrats while the Democrats hold the majority receive greater federal grants and increase their spending. The inverse is true in the case of Republican majorities. Therefore I use the share of Republican and Democrat state representatives in the majority party as instrumental variables to state spending. The results suggest state spending multiplier is about 3.4, and that additional 54,350$ of state spending generate an additional job. These estimate abstract from adverse effects of taxes or deficits on the economy.

Keywords: fiscal policy, fiscal multiplier, US states, federal grants, GSP

JEL Classification: E21, E62, H77