Stimulating Local Economies through Central Transfers: A Natural Experiment from Ecuador

This paper investigates the causal effects of central-to-local government transfers on local economic activity in Ecuador, utilizing exogenous variation from a reform in the intergovernmental transfer formula implemented in 2018. Addressing gaps in the fiscal decentralization literature, this study provides quasi-experimental evidence from a developing country context. Using an instrumental variables approach, we find that a 1% increase in transfers leads to a 1. 19%-1. 26% increase in local business sales, particularly for small and medium enterprises. We identify recurrent spend- ing, primarily current expenditure, such as personnel costs, as the main transmission mechanism, challenging prior literature that emphasizes investment spending. This research contributes novel empirical insights into how transfers impact local economies in middle-income countries and provides relevant policy implications for effectively structuring fiscal decentralization in resource-dependent contexts.