How do municipalities react to a revenue shock?

We study the fiscal reaction of German municipalities to a revenue shock that stems from the adjustment of population counts in the 1987 and 2011 censuses. We focus on the choice of instruments municipalities use in order to offset the shock, namely municipal taxes, debt, and spending. Simple models of public finance suggest that municipalities should adjust all instruments marginally. In more complicated models that take into account the political economy, this does not need to hold. In regular instrumental variable (IV) regressions, we find that municipalities significantly adjust one or two instruments. Non-parametric IV regressions that rely on generalized random forests (Athey et al., 2019) provide evidence on strategic behaviour of municipalities.