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Abstract: This note provides, in the context of an example, a new theoretical explanation of the flypaper effect by incorporating dynamic stochastic features into the conventional framework of local public finances. Under these circumstances, the flypaper effect is not an anomaly, but a natural optimizing behavior within the “traditional theory of “grants-in-aid”. When shocks to intergovernmental transfers are more permanent than those affecting private income, an increase in intergovernmental transfers shifts public goods provision upward much more than an equivalent change in private income.

Keywords: Intertemporal local fiscal behavior, stochastic processes, flypaper effect
JEL: H71, H72, H77