This study examines the short-run effects and dynamics of exogenous shocks to the regular budgets of the local authorities in Israel with emphasis on the reduction in government participation and taking into account the heterogeneity of the local authorities. To accomplish this, the study uses a panel of 193 local authorities for the years 1996-2002 and estimates a dynamic model for the components of the regular budget. This makes it possible to examine the dynamics of fiscal adjustment in response to changes in the size of the deficit and in the components of the budget. The changes in revenue from municipal taxes and other independent revenues, expenditure and participation and equalization grants were estimated by means of a Vector Error Correction model. The main findings are as follows:

(a) Exogenous changes in the components of the budget, such as a reduction in government grants, affect the level of the per capita deficit in the short run but following that the deficit converges to its original level.

(b) A reduction in government grants leads to an immediate cutback in services to residents and increased deficits.

(c) The process of adjustment in the non-Jewish local authorities is twice as long as that in the Jewish ones. Therefore, the reduction in grants leads to an increase in deficits for a longer period in non-Jewish local authorities.

(d) The process of budgetary adjustment differs among local authorities according to socioeconomic ranking. The weakest local authorities (clusters 1-3) and the strongest local authorities (clusters 8-10) respond to a change in the deficit primarily by reducing labor costs while the development town local authorities cut back their services to residents.

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