Capitalization of equalizing grants and the flypaper effect

• The literature proposes rent seeking as an explanation for the flypaper effect.
• We propose house price capitalization as an empirical test for this hypothesis.
• We find a strong flypaper effect and full capitalization of exogenous grant changes.
• Thus, home-buyers value whatever the extra grant money has been spent on.
• This is inconsistent with the rent seeking explanation for the flypaper effect.

The wide-ranging empirical support for the flypaper effect in local public finance remains a puzzle in spite of various theoretical explanations. We exploit a reform of the fiscal equalization system in the Netherlands to show that the resulting change in grants to municipalities was fully capitalized into local house prices. Nevertheless, only a small fraction was passed on to residents through property taxes, indicating local public service provision as the main adjustment channel. As the marginal homebuyer was apparently willing to pay for these services, capitalization makes rent seeking by local politicians or bureaucrats improbable — thus effectively ruling out one class of explanations for the flypaper effect. The absence of a significant effect on municipal staff provides further evidence against a bureaucratic flypaper effect.