This study examines how Japanese municipalities restore their fiscal balance after a budget shock. The results show that these fiscal adjustments occur mainly via changes in government investment, accounting for 63-95% of adjustments in permanent unit innovations in grants and own-revenue. In contrast to the role of expenditure, the municipalities' own-source revenue plays a limited role in balancing the local budget. The results also reveal that 40% of the increase in own-source revenue is offset by a reduction in grants. This suggests that the current grants system discourages municipalities from increasing their own-source revenue. Furthermore, municipalities can induce grants by expanding government current expenditure. Here, a 1. yen increase in current expenditure is followed by an increase in grants of 0.65. yen in subsequent years. Finally, we conduct an additional analysis based on population size to study how the adjustment process varies among municipalities of different sizes.
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