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INTRODUCTION
Governments typically collect revenues from three major sources: taxes, debt and own-source, non-tax revenues. In addition, in most decentralized countries, local governments obtain revenue from grants. The conventional economic approach suggests that the source of revenue should not affect how it is used. This follows from the assumption that money is fungible. Still, there is strong evidence that local governments violate this assumption. A prominent example is the so-called flypaper effect. This refers to the empirical observation that government expenditures are more responsive to changes in revenue from unconditional grants than to equivalent changes in private income. The empirical support for this anomaly is overwhelming. There also exists some evidence of non-fungibility for taxes and debt.
Different theoretical models explain part of the observed anomalies.' Still, there is no general consensus. Therefore, the suggestion by Hines and Thaler [1995] to explain the flypaper effect in terms of mental accounting is appealing if only because of its generality, which also explains the related anomalies in taxation and debt financing. The central idea of the mental accounting framework is that money from different sources is treated differently. The framework is part of the literature on anomalies in economics, and as such is directly related to Kahneman and Tversky's [1979] prospect theory.
The purpose of this paper is to present an empirical analysis of mental accounting in the local public sector. More precisely, we analyze the responses of Flemish municipalities to budgetary windfalls from three different sources. Municipalities experienced important windfalls of grant and tax revenue in recent years [Heyndels and Van Driessche, 1998]. Moreover, a more stringent budgetary policy since the beginning of the eighties resulted in a general decline in debt finance requirements. This provides a unique opportunity to analyze public sector responsiveness.
MENTAL ACCOUNTING IN THE PUBLIC SECTOR
To keep track of where their money goes and to control spending, firms use formal accounting rules and methods. The concept of mental accounting refers to a similar process at the individual or household level. More precisely, it refers to the way in which individuals and households record, summarize, analyze and report the results of transactions and other financial events [Thaler, 1998, 2]. A crucial component of mental accounting involves categorization: expenditures and funds are...