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Using a quasi-experimental setting we study municipalities' reaction to an unanticipated expansion of local public spending induced by the implementation of a horizontal transfer system in the German state of North Rhine-Westphalia. We find that the composition of the fiscal adjustment in the short run differs between municipalities with different budgetary restrictions or political constellations. In particular, we examine whether municipalities adjust their tax setting behavior, incur short-term debt or respond by adapting pay-outs for investment or administration. Municipalities under fiscal distress or with old voters increase their level of debt to a larger extent leading to growing disparities. In contrast, municipalities without a majority in the local council are reluctant to increase taxes.
