Inference in Difference-in-Differences: How Much Should We Trust in Independent Clusters?

Abstract: We analyze the challenges for inference in difference-in-differences (DID) when there is spatial correlation. We present novel theoretical insights and empirical evidence on the settings in which ignoring spatial correlation should lead to more or less distortions in DID applications. We show that details such as the time frame used in the estimation, the choice of the treated and control groups, and the choice of the estimator, are key determinants of distortions due to spatial correlation. We also analyze the feasibility and trade-offs involved in a series of alternatives to take spatial correlation into account. Given that, we provide relevant recommendations for applied researchers on how to mitigate and assess the possibility of inference distortions due to spatial correlation.