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Ch10.2.pptxFiscal Effects of Grants: Theory
Intergovernmental grants can affect the recipient’s fiscal decisions in two ways:
Income effect: the resources available to the recipient to provide a service are increased
Price effect: the recipient government’s marginal costs of providing the service are reduced.
Fiscal Effects of Grants: Theory
Most economic analyses of the expected effects of grants begin with the effects on an individual voter’s demand for the service.
A lump-sum grant will increase the available resources; the demand for a normal good will increase, but there is no change in the marginal cost.
A matching grant reduces the marginal cost of an additional unit of the service which increases the quantity demanded.
Fiscal Effects of Grants: Theory
Figure 10.7
Fiscal Effects of Grants: Theory
A fundamental result from microeconomic theory is that a decrease in price will have a greater effect on consumption than an increase in income, if that increase allows the consumer to make the same choices as the price decrease.
When the price changes there is both a substitution (or price) effect and an income effect.
When income changes, there is only the income effect.
Fiscal Effects of Grants: Theory
Example:
A consumer has a budget of $100 to spend on two goods that have a price of $1 each.
An increase in the budget to $200 at the same price doubles the amount that can be purchased; the income effect.
Keeping the budget at $100, but lowering the price to $0.50 of good 1 also doubles the amount of it that can be purchased, but the price effect causes the consumer to substitute some of good 1 for good 2 in addition.
Fiscal Effects of Grants: Theory
Because there are both income and price effects, an open-ended matching grant is expected to increase government expenditure on the aided service by more than an equivalent lump-sum grant.
Fiscal Effects of Grants: Theory
Table 10.2
Fiscal Effects of Grants: Theory
For a closed-end matching grant, the effect is the same as an open-ended grant as long as the recipient’s expenditures are less than the limit of the grant.
For governments expending more than the limit, a closed-end matching grant becomes equivalent to a lump-sum grant.
Fiscal Effects of Grants: Theory
Thus, closed-ended matching grants create two complications for analysis.
First, it is not possible to determine whether a grant is effectively a matching or a lump-sum grant without knowing the recipient government’s position.
Second, a recipient government’s reaction to the grant can move its per capita expenditure over the limit, transforming a matching grant into a lump-sum grant.
Fiscal Effects of Grants: Theory
Matching grants will induce an increase in spending on the aided category that is less than the size of the grant.
The matching grant allows for funds to be shifted to other expenditures or for tax relief.
While total expenditures on the service increases, expenditures of local funds decreases.
This result depends on the demand for the service being price inelastic.
Fiscal Effects of Grants: Theory
A lump-sum grant of $G that is restricted for use in a specific category may be no different, from the viewpoint of the recipient, than a grant of $G with no restrictions.
Can and does the recipient reallocate local funds from the specific budget category to others as a result of the grant?
Funds are fungiable.
Fiscal Effects of Grants: Theroy
Figure 10.8
Fiscal Effects of Grants: Theory
Two important implications:
The restriction on the use of the grant will bind only if the recipient’s intended expenditures on the aided category are less than what the grant would buy.
A lump-sum categorical grant does not guarantee that expenditures on the aided category will increase by the full amount of the grant.
Maintenance of effort restrictions may reduce, but not eliminate this problem.
Fiscal Effects of Grants: Theory
A common element in the allocation formula for revenue-sharing grants is tax effort.
Tax effort is measured either by tax revenue as a fraction of income or property tax as a fraction of taxable value.
Typically a higher tax effort triggers a larger revenue-sharing grant.
Fiscal Effects of Grants: Theory
A high tax effort can represents
A great demand for government services in the jurisdiction
A relatively low tax base
A high production cost for government services
Fiscal Effects of Grants: Theory
Recipient governments can affect the size of the revenue-sharing grant through the choice of their tax effort.
Fiscal Effects of Grants: Theory
Table 10.3
Fiscal Effects of Grants: Theory
In this example, initially both jurisdictions collect the same tax revenue, but have different tax efforts.
When one jurisdiction increases its tax effort, B increases its tax revenue to $600, both jurisdictions are affected.
Jurisdiction A loses some dollars of revenue-sharing to jurisdiction B.
Fiscal Effects of Grants: Theory
Important implications
A recipient can increase its revenue-sharing grant by increasing taxes at a greater rate than its competitor jurisdictions.
Even if a jurisdiction does not seek a larger revenue-sharing grant, it will have to increase taxes just to avoid losing grant funds if any competitor jurisdiction is raising taxes.
Because of uncertainty about the behavior of competitors, there is a general incentive to raise taxes and expenditures
Fiscal Effects of Grants: Theory
A special case:
If all recipients increase taxes at the same rate, no-ones revenue sharing will increase.
However, the competition has led to an increase in taxes and expenditures.
Fiscal Effects of Grants: Evidence
Research has generated several different results because of some of the complications already discussed, but some broad conclusions can be drawn from the evidence.
Fiscal Effects of Grants: Evidence
Open-ended categorical matching grants do seem to increase expenditures on the aided category and do so by a larger amount than equal-sized lump-sum grants.
Evidence also shows that expenditures rise by less than the size of the grant.
Both results match theoretical predictions.
Fiscal Effects of Grants: Evidence
Closed-ended categorical matching grants sometimes have greater expenditure effects than open-ended matching grants.
This is contrary to theory, but may be explained by differences in the types of services being supported.
Fiscal Effects of Grants: Evidence
Lump-sum grants also cause an increase in government expenditures, which seems in most cases to be smaller than the grant.
There is, however, a wide variance in the results.
Differences in initial spending levels
Differences in restrictions on the grants
Fiscal Effects of Grants: Evidence
There is also evidence that the “leakage” of grant funds may occur for different services within the same jurisdiction or between jurisdictions that have overlapping tax authority.
Example: aid to municipalities which allows for more spending and some tax reduction allows the local school district to raise its taxes and spending; a cross-governmental general equilibrium effect.
Fiscal Effects of Grants: Evidence
An additional dollar of lump-sum grant money has a greater effect on recipient government expenditures than a $1 increase in resident’s income.
This is known as the flypaper effect.
Money paid to the government tends to “stick in the public sector”.
This means that $1 of grant aid will have a larger effect on the provision of public services than a $1 tax cut by the granting government.
Is Grant Money Different than Tax Money?
Do increases in lump-sum grants and increased in private incomes affect subnational government expenditures differently?
No flypaper effect actually exists.
Poor statistical techniques
Poor interpretation of the data
The flypaper effect is real.
Political power by government officials
Desires of the voters (who may be misinformed).
Is Grant Money Different than Tax Money?
Figure 10.9 Suppose high incomes reduce the cost of providing services.
Intergovernmental Grant Policy
Three major conclusions about grant policy.
Open-ended categorical matching grants are the best device if the objective is to increase spending on a specific function.
General lump-sum grants are a better mechanism than matching grants to redistribute resources among subnational jurisdictions.
Categorical lump-sum and closed-end matching grants should generally be avoided.
Intergovernmental Grant Policy
Actual policy:
Categorical closed-ended grants are the most common form of federal grant in terms of both numbers and dollars.
When matching grants are used, the matching rates do not seem to correspond to the share of benefits that go to nonresidents.
Revenue-sharing grants go to all general-purpose local governments and include matching grant effects due to tax-effort allocation.
Block grants are often so broad that they are effectively general grants.
Intergovernmental Grant Policy
One reform suggests that open-ended matching grants be substituted for closed-ended matching grants and lump-sum grants and to set matching rates to correspond to nonresident benefits.
Intergovernmental Grant Policy
However, there is evidence that correcting for spillover effects is not the objective of the grant policy.
The main purpose of federal grants is to further economic equity.
The goal is to achieve a more equitable distribution of resources among the states, thus potentially equalizing the distribution of public goods.
