The Stimulative Effects of Intergovernmental Grants: Or Why Money Sticks Where it Hits
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Description
The theoretical literature on the impact of intergovernmental grants on state and local fiscal behavior has reached a consensus on some basic propositions. According to this theory, the form in which grant assistance is given is very important in predicting the effect of the grant on local public spending. Nonmatching grants are assumed to alter the income available to jurisdictions without altering the relative price of public goods, and are hence assumed to have an effect on local spending similar to that of any other change in private income in the community. Matching grants, on the other hand, cause relative prices to change and thus are found to stimulate more spending per dollar of grant than nonmatching grants. Empirically, one of these predictions has passed the statistical test and one has failed. The generally confirmed result is that matching grants stimulate more spending per dollar of grant than do nonmatching, revenue-sharing types of grants. Regarding the nonconfirmed hypothesis – that nonmatching grants have spending effects similar to those of other changes in private income – the preponderance of evidence is that nonmatching grants stimulate much more local spending per dollar of grant than does income going to private citizen within the community. The obvious reason for this phenomenon, which we term the “flypaper effect” (money sticks where it hits), is that bureaucrats and politicians find it easier to avoid cutting taxes when the government receives revenue-sharing monies than they do to raise taxes when some exogenous event raises the income of the community. The fact that they standard theory of intergovernmental grants has been only partially supported by empirical studies suggests that some modifications to the theory may be in order. In this paper we make two. The first uses orthodox, median-voter assumptions – that the median voter is a private employee taking all wages and prices as given – and shows why even in this case the tax price and spending effects of nonmatching grants and changes in private income may not be identical. The economic rationale for the flypaper affect hinges on the inability of voters to perceive the true marginal price of public expenditures when nonmatching grants are present. Finding this economic rationale of course does not preclude an additional political rationale, but it helps to improve the relevance of the economic theory of grants. The second modification follows the logic of the first, except that we now investigate tax price and spending behavior for the case where some voters belong to the public (rather than private) sector and may possess sufficient power to determine public employee wage rates and output levels. These two amendments to the traditional theory are developed in a model of an economy with two types of governments – an exogenous federal government and an endogenous local government – and just one type of grant, consisting of nonmatching aid of a fixed dollar amount. The model distinguishes between private and public sector employees, analyzing the optimizing behavior of both. In the first section of the paper the formal assumptions for both the private and public employee models are presented. The second section uses the private employee model to examine the utility-maximizing behavior of private sector employees when all prices and wages are taken as given and develops our economic rationalization of the flypaper effect. The third section then deal with the public employee case, this time distinguishing between real and nominal flypaper effects because wages may not be exogenous. The final section gives a few concluding observations.
Source Publication
Fiscal Federalism and Grants-in-Aid
Source Editors/Authors
Peter Mieszkowski, William H. Oakland
Publication Date
1979
Recommended Citation
Courant, Paul N.; Gramlich, Edward M.; and Rubinfeld, Daniel L., "The Stimulative Effects of Intergovernmental Grants: Or Why Money Sticks Where it Hits" (1979). Faculty Chapters. 1876.
https://gretchen.law.nyu.edu/fac-chapt/1876
