Fiscal capacity equalisation, at least of the type implemented in Australia, is shown to link regions together through a grant distribution formula that creates an incentive for regions to act strategically in order to influence the size of their grant. This behaviour distorts the provision of local public goods away from optimal levels of provision by changing regional perceptions of the marginal benefit from local public good provision. In addition, the inter-regional transfer of income that occurs with equalisation leads to inefficiency in the spatial allocation of mobile factors of production. As a result, we conclude that equalisation may create economic inefficiency, and lead to a lower level of social welfare.
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