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The Stimulative Effects of Intergovernmental Grants and the Marginal Cost of Public Funds

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  • Bev Dahlby
  • Ergete Ferede

Abstract

We test the hypothesis that the flypaper effect can arise if the recipient government finances part of its expenditures with a distortionary tax. We present a simple theoretical framework that shows how a lump-sum transfer stimulates the marginal expenditures of a recipient government through an income effect and a price effect. We test the predictions of this model using data on Canadian provincial expenditures and federal transfers to the provinces over the period 1981 to 2008. Our econometric results indicate that a $0.10 increase in a provincial government’s marginal cost of public funds increases the stimulative effect of lump-sum grants by $0.32.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3863.

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Date of creation: 2012
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Handle: RePEc:ces:ceswps:_3863

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Keywords: intergovernmental grants; marginal cost of public funds; flypaper effect;

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References

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  1. Anwar Shah, 1996. "A Fiscal Need Approach to Equalization," Canadian Public Policy, University of Toronto Press, vol. 22(2), pages 99-115, June.
  2. Johansson, Eva, 2003. "Intergovernmental grants as a tactical instrument: empirical evidence from Swedish municipalities," Journal of Public Economics, Elsevier, Elsevier, vol. 87(5-6), pages 883-915, May.
  3. Fernando Aragon, 2012. "Local Spending, Transfers and Costly Tax Collection," Discussion Papers dp12-09, Department of Economics, Simon Fraser University.
  4. Gordon, Nora, 2004. "Do federal grants boost school spending? Evidence from Title I," Journal of Public Economics, Elsevier, Elsevier, vol. 88(9-10), pages 1771-1792, August.
  5. Bev Dahlby, 2008. "The Marginal Cost of Public Funds: Theory and Applications," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262042509, December.
  6. Gary S. Becker & Casey B. Mulligan, 1998. "Deadweight Costs and the Size of Government," University of Chicago - George G. Stigler Center for Study of Economy and State, Chicago - Center for Study of Economy and State 144, Chicago - Center for Study of Economy and State.
  7. Michael Baker & Abigail Payne, 1998. "An empirical study of matching grants: The "cap on CAP"," Working Papers msmart-98-03, University of Toronto, Department of Economics.
  8. Edward M. Gramlich & Harvy Galper, 1973. "State and Local Fiscal Behavior and Federal Grant Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 4(1), pages 15-66.
  9. Craig Volden, 2007. "Intergovernmental Grants: A Formal Model of Interrelated National and Subnational Political Decisions," Publius: The Journal of Federalism, Oxford University Press, Oxford University Press, vol. 37(2), pages 209-243, Spring.
  10. Case, Anne C. & Rosen, Harvey S. & Hines, James Jr., 1993. "Budget spillovers and fiscal policy interdependence : Evidence from the states," Journal of Public Economics, Elsevier, Elsevier, vol. 52(3), pages 285-307, October.
  11. Bev Dahlby, 2011. "The marginal cost of public funds and the flypaper effect," International Tax and Public Finance, Springer, Springer, vol. 18(3), pages 304-321, June.
  12. Pablo Acosta, 2010. "The “flypaper effect” in presence of spatial interdependence: evidence from Argentinean municipalities," The Annals of Regional Science, Springer, Springer, vol. 44(3), pages 453-466, June.
  13. Douglas Staiger & James H. Stock, 1997. "Instrumental Variables Regression with Weak Instruments," Econometrica, Econometric Society, Econometric Society, vol. 65(3), pages 557-586, May.
  14. Gamkhar, Shama & Oates, Wallace E., 1996. "Asymmetries in the Response to Increases and Decreases in Intergovernmental Grants: Some Empirical Findings," National Tax Journal, National Tax Association, vol. 49(4), pages 501-12, December.
  15. Thiess Buettner & David E. Wildasin, 2003. "The Dynamics of Municipal Fiscal Adjustment," Public Economics, EconWPA 0309007, EconWPA.
  16. Brian Knight, 2002. "Endogenous Federal Grants and Crowd-out of State Government Spending: Theory and Evidence from the Federal Highway Aid Program," American Economic Review, American Economic Association, American Economic Association, vol. 92(1), pages 71-92, March.
  17. Bev Dahlby & Ergete Ferede, 2011. "What Does it Cost Society to Raise a Dollar of Tax Revenue? The Marginal Cost of Public Funds," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 324, March.
  18. Hamilton, Jonathan H., 1986. "The flypaper effect and the deadweight loss from taxation," Journal of Urban Economics, Elsevier, vol. 19(2), pages 148-155, March.
  19. James R. Hines & Richard H. Thaler, 1995. "The Flypaper Effect," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 9(4), pages 217-226, Fall.
  20. Winer, Stanley L, 1983. "Some Evidence on the Effect of the Separation of Spending and Taxing Decisions," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(1), pages 126-40, February.
  21. Dollery, Brian & Worthington, Andrew, 1999. "Fiscal Illusion at the Local Level: An Empirical Test Using Australian Municipal Data," The Economic Record, The Economic Society of Australia, The Economic Society of Australia, vol. 75(228), pages 37-48, March.
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