Comparing the distortionary effects of alternative in-kind intergovernmental transfers

This paper compares the distortions associated with alternative inter-governmental allocation rules when a central authority provides inputs for the provision of social services by local governments, and when local governments differ in their needs. Under a quantity-based mechanism, the input choices of high-need localities will tend to be distorted downwards. In order to convince the center of their higher needs, these communities signal their status by spending too little. However, under an expenditure-based mechanism the direction of distortion of the input choices of high-need localities depends on the price elasticity of demand for the local input. When demand is inelastic (elastic), in order to signal their high needs, high-need localities spend too much (little) on local inputs.