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Endogenous Federal Grants and Crowd-out of State Government Spending: Theory and Evidence from the Federal Highway Aid Program

  • Brian Knight

Contrary to simple theoretical predictions, existing evidence suggests that federal grants do not crowd out state government spending. A legislative bargaining model with endogenous grants documents a positive correlation between grant receipts and preferences for public goods; this correlation has likely biased existing work against measuring crowd-out. To correct for such endogeneity, the model motivates instruments based on the political power of state congressional delegations. Exploiting this exogenous variation in grants, the instrumental variables estimator reports crowd-out that is statistically and economically significant. This endogeneity may explain the flypaper effect, a nonequivalence between grant receipts and private income. (JEL D70, H40, H77)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/000282802760015612
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 92 (2002)
Issue (Month): 1 (March)
Pages: 71-92

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Handle: RePEc:aea:aecrev:v:92:y:2002:i:1:p:71-92
Note: DOI: 10.1257/000282802760015612
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