An Institutional Explanation for the Stickiness of Federal Grants

Researchers have struggled to understand why federal block grants, contrary to economic theory, have a large stimulative effect on the spending of state and local governments. This article proposes and tests an institutional explanation for this effect. We argue that certain budgetary rules, by limiting the ability of subnational governments to respond to voter demands for increased spending, may systematically force lawmakers to under-provide public goods. When this occurs, governments are likely to treat grant revenue as a supplement to total expenditures and not return this money to voters in the form of a tax cut as suggested by existing theory. To evaluate our hypothesis, we use data on the Community Development Block Grant program and municipal tax and expenditure limitations. Results show that restrictive fiscal institutions significantly increase the stimulative power of federal grant revenue. (JEL H7, H4, R5) The Author 2008. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.