Interregional Fiscal Equity and Benefit Transfers

Over twenty years ago James M. Buchanan showed that serious horizontal inequities could exist in a federated system in the sense that residents of relatively low-income political subdivisions might receive lower benefits (net of taxes) from central and state government expenditures than people with the same income residing in high-income states. One possible solution offered was the imposition of discriminatory federal income tax rates with higher rates being charged in high-income states. This paper suggests an alternative solution in the form of federal transfers of benefits among states, either via conditional grants or revenue-sharing. The relative merits of the two approaches are discussed, and it is shown that the redistribution of benefits can be achieved at minimum cost by an application of the Hitchcock transportation problem.