Vertical Grants and Local Public Efficiency

This paper analyses the impact of vertical grants on local public sector efficiency. First, we develop a theoretical model in which the bureaucrat sets the tax price while voters choose the quantity of public services. We use a very simple theoretical model to show that grants reduce efficiency even if voters do not suffer from fiscal illusion. Second, we use the model and the fact that vertical financial equalization systems often reduce differences in fiscal capacity to argue that empirical studies based on cross-sectional data may yield a positive relationship between grants and efficiency even when the underlying causal effect is negative. Third, we perform an empirical analysis for the German state of Saxony-Anhalt, which has implemented such a fiscal equalization system. The empirical patterns we observe support the argument that the fiscal equalization system may have this inference-disturbing effect.