Intergovernmental Grants and Public Input Provision: Theory and Evidence from Germany

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp07006.pdf Non-Technical SummaryThere exists a broad literature on fiscal competition which, so far, has mainly focussed on the aspect of tax competition. The standard argument states that competing governments lower their tax rates in order to attract a mobile tax base, thereby neglecting negative externalities which arise for other jurisdictions. The bottom line is an inefficiently low level of taxation and a relative underprovision of public goods. Recent theoretical literature suggests that fiscal externalities resulting from tax competition tend to be internalised by redistributive grant systems, thereby raising efficiency of local public finances. Empirical research supports the view that revenue sharing exerts a strong impact on jurisdictions' tax policy.An aspect which has attracted far lesser attention in the literature on fiscal competition is that local governments may also compete for mobile tax bases via the provision of productivity-enhancing public goods. Theoretical research suggests that fiscal competition in the presence of a public input to production leads to a bias in the local spending mix, i.e. a relative overprovision of this public input and a relative underprovision of a purely consumptive public good. Here, we use a simple model of fiscal competition and introduce a system of redistributive grants. As we assume tax policy to be coordinated at the federal level, local jurisdictions can only attract the mobile tax base by providing a productivity-enhancing public input. Using this framework of "expenditure competition" we analyse how fiscal equalisation transfers affect the local spending mix. We find that a higher degree of redistribution induces the local governments to rebalance their expenditure towards a higher share of purely consumptive spending. As the provision of federal expenditure matching grants constitutes a way of correcting positive fiscal externalities due to public input provision we also expand our framework in order to analyse the effects of federal co-financing on the pattern of local public spending.The implications from the theoretical analysis are finally tested in the course of an empirical analysis of German state expenditure policies. Germany is a very interesting case to study in this context as tax rates for the most important tax sources are set coordinately at the federal level and, on the other hand, states can rather f...

The Impact of Fiscal Equalization on Local Expenditure Policies - Theory and Evidence from Germany

“…The model in this paper builds on the theoretical analysis in Hauptmeier (2007). We use a standard framework of fiscal competition (e.g., Zodrow and Mieszkowski, 1986;Keen and Marchand, 1997) and consider a federation with a set of n local jurisdictions, labelled i = 1, ..., n. In each jurisdiction a competitive firm produces a homogenous private good using immobile labor L, perfectly mobile capital K and a publicly provided input P .…”

“…As in Hauptmeier (2007) the impact of public inputs is modelled by introducing a shiftterm, P β i , into the production function which captures total factor productivity. The public input is substituted by its budgetary share λ i times the local budget, b i .…”