This paper examines the welfare impact of intergovernmental transfers when recipient governments use distortionary taxes. Both lump-sum and matching grants are investigated. A ‘distortionary factor’ depending on local demand and supply elasticities and the local tax rate on the taxed commodity determines the real income change to a jurisdiction per dollar transferred. Matching grants are dominated by lump-sum grants when these can be set optimally for each recipient. If grant policy must be uniform, positive (or negative) matching rates are desired if equity-adjusted distortionary factors are positively (negatively) correlated with local public service levels.

David E. Wildasin / dew@davidwildasin.us