The Welfare Effects of Intergovernmental Grants in an Economy with Distortionary Local Taxes: A Simple General Equilibrium Analysis
David E. Wildasin Department of Economics Indiana University Bloomington, IN 47405 USA
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.