Abstract
Empirical studies indicate that unconditional intergovernmental grants have a flypaper effect. Several authors have modeled recipient government spending under fiscal illusion to explain this phenomenon. In short, grants reduce the perceived marginal cost of recipient government output. This paper develops a more general model of illusion that incorporates the grantor government, thereby eliminating inconsistencies encountered in previous models. The more general model implies that grant finance increases the perceived marginal cost of grantor government output. Thus grant-induced illusion should have two effects: an increase in recipient output and a decrease in grantor output. The empirical work supports this hypothesis.
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