Granting public or private consumption? Effects of grants on local public spending and income taxes

Abstract

Most of the early empirical estimates on effects of intergovernmental grants contradict theoretical predictions. In the more recent literature that emphasizes the importance of convincing empirical strategies, the results are more mixed. This paper contributes to this literature by estimating causal effects on local expenditures and income taxes of general, unconditional grants. This is done in a difference-in-difference model utilizing policy-induced increases in grants to a group of remotely populated municipalities in Finland. The finding is that increased grants have a statistically and economically significant positive immediate effect on local expenditures. The effect on local income taxes, while statistically significant, is considerably smaller in magnitude. Furthermore, there is no evidence of dynamic crowding-out—i.e., that the immediate response in expenditures is reversed in later years.