Granting Public or Private Consumption? Effects of Grants on Local Public Spending and Income Taxes

Abstract

While the literature on how intergovernmental grants affect the budget of receiving jurisdictions is numerous, the very few studies that explicitly deal with likely endogeneity problems focus on grants targeted towards specific sectors or to specific type of recipients. The results from these studies are mixed and make clear that knowledge about grants effects is to this date still insufficient. This paper contributes by estimating causal effects on local expenditures and income tax rates of general, nontargeted grants to Finnish municipalities. This is done in a difference-in-difference model utilizing policy-induced increases in grants to a group of remotely populated municipalities. The robust finding is that increased grants have a negligible effect on local income tax rates, but that there is an immediate one-to-one correspondence between grants and local expenditures. Furthermore, expenditures continue to increase also some time after the grant increase, although this response is estimated less precisely. The flypaper behavior displayed by the treatment group can potentially be explained by “separate mental accounting” – i.e., voters treating the government budget constraint separately from their own.