Intergovernmental grants and local public finance: An empirical examination in Israel

Abstract

What is the overall effect of intergovernmental grants on local public finance? While previous studies show an asymmetric effect of changes in intergovernmental grants on local taxation, other budgetary variables are often neglected. We take advantage of a 2011 Israeli reform in the context of a centralized country, which resulted in reduced intergovernmental grants for some local governments and increases for others, and analyse the overall effect on local spending, taxation, and deficits, using event study and difference-in-differences methodologies. Our results show that grant reductions led local governments to increase local tax rates and their annual deficits, but did not change local spending levels while revealing the mechanism behind rates adjustments. Local governments which experienced an increase in their grants increased their expenditures and lowered their tax rates and deficit levels. We find an asymmetric effect on tax rates: a grant reduction causes a tax hike which is twice as large as the tax reductions following a grant increase. This asymmetric effect can create tax hikes when grants decrease and then increase to their original level. Our results help establish the effect of intergovernmental grants on local taxation, and their effect on expenditure and fiscal balance in a centralized country.