Vertical Fiscal Gaps and Economic Performance: A Theoretical Review and an Empirical Meta-Analysis

Abstract

How can policymakers reform US federalism for better economic performance? This paper focuses on vertical fiscal gaps: the proportion of subcentral government expenditure funded by central government grants and shared revenue over which subcentral governments lack autonomous control. On one hand, public finance theories show that central grants to subcentral governments can serve a useful purpose in aligning subcentral incentives to public welfare. On the other hand, political economy logic predicts that these grant programs will be a tempting target for rent-seeking politics, harming economic performance. To settle the theoretical conflict, it is necessary to investigate the evidence on the economic effects of vertical fiscal gaps in federal democracies. That evidence shows that, among federal democracies like the United States, vertical fiscal gaps lead to higher subcentral and overall government debt and spending. Moreover, in the United States, cost-sharing grants appear to promote a higher state and local tax burden, and transfers also undermine voter knowledge and public-sector efficiency. These findings are more consistent with political economy theories than with the traditional publicfinance view. Although intergovernmental transfers may sometimes be appropriate, the evidence suggests that in the United States the greater risk comes from their overuse. This paper derives policy implications for the United States.