This paper uses a simple model of fiscal competition between local jurisdictions to analyse the impact of intergovernmental grants on the composition of public spending. We find that a higher degree of redistribution within a system of ”fiscal equalisation” coincides with a smaller overall share of spending on productivity-enhancing public inputs. Furthermore, in order to test the theoretical predictions, we carry out an empirical analysis based on a panel of German states. The results are consistent with the theoretical findings and support the existence of an incentive effect of intergovernmental grants on state expenditure policies.
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