Comparing the Distortionary Effects of Alternative Intergovernmental Transfers

Abstract

This article compares the distortions associated with alternative intergovernmental allocation rules when a central authority provides inputs for the provision of social services by local governments, as well as when local governments differ in their needs. Under a quantity-based mechanism, the input choices of high-need localities will tend to be distorted downward. To convince the center of their higher needs, these communities signal their status by spending too little. However, under an expenditure-based mechanism, the direction of distortion of the input choices of high-need localities depends on the price elasticity of demand for the local input. When demand is inelastic (elastic), to signal their high needs, high-need localities spend too much (little) on local inputs. If social services have positive interjurisdictional externalities, expenditure-based mechanisms are preferred, at least in the case of inelastic demand.