Intergovernmental Grants in the Presence of Distortionary Taxation and Foreign Ownership

Abstract

This article analyzes intergovernmental transfers in a federal setting where lower level governments use distortionary taxation. Transfer policy is modeled in a federation with two states: foreign ownership of land and endogenously determined tax rates. The article concludes that under these circumstances, the standard result in the literature requires modification. Not only will the federal government be unable to achieve the national output-maximizing solution through the use of transfer payments, but the prescription for equating net fiscal benefits across states will, in general, not even achieve a second best.