| Abstract: |
Economic theory predicts that unconditional intergovernmental grant income and
private income are perfectly fungible. Despite this prediction, the literature
on fiscal federalism documents that grant and private income are empirically
non-equivalent. A large scale school finance reform in New Hampshire--the
typical school district experienced a 200 percent increase in grant
income--provides an unusually compelling test of the equivalence prediction.
Most theoretical explanations for non-equivalence focus on mechanisms which
produce public good provision levels which differ from the decisive voter's
preferences. New Hampshire determines local public goods provision via a form
of direct democracy--a setting which rules out these explanations. In contrast
to the general support in the literature for non-equivalence, the empirical
estimates in this paper suggest that approximately 92 cents per grant dollar
are spent on tax reduction. These results not only document that equivalence
holds in a setting with a strong presumption that public good provision
decisions reflect the preferences of voters, but also directly confirm the
prediction of the seminal work of Bradford and Oates (1971) that lump-sum
grant income is equivalent to a tax reduction. In addition, the paper presents
theoretical arguments that grant income capitalization and heterogeneity in
the marginal propensity to spend on public goods may generate spurious
rejections of the equivalence prediction. The heterogeneity argument is
confirmed empirically. Specifically, the results indicate that lower income
communities spend more of the grant income on education than wealthier
communities, a finding interpreted as revealing that the Engel curve for
education is concave. |