nep-pbe New Economics Papers
on Public Economics
Issue of 2012‒07‒29
23 papers chosen by
Keunjae Lee
Pusan National University

  1. The use of tax havens in exemption regimes By Gumpert, Anna; Hines Jr., James R.; Schnitzer, Monika
  2. Urban Public Finance By Edward L. Glaeser
  3. The Binary Choice Approach of Laffer Curve By Mihai Mutascu
  4. Revenue equalization and personal income tax in Estonian municipalities By Viktor Trasberg
  5. Dynamic Tax Competition under Asymmetric Productivity of Public Capital By Hiroki Tanaka; Masahiro Hidaka
  6. Redistributive Preferences, Redistribution, and Inequality: Evidence from a Panel of OECD Countries By Kuhn, Andreas
  7. Fiscal Union in Europe? Redistributive and Stabilising Effects of an EU Tax-Benefit System By Bargain, Olivier; Dolls, Mathias; Fuest, Clemens; Neumann, Dirk; Peichl, Andreas; Pestel, Nico; Siegloch, Sebastian
  8. The Debt-Equity Bias: consequences and solutions By Serena Fatica; Thomas Hemmelgarn; Gaetan Nicodeme
  9. Security returns and tax aversion bias: Behavioral responses to tax labels By Blaufus, Kay; Möhlmann, Axel
  10. Fiscal federalism, regional public investment and spatial interaction processes: the case of Italy By Giuseppe Di Giacomo; Fabio Mazzola
  11. Fiscal Multipliers and Public Debt Dynamics in Consolidations By Jocelyn Boussard; Francisco de Castro; Matteo Salto
  12. Evolution of security transaction tax in India By Sinha, Pankaj; Mathur, Kritika
  13. Infrastructure Capital in Russia: Effects On Economic Growth By Evgeniya Kolomak
  14. How close is your government to its people ? worldwide indicators on localization and decentralization By Ivanyna, Maksym; Shah, Anwar
  15. The effects of regional subsidies to the spatial distribution of economic activity and welfare in the constructed capital model By Egle Tafenau
  16. Who believes in fiscal and monetary stimulus? By Amdur, David
  17. Income Inequality and Self-Reported Values By Corneo, Giacomo; Neher, Frank
  18. Modelling the Excess Burden of Royalties By Henry Ergas; Jonathan Pincus
  19. Public goods and the hold-up problem under asymmetric information By Schmitz, Patrick W
  20. Taxing pollution: agglomeration and welfare consequences By Berliant, Marcus; Peng, Shin-Kun; Wang, Ping
  21. Asymmetric taxation of profits and losses and its influence on investment timing: Paradoxical effects of tax increases By Mehrmann, Annika; Schneider, Georg; Sureth, Caren
  22. Intangible Capital and Growth in Advanced Economies: Measurement and Comparative Results By Corrado, Carol; Haskel, Jonathan; Iommi, Massimiliano; Jona-Lasinio, Cecilia
  23. Welfare financing: Grant allocation and efficiency By Allers, Maarten A.; Toolsema, Linda A.

  1. By: Gumpert, Anna; Hines Jr., James R.; Schnitzer, Monika
    Abstract: This paper analyzes the tax haven investment behavior of multinational firms from a country that exempts foreign income from taxation. High foreign tax rates generally encourage firms to invest in tax havens, though significant costs of reallocating taxable income dampen these incentives. The behavior of German manufacturing firms from 2002-2008 is consistent with this prediction: at the mean, one percentage point higher foreign tax rates are associated with three percentage point greater likelihoods of owning tax haven affiliates. This contrasts with earlier evidence for U.S. firms subject to home country taxation, which are more likely to invest in tax havens if they face lower foreign tax rates. Foreign tax rates appear to be unrelated to tax haven investments of German firms in service industries, possibly reflecting the difficulty they face in reallocating taxable income.
    Keywords: Tax Havens; Multinational Firms; Tax Avoidance; Profit Shifting; Manufacturing FDI; Service FDI
    JEL: H87 F23
    Date: 2012–04
  2. By: Edward L. Glaeser
    Abstract: America’s local governments spend about one-eighth of our national income, one-fourth of total government spending, and employ over 14 million people. This paper surveys the large and growing economics literature on local governments and their finances. A primary difference between local and national government is the ease of labor mobility within countries, which disciplines local governments and means that heterogeneous service levels can be beneficial, but mobility also challenges local attempts at redistribution. The empirical literature on mobility responses to local government is distinguished, but remains a pressing area for future research. We have sophisticated models of local spending, tax policy and institutional design, but research is often far less developed on even basic questions of costs and benefits of core local public services.
    JEL: H0 H2 H23 H71
    Date: 2012–07
  3. By: Mihai Mutascu (Department of Finance, Faculty of Economics and Business Administration, West University of Timisoara, Romania)
    Abstract: The paper analyzes empirically, based on “Laffer effects”, in Romania’s case, the relationship between tax revenues (dependent variable) and tax rates (independent variables). The analysis is based on the construction of a binary choice model (Linear Probit Model) and the data set is covering the period 1999 - 2009 (first trimester), with quarterly frequency. The main results show that the two “Laffer effects” have a different probability of existence. If the government knows which the maximum probabilities are for each of the two effects, then he can construct a coherent tax policy arrangement that raise or decrease the tax revenues, based on flat or progressive tax systems (the tax evasion is considered to be constant).
    Keywords: Tax revenues, Tax rates, Laffer curve, Effects, Probability, Probit analysis
    JEL: H21 H71 E62 C35
    Date: 2012–04–10
  4. By: Viktor Trasberg
    Abstract: The main tax income for the sub-national governments in Estonia is personal income tax (PIT), which is shared between central and local governments. Since 2004, the share of that tax which is allocated to local governments has been steadily growing. Also, various grants from the central budget to local ones have increased. The situation changed radically during recession years. To cope with the central budget deficit, the central government cut transfers to the local governments and redistributed the PIT revenues in favor of central budget. As a result, the local governments’ fiscal situation deteriorated significantly. Also, local governments’ ability to attract additional funds from EU sources (e.g. structural funds) has been lessened. The research paper concentrates on the analyses of PIT income revenue fluctuations across the local governments and recession impact on various sub-national government groups. There is different importance (share) of PIT revenues in the local budgets. Then higher the incomes in a jurisdiction, there is also larger municipality’s PIT revenue. Using econometric methods, there will be analyzed municipalities revenue factors, impact of central government policies and municipalities fiscal position in the situation of sharp economic fluctuations. Additionally will be generalized municipalities activities to cope with economic recession – the measures to support jurisdictions’ residents in situation of declining public and individual revenues and other hand, increasing need for social services.
    Date: 2011–09
  5. By: Hiroki Tanaka; Masahiro Hidaka
    Abstract: We here expand the static tax competition models in symmetric small regions, which were indicated by Zodrow and Mieszkowski (1986) and Wilson (1986), to a dynamic tax competition model in large regions, taking consideration of the regional asymmetry of productivity of public capital and the existence of capital accumulation. The aim of this paper is to verify how the taxation policy affects asymmetric equilibrium based on a simulation analysis using an overlapping generations model in two regions. It is assumed that the public capital as a public input is formed on the basis of the capital tax of local governments and the lump-sum tax of the central government. As demonstrated in related literature, the optimal capital tax rate should become zero when the lump-sum tax is imposed only on older generations, however, the optimal tax rate may become positive when it is imposed proportionally on younger and older generations. In the asymmetric equilibrium, several cooperative solutions can possibly exist which can achieve a higher welfare standard than the actualized cooperative solution either in Region1 or 2. JEL classification Ôºö H21; H42; H71; H77; R13; R53 Keywords Ôºö Tax competition, Capital taxation, Capital accumulation, Public inputs, Infrastructure
    Date: 2011–09
  6. By: Kuhn, Andreas (University of Zurich)
    Abstract: This paper describes individuals’ inequality perceptions, distributional norms, and redistributive preferences in a panel of OECD countries, primarily focusing on the association between these subjective measures and the effective level of inequality and redistribution. Not surprisingly, the effective level of redistribution (after tax-and-transfer inequality) is positively (negatively) correlated with redistributive preferences. There is also evidence showing that the subjective and objective dimension of inequality and redistribution are, at least partially, linked with individuals’ political preferences and their voting behavior. The association between objective and subjective measures of inequality and redistribution vanishes, however, once more fundamental country characteristics are taken into account. This suggests that these characteristics explain both redistributive preferences as well as the effective level of redistribution and after tax-and-transfer inequality.
    Keywords: inequality perceptions, distributional norms, redistributive preferences, inequality, redistribution, political preferences
    JEL: D31 D63 J31
    Date: 2012–07
  7. By: Bargain, Olivier; Dolls, Mathias; Fuest, Clemens; Neumann, Dirk; Peichl, Andreas; Pestel, Nico; Siegloch, Sebastian
    Abstract: The current debt crisis has given rise to a debate about deeper fiscal integration in Europe. The view is widespread that moving towards a fiscal union would have a stabilising effect in the event of macroeconomic shocks. In this paper we study the economic effects of introducing two elements of a fiscal union: Firstly, an EU-wide tax and transfer system and secondly, an EU-wide system of fiscal equalisation. Using the European tax-benefit calculator EUROMOD, we exploit representative household microdata from 11 Eurozone countries to simulate these policy reforms and to study their effects on the distribution of income as well as their impact on automatic fiscal stabilisers. We find that replacing one third of the national tax and transfer systems by a European system would lead to significant redistributive effects both within and across countries. These effects depend on income levels and the structures of the existing national tax and transfer systems.The EU system would improve fiscal stabilisation especially in credit constrained countries. It would absorb between 10 and 15 per cent of a macroeconomic income shock. Introducing a fiscal equalisation system based on taxing capacity would redistribute revenues from high to low income countries. The stabilisation properties of this system, however, are ambiguous. This suggests that not all forms of fiscal integration will improve macroeconomic stability in the Eurozone.
    Date: 2012–07–07
  8. By: Serena Fatica (European Commission); Thomas Hemmelgarn (European Commission); Gaetan Nicodeme (European Commission)
    Abstract: The tax deductibility of interest payments in most corporate income tax systems coupled with no such measure for equity financing creates economic distortions and exacerbates leverage. This paper discusses the consequences of this debt bias and the possible remedies.
    Keywords: Taxation, Financial sector, Debt, Allowance for Corporate Equity, Comprehensive Business Income Tax, corporate structure.
    JEL: H25 H32 G21 G32
    Date: 2012–08
  9. By: Blaufus, Kay; Möhlmann, Axel
    Abstract: This paper studies behavioral responses to taxes in financial markets. It is motivated by recent puzzling empirical evidence of taxable municipal bond yields significantly exceeding the level expected relative to tax exempt bonds. A behavioral explanation is a tax aversion bias, the phenomenon that people perceive an additional burden associated with tax payments. We conduct market experiments on the trading of differently taxed and labeled securities. The data show an initial overvaluation of tax payments that diminishes when subjects gain experience. The tax deduction of expenses is valued more than an equivalent tax exemption of earnings. We find that the persistence of the tax aversion bias critically depends on the quality of feedback. This suggests that tax aversion predominantly occurs in one-time, unfamiliar financial decisions and to a lesser extent in repetitive choices. --
    Keywords: Behavioral finance,Behavioral taxation,Investor psychology,Tax aversion,Experiment
    JEL: D03 G32 H20 H3
    Date: 2012
  10. By: Giuseppe Di Giacomo; Fabio Mazzola
    Abstract: The aim of this paper is to examine interregional interactions in public expenditure (for NUTS I and NUTS II level regions) using a new database on Italian Regional Public Accounts (RPA) over the period 1996-2007. Intergovernmental interactions are particularly important for assessing the impact of the reform towards fiscal federalism which is currently under way in Italy. As pointed out by Salmon (1987,2002), a more decentralized system implies that governments situated at the same level in a multi-level governmental system compete each other as well as with those located along the hierarchy. Competitive behavior is also a key element in many recent models of local government behavior (Brueckner, 1997, 2000) and is now the focus of a growing empirical literature based on strategic interaction in local policy decisions analyzed through the estimation of a reaction function (Millimet, 2002; Revelli, 2003). The paper provides empirical evidence on complementary/competitive relationships in terms of capital public expenditure using the approach originally developed by Dendrinos and Sonis (1988, 1990). This model has been applied to income variables in several papers (Hewings et al. 1996, Magalhaes et al.1999, Dall’erba et al., 2003) but the use of policy variables has not been explored yet. By investigating the occurrence of competitive versus complementary interactions in regional public expenditure, the paper suggests that the definition of a fiscal federalism scheme should take into account adequately both direct and indirect effects.
    Date: 2011–09
  11. By: Jocelyn Boussard; Francisco de Castro; Matteo Salto
    Abstract: The success of a consolidation in reducing the debt ratio depends crucially on the value of the multiplier, which measures the impact of consolidation on growth, and on the reaction of sovereign yields to such a consolidation. We present a theoretical framework that formalizes the response of the public debt ratio to fiscal consolidations in relation to the value of fiscal multipliers, the starting debt level and the cyclical elasticity of the budget balance. We also assess the role of markets confidence to fiscal consolidations under alternative scenarios. We find that with high levels of public debt and sizeable fiscal multipliers, debt ratios are likely to increase in the short term in response to fiscal consolidations. Hence, the typical horizon for a consolidation during crises episodes to reduce the debt ratio is two-three years, although this horizon depends critically on the size and persistence of fiscal multipliers and the reaction of financial markets. Anyway, such undesired debt responses are mainly short-lived. This effect is very unlikely in non-crisis times, as it requires a number of conditions difficult to observe at the same time, especially high fiscal multipliers.
    JEL: E62 H63
    Date: 2012–07
  12. By: Sinha, Pankaj; Mathur, Kritika
    Abstract: Securities Transaction Taxes have received much attention over the last few years with countries and global organizations trying to control the level of speculations, especially since the Global Financial Crisis. This study examines the impact of an increase in the level of securities transaction tax on traded quantity of shares and time series behaviour of stock returns using data from two prominent national stock exchanges of India. We find that when the tax on equity transactions increases from 0.1% to 0.125%, the quantity of traded shares (volume) decreases by more than twenty five percent. Since the volatility of returns on stocks is not constant through time, conditional heteroscedasticity models are used to estimate the volatility of stock returns. The impact of tax on volatility of return on indices is insignificant.
    Keywords: securities transaction taxes; stock market; returns; traded shares
    JEL: G14 G12 G18 G10
    Date: 2012–06–30
  13. By: Evgeniya Kolomak
    Abstract: Aims of the study are to estimate 1) contribution of infrastructure capital in productivity growth in Russia, and 2) level and spatial extension of the spillovers for different categories of infrastructure. We measure stock of the traditional infrastructure sectors: railways, highways, communication. We use data for 79 Russian regions, covered period is 1992 - 2007. The basic idea of econometric estimates is to expand a production function including infrastructure capital stock. We examine several different categories of public capital. The log-linear Cobb-Douglas form of the production function gives empirical model. We assume existence of spatial spillovers of the infrastructure elements and dependence of regional productivity on public capital of neighboring regions introducing into the model spatial weights matrix and a spatial lag component. There are several problems of econometric estimates relating to the model. The first one is correct specification of the spatial dependence, what includes construction of the spatial weights matrix. The proposed strategy is to run series of regressions using different spatial weighs matrixes. The second one is common trends of output and public capital. One of the proposed ways to resolve the problem is to use some forms of differences. The third problem involves missing variables; panel data and taking of the differences to some extent lessen this problem. Another problem is causality: does absence of progress in infrastructure capital reduce economic growth or does low growth of output decrease the demand for infrastructure? The endogeneity poses question of instrumental variables, the choice of a spatial lag of the predicted values of the dependent variable or of spatially lagged exogenous variables is considered. Infrastructure capital is a public good however its effects can be distributed uneven among different sectors of economic activity. To take this fact into account the proposed set of growth model estimations are done for two alternative production functions focusing on gross regional product and on manufacturing sector only. The results are as follows: - estimates of contribution of infrastructure capital in productivity growth in Russia; - evidence of infrastructure externalities; - estimates of infrastructure spatial spillovers for different categories.
    Date: 2011–09
  14. By: Ivanyna, Maksym; Shah, Anwar
    Abstract: This paper is intended to provide an assessment of the impact of the silent revolution of the last three decades on moving governments closer to people to establish fair, accountable, incorruptible and responsive governance. To accomplish this, a unique data set is constructed for 182 countries by compiling data from a wide variety of sources to examine success toward decentralized decision making across the globe. An important feature of this data set is that, for comparative purposes, it measures government decision making at the local level rather than at the sub-national levels used in the existing literature. The data are used to rank countries on political, fiscal and administrative dimensions of decentralization and localization. These sub-indexes are aggregated and adjusted for heterogeneity to develop an overall ranking of countries on the closeness of their government to the people. The resulting rankings provide a useful explanation of the Arab Spring and other recent political movements and waves of dissatisfaction with governance around the world.
    Keywords: National Governance,Subnational Economic Development,Parliamentary Government,Debt Markets,Public Finance Decentralization and Poverty Reduction
    Date: 2012–07–01
  15. By: Egle Tafenau
    Abstract: The paper asks whether subsidies aiming to redistribute economic activity across regions can be justified with the welfare argument. Moreover, different tax systems are compared with respect to the size of the subsidy needed for achieving a certain spatial distribution of economic activity, and achievable welfare level. The constructed capital model with two regions is chosen as the underlying model, with the regions interpreted as parts of one country. Until now only a little attention has been paid to policy and welfare issues in the NEG literature. It is known that the results of a political intervention meant for increasing welfare could instead decrease it. The paper shows that with an appropriate tax system the adverse effects of subsidies can at least be alleviated. A proportional subsidy to capital increases the overall capital stock, enabling to draw utility from a wider variety of goods. However, the regional effects are different: compared to the no-subsidy case, the subsidized region can enjoy a larger share of locally produced and thus, cheaper goods, while the non-subsidized region has to import more. Moreover, when the subsidy is financed by a uniform income tax, all economic agents bear the tax burden and might face a welfare decrease. If the subsidy is financed by collecting taxes only from the subsidised region, the residents in the non-subsidised region are not hurt by the income loss, but they still lose due to higher price index. The residents of the subsidised region have to give up more of their income for financing the subsidy. Thus, in both cases the net effects are unclear, depending on the values of parameters and the level of trade costs. The Rawlsian and utilitarian welfare function, and the compensated Pareto criterion are applied for welfare analysis. According to the first two concepts the policy can be welfare increasing. The analysis of a potential Pareto improvement through a compensation shows that mostly it is not possible to set a preference order over the policy and no-policy case. However, over some range of trade costs a welfare improvement is possible.
    Date: 2011–09
  16. By: Amdur, David
    Abstract: Does the public believe that fiscal and monetary stimulus reduce unemployment? I present survey evidence on this question from a random sample of Pennsylvania residents. Few respondents express a consistently Keynesian view of fiscal and monetary stimulus. In fact, the typical respondent believes that an increase in government spending makes unemployment worse. Views on monetary stimulus depend on how the question is framed. The typical respondent believes that Fed money creation worsens unemployment while a Fed interest rate cut improves it. I show how opinion varies by political party, educational attainment, income, and other demographic characteristics. Favorable opinions about government spending are strongly associated with support for President Obama's economic policies, even after controlling for political party and for respondents' opinions about the current state and trajectory of the economy.
    Keywords: Opinion survey; fiscal stimulus; monetary stimulus; unemployment; Keynesian economics
    JEL: E62 E12 A20 E52
    Date: 2012–07
  17. By: Corneo, Giacomo; Neher, Frank
    Abstract: This paper offers a comprehensive econometric investigation of the impact of income inequality on the values endorsed by people. Using survey data from all thirty-four OECD countries over a period of almost thirty years, the following dimensions of value systems are investigated: work ethic, civism, obedience, honesty, altruism, and tolerance. In most cases, no robust effects from inequality on values are detected. However, there is evidence that a more unequal income distribution strengthens the work ethic of the population. Thus, income inequality seems to generate work incentives not only via the pecuniary reward of work but also through the symbolic reward it receives.
    Keywords: Income inequality; Value systems
    JEL: D63 O15 O57 Z1
    Date: 2012–05
  18. By: Henry Ergas (SMART Infrastructure Facility, University of Wollongong); Jonathan Pincus (School of Economics, University of Adelaide)
    Abstract: The Australian Treasury contracted KPMG Econtech (2010) to estimate the efficiency cost of Australian taxes, using the MM900 Computable General Equilibrium model. The resultant report, endorsed by Treasury, was a major input into the Henry report into Australia’s Future Tax System (AFTS) and into the policy decisions that ensued. It was also widely cited in the debates that followed as justification for a new Commonwealth tax on mining. KPMG Econtech (2010) found an average excess burden (AEB) of 50%: royalties cost the economy 50 cents for a dollar of revenue, making royalties the second most inefficient major tax, after gambling taxes. KPMG Econtech also found that miners earn excess profits, by way of resource rents. Subsequently, AFTS recommended that royalties be replaced by an excess profits tax. In MM900, in response to the fall in mining output and exports, private after tax income has to fall to restore foreign balance. So the first round impacts of royalties on mining output and exports are crucial to the estimate of an AEB. In partial equilibrium, the simulated fall in mining output of 7.5% means an AEB of 3.75%; general equilibrium effects apparently boost the AEB to 50%. However, we show that it is difficult, if not impossible, to understand from the report quite how such large effects are obtained or more generally, to reconcile the high estimated AEB with the data in the report. This is all the more troubling as KPMG Econtech’s own account of the industry—that, having paid royalties, it was still earning excess profits by way of resource rents—suggests that royalties had a low excess burden.
    Date: 2012–07
  19. By: Schmitz, Patrick W
    Abstract: An agent can make an observable but non-contractible investment. A principal then offers to collaborate with the agent to provide a public good. Private information of the agent about his valuation may either decrease or increase his investment incentives, depending on whether he learns his type before or after the investment stage.
    Keywords: asymmetric information; incomplete contracts; investment incentives; public goods
    JEL: D82 D86 H41
    Date: 2012–07
  20. By: Berliant, Marcus; Peng, Shin-Kun; Wang, Ping
    Abstract: This paper demonstrates that a pollution tax with a fixed cost component may lead, by itself, to stratification between clean and dirty firms without heterogeneous preferences or increasing returns. We construct a simple model with two locations and two industries (clean and dirty) where pollution is a by-product of dirty good manufacturing. Under proper assumptions, a completely stratified configuration with all dirty firms clustering in one city emerges as the only equilibrium outcome when there is a fixed cost component of the pollution tax. Moreover, a stratified Pareto optimum can never be supported by a competitive spatial equilibrium with a linear pollution tax that encompasses Pigouvian taxation as a special case. To support such a stratified Pareto optimum, however, an effective but unconventional policy prescription is to redistribute the pollution tax revenue from the dirty to the clean city residents.
    Keywords: pollution tax; agglomeration of polluting producers; endogenous stratification
    JEL: D62 R13 H23
    Date: 2012–07–24
  21. By: Mehrmann, Annika; Schneider, Georg; Sureth, Caren
    Abstract: Applying a time-discrete investment model and a setting with an entry and an exit option and cash flow uncertainty we present a dynamic analysis of the impact of various loss offset regimes on risky investment timing decisions. We find that a tax system with loss offset restrictions will not distort timing decisions if the investor can exit the project. By contrast, in a setting without exit flexibility a tax discrimination against losses can cause paradoxical effects. In that respect, we analytically identify conditions for higher taxes to increase investors' propensity to choose early investment and hence accelerate entrepreneurial investment. --
    Keywords: asymmetric taxation,loss offset restrictions,timing flexibility,investment decisions,uncertainty,tax effects
    JEL: H21 H25
    Date: 2012
  22. By: Corrado, Carol; Haskel, Jonathan; Iommi, Massimiliano; Jona-Lasinio, Cecilia
    Abstract: Conventional measures of business investment consist primarily of tangible assets such as plant and equipment, vehicles, office buildings and other commercial structures. Corrado, Hulten and Sichel (2005, 2009) show business investment in intangibles (software, design, R&D, branding, organizational capital) exceeds tangible investment for the United States. This paper presents a harmonized data set and analysis of intangible investment, 1995-2009, for the EU27, Norway and the US, and growth accounts including intangible capital for 14 countries. We find (a) intangible investment in the EU is less than the US, but the share of intangible investment in GDP has been growing faster than the share of tangible (b) between 1995 and 2007 capital deepening accounted for almost 50% of growth in the EU and 65% in the US, with intangible investment contributing around half of capital deepening (c) higher rates of intangible capital deepening are associated with higher TFP growth, consistent with spillovers from intangibles.
    Keywords: growth; intangibles; investment
    JEL: O47 O57
    Date: 2012–07
  23. By: Allers, Maarten A.; Toolsema, Linda A. (Groningen University)
    Abstract: Welfare is often administered locally, but financed through grants from the central government. This raises the question how the central government can prevent local governments from spending more than necessary. Block grants are more efficient than matching grants, because the latter reduce the local governments? incentive to limit welfare spending. However, conventional block grant financing is less equitable, indeed, it may put a heavy burden on local governments in economically weak regions. This paper considers block grants which depend on exogenous spending need determinants, and are estimated from previous period welfare spending. This allocation method gives rise to perverse incentives by reducing the marginal costs of welfare spending. We derive the conditions for such a grant to be more efficient than a matching grant, and apply our results to the Netherlands, where such a grant exists since 2004. We conclude that the Dutch style grant is likely to be more efficient than a matching grant. As it is also more equitable, other countries might want to consider introducing a similar grant.
    Date: 2012

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