The impact of intergovernmental grants on cost efficiency: theory and evidence from German municipalities

In: Discussion paper 08-051

Abstract

In this paper we use a simple bureaucracy model of fiscal illusion to analyze the impact of intergovernmental grants on the cost effciency of local jurisdictions. We find that a higher degree of redistribution within a system of fiscal equalization or an increase in the amount of grants received by a local jurisdiction leads to an extension of organizational slack or X-ineffciency in that jurisdiction. This theoretical prediction is tested by conducting an empirical analysis using a broad panel of German municipalities. The results of the empirical analysis are consistent with the theoretical findings and therefore support the existence of a negative incentive effect of intergovernmental grants on local authorities' cost effciency.