Abstract:
This paper analyzes whether changes in the timing of equalizing transfers to state governments necessitate an adjustment in federal corrective policy. According to the existing literature (assuming an ex-ante choice of transfers), the corrective grant is equal to the marginal damage/benefit inflicted by externality generation. When the federal government accommodates state finances ex-post, the grant differs in formula from existing prescription. Allocative federal policy corrects state policy incentives twofold. It entails a correction for the distortion in the marginal benefit of state spending (as in earlier literature) and for the distortion in the marginal cost of public funds induced by the ex-post provision of transfers. The required grant rule is generically disproportionate to the equilibrium externality (even with lump-sum taxation). Furthermore, the ex-post provision of transfers is critical for the nature of the equilibrium inefficiency. Equalizing transfers at least partly internalize consumption spill-overs, but simultaneously establishes a new source of inefficiency. As a final result, the existing prescription for allocative federal policy continues to apply if the public good is pure.
