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The marginal cost of public funds and the flypaper effect

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Abstract

A lump-sum intergovernmental transfer has a “price effect”, as well as an “income effect”, because it allows the recipient government to reduce its tax rate, which lowers its marginal cost of public funds, while still providing the same level of public service. This reduction in the effective price of providing the public service helps to explain the “flypaper effect”—the empirical observation that a lump-sum grant has a much larger effect on spending than an increase in personal income. Contrary to the assertions of Mieszkowski (Modern Public Finance, 1994) and Hines and Thaler (J. Econ. Perspect. 9:217–226, 1995), a model of a benevolent local government financing its expenditures with a distortionary tax predicts flypaper effects from lump-sum grants that are similar to those observed in many econometric studies.

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Authors and Affiliations

  1. Department of Economics, University of Alberta, T6G 2H4, Edmonton, Alberta, Canada

    Bev Dahlby

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  1. Bev Dahlby
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Correspondence to Bev Dahlby.

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This paper was originally prepared for the World Bank as part of a background report providing a conceptual framework for the reform of intergovernmental transfers in Brazil. I would like to thank Fernando Blanco, Jon Hamilton, Stuart Landon, Enlinson Mattos, Mark Maxson, Mel McMillan, Jay Wilson, Matthias Wrede, and two anonymous referees for their comments. The usual disclaimers apply.

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Dahlby, B. The marginal cost of public funds and the flypaper effect. Int Tax Public Finance 18, 304–321 (2011). https://doi.org/10.1007/s10797-010-9160-x

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