International Tax and Public Finance

, Volume 23, Issue 1, pp 114–139 | Cite as

The stimulative effects of intergovernmental grants and the marginal cost of public funds

  • Bev Dahlby
  • Ergete Ferede


This paper tests the hypothesis that the stimulative effects of intergovernmental grants increase with the marginal cost of public funds of the recipient government. We present a simple theoretical framework that shows how a lump-sum transfer stimulates the marginal expenditures of a recipient government through an income effect and a price effect. We then test the prediction of this model using Canadian provincial data and exploit the discontinuity in the equalization grants allocation formula to identify the effects of grants. Our results indicate that the stimulative effects of lump-sum grants on spending increase with the provincial government’s marginal cost of public funds (MCF). One policy implication of our results is that higher intergovernmental transfers may be welfare improving if the federal government has a lower MCF than the provinces.


Intergovernmental grants Marginal cost of public funds Flypaper effect Fiscal federalism 

JEL Classification

H71 H72 H77 



We would like to thank the two anonymous referees of the journal for their valuable comments and suggestions. This paper also benefited from comments and suggestions of participants at the 46th Canadian Economics Association meetings in Calgary and CESifo area conference on Public Sector Economics in Munich. All remaining errors are our own.


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Copyright information

© Springer Science+Business Media New York 2015

Authors and Affiliations

  1. 1.The School of Public Policy and Department of EconomicsUniversity of CalgaryCalgaryCanada
  2. 2.Department of EconomicsMacEwan UniversityEdmontonCanada

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