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The flypaper effect and the revenue impact of grants-in-aid
Economics Letters North-Holland
351
30 (1989) 351-356
THE FLYPAPER
EFFECT AND THE REVENUE
IMPACT
OF GRANTS-IN-AID
Muhammed N. ISLAM and Saud A. CHOUDHURY Concordia Uniuersity, Montreal, Quebec, Canada H3G lM8 Received Accepted
19 August 1988 2 November 1988
Using a median voter model, which assumes grants as endogenous, this paper finds strong evidence of the flypaper effect of unconditional grants to Ontario municipalities. Unconditional grants are therefore not expected to reduce the tax burden of local residents.
1. Introduction Previous empirical studies [see Gramlich and Gaiphor (1973) Inman (1979) and Stine (1985)] suggest that the expenditure response to an increase in unconditional grants is significantly greater than that resulting from an equal increase in private income. This so-called flypaper effect of unconditional grants predicts that most of the grants would be spent in financing increased public spending and would provide very little tax relief. Other studies [see, e.g., Megdal (1986) Slack (1980) and Zampelli (1986)], however, found little evidence in support of the flypaper theory of incidence. The lack of a consensus in the results may be due to (a) an improper specification of the grant variable unconditional grants were defined to include closed-ended matching grants [see Megdal (1986)], and (b) the questionable exogeneity assumptions with respect to grants that are implicit in some of these studies [see Zampelli (1986)]. Although many U.S. studies [see Megdal (1986)] offered explanations for the flypaper effect of state and local public finance, there is hardly any Canadian study which differentiates between the expenditure effects of private income and unconditional grants [see Slack (1980)]. This paper addresses the above econometric issues and investigates the flypaper theory within the framework of a median voter model, which is tested on a pooled time series and cross-section data of 49 upper-tier municipalities in Ontario during the eight-year period 1977-1984. By pooling the data, 392 observations on a wide range of variables were obtained. The results provide strong evidence in support of the flypaper effect of unconditional grants.
2. The model The median voter hypothesis serves as a basic paradigm for incorporating political factors into economic analysis via the preference of the pivotal median voter [Romer and Rosenthal (1979)]. He is assumed to maximize his preference function U= u(XIKa, 0165-1765/89/$3.50
Y-
t;AV)
0 1989, Elsevier Science Publishers
(1) B.V. (North-Holland)
352
M.N. Islam, S.A. Choudhury / Flypaper effeeci and revenue impact of grants-in-aid
subject to his budget constraint P,X,+(Y-t;AV)=Y+G,+G,+OR,
(2)
where X,N-* is his consumption of the quasi-public good Xi, which is shared by N consumers each paying a tax price of $P, (a is the congestion parameter); (Y - t, . AV) is his disposable personal income less property taxes, which is used as a proxy for his consumption of all other goods; and G,,, G,, and OR are the absolute amounts of unconditional grants, conditional grants, and other revenues received by the municipality per individual. The tax price he pays for the public good equals his tax share times the unit cost (AC) of supplying the product. The tax share, measured as the ratio of his assessed property value to the total value of all properties in the municipalities, may depend upon his income or other personal characteristics but it does not depend upon the size of municipal expenditures and is thus considered to be exogenous to the municipal budgetary process. If we assume that AC does not vary across municipalities, P, would be proportional to his tax share. The tax base (AV) is determined by provincial assessment authorities based upon municipal wealth and thus, from the point of view of the municipality, it is also exogenous. Although the tax price and the tax base can both be assumed to be exogenous, the tax rate (t,) is nevertheless endogenous because the municipality is committed to balance its budget on current account and this requires that it simultaneously chooses an expenditure level and a tax rate which will result in a balanced budget. It is initially assumed that grants and other revenues are exogenous to the system. Subject to the usual assumption of diminishing marginal utility and continuous second derivatives, the constrained utility maximization yields the following system of demand equations in general form:
E=f(G,, G,, OR, P,, N, Y, Z>, t, =f(G,,
G,, OR, P,, N, Y, AV,
(3)
Z),
(4)
and the constraint E=N(t;AV+G,+G,+OR).
(5)
The vector Z is included to control for inter-municipal differences in the demand for local public services resulting from such socio-economic characteristics of each municipality as its density of population, the level of school taxes, location of the municipality in the north or in the south, the lagged values of tax rate and expenditures. The grant variables may. not, however, be exogenous as they were assumed earlier. Although the province restricts the maximum amount of grants that can be given to all municipalities in a given year, the actual amount received by a particular municipality is determined by taking account of its important socio-demographic characteristics, and annual changes in its expenditure needs and tax base. The grant variables exhibit a systematic pattern and a stochastic component. The systematic component may be assumed to depend on the predetermined (exogenous) variables in the model and the stochastic component is found to vary with the fluctuations in expenditures, tax receipts, and so on. It is the latter component that creates a dependence of grants on the error term in the expenditure equation and hence grants should be treated as endogenous to the system. We therefore postulate the unconditional grants as given by
G,=f[AE,, (&.AV)t-l, OR, Y,
N,
Z],
(6)
MN. Islam, S.A. Choudhuty / Flypaper effect and revenue impact of granis-in-aid
353
where G, excludes closed-ended matching grants and includes general per-capita grants, police per-capita grants, and levy-based grants (e.g., general support grants, special support-based grants to northern municipalities and resource-equalization grants). The conditional grants are specific-purpose transfers which equal some matching rate times the endogenous municipal expenditures on such functions as improvement of roads, communication facilities, health, education, and public welfare. Since the matching rate is often adjusted on an ad hoc basis depending upon changing municipal circumstances in respect of their revenues and expenditures, we determine G, directly from a behavioural equation, taking into account the endogeneity of the aided expenditures. The conditional grants are given by
G,=f(AE,,, A%,, OR, Y, N, Z). The aided expenditures E,, (on transportation and public welfare) are given by E,,=f[(t;AV),_,, E,,=~[(~,.AV),_~,
and communications)
OR, Y, N, z]> OR, Y, N, Z],
and E,,
(on health, education,
i’l> i>l.
The user fees and other revenues include a wide variety of fees and licences, each comprising a small percentage of overall expenditures and each being regulated by specific municipal by-laws. We have, therefore, assumed them to be exogenous and the simultaneous equation bias in the results due to this assumption is not expected to be serious.
3. The data and exogeneity tests 3. I. The data The basic data relate to three broad categories: (i) local government revenues from internal and external sources; (ii) local government expenditures by functions; and (iii) demographic characteristics of each municipality and its population. Roughly seventy percent of municipal revenues are raised internally from property taxes (42%), user fees and other revenues (28%). The remaining 30% of overall revenues come from the province in the form of conditional grants (20%) and unconditional grants (10%). These data are collected from Local Government Finance and/or from Annual Reports of Municipal Statistics (various issues). There are few limitations of the data that should be emphasized. First, we could not cover any period earlier than 1977 because of the lack of consistent data on all of the variables used in this study. Second, our earlier assumption that the costs of supplying public goods are the same in each municipality may not be valid, because some of the inputs of municipal operations (e.g., land, labour, raw materials, etc.) may be locally supplied and their prices are likely to vary between communities. This requires that expenditure figures should be deflated by the local price index for public goods. Ideally we should also deflate income data by the local price index for all goods. But these local price indices are not currently available and, therefore, we use the consumer price index (1981-100) as a common deflator. 3.2. Exogeneity
tests
The exogeneity tests used in this study are based on the works of Engle, Hendry and Richard (1983). If one uses a single-equation least squares regression model to draw an inference about the
354
M.N. Islam, S.A. Choudhury / Flypaper effect and revenue impact of grants-in-aid
impacts of grants on expenditures, a ‘weak exogeneity’ assumption with respect to grants is adequate. If the purpose is to make a forecast of expenditures given any specific amount of grants, one would require an assumption of ‘strong exogeneity’. If, however, the aim of the analysis is to make an evaluation of alternative policy measures based on coefficient estimates of grants, an assumption of ‘super exogeneity’ of the variables would be required. Both strong and super exogeneity of the variables require that they must be weakly exogenous and not vice versa. We test for weak exogeneity of G, and G, by using the Lagrange multiplier test, which involves a sequential procedure in computing the correlation between the error term in the expenditure equation and the error term in the grant function while taking account of relevant predetermined variables in the system. The predetermined variables used are the lagged values of property taxes, school taxes and a dummy variable for northern municipalities. The computed R2 in case of G, and G, are 0.6831 and 0.5708, respectively. Multiplying them by the sample size n (= 392) we find the test statistics x2 to be equal to 267.07 and 223.18, respectively, which are statistically significant at the 1% level corresponding to 5 degrees of freedom. This confirms our earlier assumption that both G, and G, are endogenous. Since these variables are not weakly exogenous, by definition, they cannot be strongly or super exogenous.
4. Estimation of the model 4. I. Estimation problems We adopt a loglinear form for each of equations (3)-(4) and (6)-(9) in the model and append an error term ui (i = 1, 2,. . . ,6) which is assumed to be lognormally distributed with zero mean and constant variance. By estimating equations (3) and (6)-(9) and given the budget constraint (5), one can determine the parameters of eq. (4). The estimation of the model poses a number of problems. First, the use of pooled time series and cross-section data leads to cross-equation correlations and heteroscedasticity in the error terms. Using the White test [see White (1980)] we estimated the test statistic x2 (= nR2) to be equal to 5.68, which falls short of the critical x2 value of 61.53 for 45 degrees of freedom and, hence, we do not consider heteroscedasticity in the error terms as a serious problem. Second, the choice of an appropriate estimation technique is crucial. We have used the two-stage least squares (2SLS) technique to estimate the model (see table 1 and then estimated the variance-covariance matrix of estimated residuals in various equations in table 1. The results indicate that although there exist certain degrees of correlations among the different pairs of residuals, they are not, however, significant. Thus, the use of the 3SLS rather than the 2SLS technique would not lead to an appreciable increase in the efficiency of parameter estimates. The 2SLS estimator has the same desirable large sample properties as the 3SLS estimator. While 2SLS and 3SLS are both sensitive to specification errors in the variables in the model, the latter requires in addition a correct specification of each equation. A single specification error is passed on to all equations in the model and hence 2SLS is preferred to 3SLS. 4.2. Empirical results Table 1 reports only the coefficient estimates of expenditure and tax rate equations. Since the expenditure equation (at well as the tax rate equation) is in loglinear form, the coefficient estimates represent spending elasticities. The flypaper effect relates to marginal spending propensities; an estimated unconditional aid propensity much larger than the income propensity will indicate an evidence of the flypaper effect. From the estimated spending elasticities with respect to uncondi-
- 0.3976 0.9231
Constant
least squares
0.3268 * 0.2241*
OR
a*b
-0.1559 * - 0.2050 *
Y
and tax rate equations.
- 0.3356 * - 0.0556
G,
G”
- 0.2830 * - 0.0294
variables
of expenditure
Independent
estimates
- 0.2583 * 0.3919 *
Pl
0.1148* 0.3701*
T,
0.4805 * -0.5101*
N
-0.1670* - 0.0973 *
Nd
0.2193* -0.5125 *
T -1
0.9949 0.9379
A2
442.08 332.67
Log-likelihood value
a * Coefficients are significant at the 5% level of significance. per individual. The b The data on expenditures (revenues, e.g., GU, G,, OR, taxes) are measured in amounts of dollars spent (collected) annually by each municipality tax rate measures the ratio of total taxes ($ million) to total population (thousands). Density of population ( Nd) is measured by the number of people per hectare, T, represents school taxes, and T_, is the property taxes lagged one year. Income (Y) is the median annual income ($) of local residents. The tax price (I’,) is proxied by the ratio of assessed property values of the median voter to all property values in the municipality.
Expenditures b Tax rate
Dependent variables
Table I Two-stage
356
M.N. Islam, S.A. Choudhury / Flypaper effeci and reuenue impact of grants-in-aid
tional grants and income (-0.2830 and - 0.1559, respectively), we derived the corresponding marginal spending propensities to be equal to - 2.83 and - 0.39, respectively, at the mean values of G,, Y, and E. These estimates provide a strong evidence in support of the flypaper effect of unconditional grants and this implies that untied aid contributes very little in alleviating the tax burden of municipal residents. [Our results contradict those of Slack (1980) who found no evidence of the flypaper effect of unconditional grants.] The coefficient estimate of G, in the tax rate equation is quite small in magnitude and statistically insignificant. Unconditional grants are therefore not expected to cause a significant reduction in the tax rates of local residents. In fact, our finding is consistent with the provincial policy of providing the bulk of its grants to municipalities in the form of conditional transfers. The expenditure and tax effects of other variables conform to standard results in the literature.
5. Summary and conclusions This paper uses a median voter model to investigate the flypaper effect of unconditional grants to Ontario municipalities. In applying the model, grants are assumed to be endogenous and this assumption is supported by ‘weak’, ‘ strong’, and ‘super’ exogeneity test results. The empirical results provide a strong evidence of the flypaper effect, which contradicts recent Canadian studies. This suggests that a policy of using unconditional grants to reduce property taxes would be erroneous.
References Engle, R.F., D.F. Hendry and J.F. Richard, 1983, Exogeneity, Econometrica 51, March, 277-304. Gramlich, E.M. and H. Galper, 1973, State and local fiscal behaviour and federal grant policy, Brookings Papers on Economic Activity, 357-400. Inman, R.P., 1979. The fiscal performance of local governments: An Interpretative review, in: Peter Mieszkowski and Mahlon Straszheim, eds., Current issues in urban economics (Johns Hopkins University Press, Baltimore, MD) 270-321. Megdal, S.B., 1987. The flypaper effect revisited: An econometric explanation, Review of Economics and Statistics 66, no. 2, May, 347-351. Romer, T. and H. Rosenthal, 1980, An institutional theory of the effects of intergovernmental grants, National Tax Journal 33,451-458. Slack, E.N., 1980, Local fiscal response to intergovernmental transfers, Review of Economics and Statistics 63, 364-370. Stine, W.F., 1985, Estimating the responsiveness of local revenue to intergovernmental grants, National Tax Journal 38, no. 2, 227-234. White, H., 1980, A heteroscedasticity-consistent covariance matrix estimator and a direct test for heteroscedasticity, Econometrica 48, May, 817-838. Zampelli, E.M., 1986, Resource fungibility, the flypaper effect, and the expenditure impact of grants-in-aid, Review of Economics and Statistics 68, no. 1, 33-70.
351
30 (1989) 351-356
THE FLYPAPER
EFFECT AND THE REVENUE
IMPACT
OF GRANTS-IN-AID
Muhammed N. ISLAM and Saud A. CHOUDHURY Concordia Uniuersity, Montreal, Quebec, Canada H3G lM8 Received Accepted
19 August 1988 2 November 1988
Using a median voter model, which assumes grants as endogenous, this paper finds strong evidence of the flypaper effect of unconditional grants to Ontario municipalities. Unconditional grants are therefore not expected to reduce the tax burden of local residents.
1. Introduction Previous empirical studies [see Gramlich and Gaiphor (1973) Inman (1979) and Stine (1985)] suggest that the expenditure response to an increase in unconditional grants is significantly greater than that resulting from an equal increase in private income. This so-called flypaper effect of unconditional grants predicts that most of the grants would be spent in financing increased public spending and would provide very little tax relief. Other studies [see, e.g., Megdal (1986) Slack (1980) and Zampelli (1986)], however, found little evidence in support of the flypaper theory of incidence. The lack of a consensus in the results may be due to (a) an improper specification of the grant variable unconditional grants were defined to include closed-ended matching grants [see Megdal (1986)], and (b) the questionable exogeneity assumptions with respect to grants that are implicit in some of these studies [see Zampelli (1986)]. Although many U.S. studies [see Megdal (1986)] offered explanations for the flypaper effect of state and local public finance, there is hardly any Canadian study which differentiates between the expenditure effects of private income and unconditional grants [see Slack (1980)]. This paper addresses the above econometric issues and investigates the flypaper theory within the framework of a median voter model, which is tested on a pooled time series and cross-section data of 49 upper-tier municipalities in Ontario during the eight-year period 1977-1984. By pooling the data, 392 observations on a wide range of variables were obtained. The results provide strong evidence in support of the flypaper effect of unconditional grants.
2. The model The median voter hypothesis serves as a basic paradigm for incorporating political factors into economic analysis via the preference of the pivotal median voter [Romer and Rosenthal (1979)]. He is assumed to maximize his preference function U= u(XIKa, 0165-1765/89/$3.50
Y-
t;AV)
0 1989, Elsevier Science Publishers
(1) B.V. (North-Holland)
352
M.N. Islam, S.A. Choudhury / Flypaper effeeci and revenue impact of grants-in-aid
subject to his budget constraint P,X,+(Y-t;AV)=Y+G,+G,+OR,
(2)
where X,N-* is his consumption of the quasi-public good Xi, which is shared by N consumers each paying a tax price of $P, (a is the congestion parameter); (Y - t, . AV) is his disposable personal income less property taxes, which is used as a proxy for his consumption of all other goods; and G,,, G,, and OR are the absolute amounts of unconditional grants, conditional grants, and other revenues received by the municipality per individual. The tax price he pays for the public good equals his tax share times the unit cost (AC) of supplying the product. The tax share, measured as the ratio of his assessed property value to the total value of all properties in the municipalities, may depend upon his income or other personal characteristics but it does not depend upon the size of municipal expenditures and is thus considered to be exogenous to the municipal budgetary process. If we assume that AC does not vary across municipalities, P, would be proportional to his tax share. The tax base (AV) is determined by provincial assessment authorities based upon municipal wealth and thus, from the point of view of the municipality, it is also exogenous. Although the tax price and the tax base can both be assumed to be exogenous, the tax rate (t,) is nevertheless endogenous because the municipality is committed to balance its budget on current account and this requires that it simultaneously chooses an expenditure level and a tax rate which will result in a balanced budget. It is initially assumed that grants and other revenues are exogenous to the system. Subject to the usual assumption of diminishing marginal utility and continuous second derivatives, the constrained utility maximization yields the following system of demand equations in general form:
E=f(G,, G,, OR, P,, N, Y, Z>, t, =f(G,,
G,, OR, P,, N, Y, AV,
(3)
Z),
(4)
and the constraint E=N(t;AV+G,+G,+OR).
(5)
The vector Z is included to control for inter-municipal differences in the demand for local public services resulting from such socio-economic characteristics of each municipality as its density of population, the level of school taxes, location of the municipality in the north or in the south, the lagged values of tax rate and expenditures. The grant variables may. not, however, be exogenous as they were assumed earlier. Although the province restricts the maximum amount of grants that can be given to all municipalities in a given year, the actual amount received by a particular municipality is determined by taking account of its important socio-demographic characteristics, and annual changes in its expenditure needs and tax base. The grant variables exhibit a systematic pattern and a stochastic component. The systematic component may be assumed to depend on the predetermined (exogenous) variables in the model and the stochastic component is found to vary with the fluctuations in expenditures, tax receipts, and so on. It is the latter component that creates a dependence of grants on the error term in the expenditure equation and hence grants should be treated as endogenous to the system. We therefore postulate the unconditional grants as given by
G,=f[AE,, (&.AV)t-l, OR, Y,
N,
Z],
(6)
MN. Islam, S.A. Choudhuty / Flypaper effect and revenue impact of granis-in-aid
353
where G, excludes closed-ended matching grants and includes general per-capita grants, police per-capita grants, and levy-based grants (e.g., general support grants, special support-based grants to northern municipalities and resource-equalization grants). The conditional grants are specific-purpose transfers which equal some matching rate times the endogenous municipal expenditures on such functions as improvement of roads, communication facilities, health, education, and public welfare. Since the matching rate is often adjusted on an ad hoc basis depending upon changing municipal circumstances in respect of their revenues and expenditures, we determine G, directly from a behavioural equation, taking into account the endogeneity of the aided expenditures. The conditional grants are given by
G,=f(AE,,, A%,, OR, Y, N, Z). The aided expenditures E,, (on transportation and public welfare) are given by E,,=f[(t;AV),_,, E,,=~[(~,.AV),_~,
and communications)
OR, Y, N, z]> OR, Y, N, Z],
and E,,
(on health, education,
i’l> i>l.
The user fees and other revenues include a wide variety of fees and licences, each comprising a small percentage of overall expenditures and each being regulated by specific municipal by-laws. We have, therefore, assumed them to be exogenous and the simultaneous equation bias in the results due to this assumption is not expected to be serious.
3. The data and exogeneity tests 3. I. The data The basic data relate to three broad categories: (i) local government revenues from internal and external sources; (ii) local government expenditures by functions; and (iii) demographic characteristics of each municipality and its population. Roughly seventy percent of municipal revenues are raised internally from property taxes (42%), user fees and other revenues (28%). The remaining 30% of overall revenues come from the province in the form of conditional grants (20%) and unconditional grants (10%). These data are collected from Local Government Finance and/or from Annual Reports of Municipal Statistics (various issues). There are few limitations of the data that should be emphasized. First, we could not cover any period earlier than 1977 because of the lack of consistent data on all of the variables used in this study. Second, our earlier assumption that the costs of supplying public goods are the same in each municipality may not be valid, because some of the inputs of municipal operations (e.g., land, labour, raw materials, etc.) may be locally supplied and their prices are likely to vary between communities. This requires that expenditure figures should be deflated by the local price index for public goods. Ideally we should also deflate income data by the local price index for all goods. But these local price indices are not currently available and, therefore, we use the consumer price index (1981-100) as a common deflator. 3.2. Exogeneity
tests
The exogeneity tests used in this study are based on the works of Engle, Hendry and Richard (1983). If one uses a single-equation least squares regression model to draw an inference about the
354
M.N. Islam, S.A. Choudhury / Flypaper effect and revenue impact of grants-in-aid
impacts of grants on expenditures, a ‘weak exogeneity’ assumption with respect to grants is adequate. If the purpose is to make a forecast of expenditures given any specific amount of grants, one would require an assumption of ‘strong exogeneity’. If, however, the aim of the analysis is to make an evaluation of alternative policy measures based on coefficient estimates of grants, an assumption of ‘super exogeneity’ of the variables would be required. Both strong and super exogeneity of the variables require that they must be weakly exogenous and not vice versa. We test for weak exogeneity of G, and G, by using the Lagrange multiplier test, which involves a sequential procedure in computing the correlation between the error term in the expenditure equation and the error term in the grant function while taking account of relevant predetermined variables in the system. The predetermined variables used are the lagged values of property taxes, school taxes and a dummy variable for northern municipalities. The computed R2 in case of G, and G, are 0.6831 and 0.5708, respectively. Multiplying them by the sample size n (= 392) we find the test statistics x2 to be equal to 267.07 and 223.18, respectively, which are statistically significant at the 1% level corresponding to 5 degrees of freedom. This confirms our earlier assumption that both G, and G, are endogenous. Since these variables are not weakly exogenous, by definition, they cannot be strongly or super exogenous.
4. Estimation of the model 4. I. Estimation problems We adopt a loglinear form for each of equations (3)-(4) and (6)-(9) in the model and append an error term ui (i = 1, 2,. . . ,6) which is assumed to be lognormally distributed with zero mean and constant variance. By estimating equations (3) and (6)-(9) and given the budget constraint (5), one can determine the parameters of eq. (4). The estimation of the model poses a number of problems. First, the use of pooled time series and cross-section data leads to cross-equation correlations and heteroscedasticity in the error terms. Using the White test [see White (1980)] we estimated the test statistic x2 (= nR2) to be equal to 5.68, which falls short of the critical x2 value of 61.53 for 45 degrees of freedom and, hence, we do not consider heteroscedasticity in the error terms as a serious problem. Second, the choice of an appropriate estimation technique is crucial. We have used the two-stage least squares (2SLS) technique to estimate the model (see table 1 and then estimated the variance-covariance matrix of estimated residuals in various equations in table 1. The results indicate that although there exist certain degrees of correlations among the different pairs of residuals, they are not, however, significant. Thus, the use of the 3SLS rather than the 2SLS technique would not lead to an appreciable increase in the efficiency of parameter estimates. The 2SLS estimator has the same desirable large sample properties as the 3SLS estimator. While 2SLS and 3SLS are both sensitive to specification errors in the variables in the model, the latter requires in addition a correct specification of each equation. A single specification error is passed on to all equations in the model and hence 2SLS is preferred to 3SLS. 4.2. Empirical results Table 1 reports only the coefficient estimates of expenditure and tax rate equations. Since the expenditure equation (at well as the tax rate equation) is in loglinear form, the coefficient estimates represent spending elasticities. The flypaper effect relates to marginal spending propensities; an estimated unconditional aid propensity much larger than the income propensity will indicate an evidence of the flypaper effect. From the estimated spending elasticities with respect to uncondi-
- 0.3976 0.9231
Constant
least squares
0.3268 * 0.2241*
OR
a*b
-0.1559 * - 0.2050 *
Y
and tax rate equations.
- 0.3356 * - 0.0556
G,
G”
- 0.2830 * - 0.0294
variables
of expenditure
Independent
estimates
- 0.2583 * 0.3919 *
Pl
0.1148* 0.3701*
T,
0.4805 * -0.5101*
N
-0.1670* - 0.0973 *
Nd
0.2193* -0.5125 *
T -1
0.9949 0.9379
A2
442.08 332.67
Log-likelihood value
a * Coefficients are significant at the 5% level of significance. per individual. The b The data on expenditures (revenues, e.g., GU, G,, OR, taxes) are measured in amounts of dollars spent (collected) annually by each municipality tax rate measures the ratio of total taxes ($ million) to total population (thousands). Density of population ( Nd) is measured by the number of people per hectare, T, represents school taxes, and T_, is the property taxes lagged one year. Income (Y) is the median annual income ($) of local residents. The tax price (I’,) is proxied by the ratio of assessed property values of the median voter to all property values in the municipality.
Expenditures b Tax rate
Dependent variables
Table I Two-stage
356
M.N. Islam, S.A. Choudhury / Flypaper effeci and reuenue impact of grants-in-aid
tional grants and income (-0.2830 and - 0.1559, respectively), we derived the corresponding marginal spending propensities to be equal to - 2.83 and - 0.39, respectively, at the mean values of G,, Y, and E. These estimates provide a strong evidence in support of the flypaper effect of unconditional grants and this implies that untied aid contributes very little in alleviating the tax burden of municipal residents. [Our results contradict those of Slack (1980) who found no evidence of the flypaper effect of unconditional grants.] The coefficient estimate of G, in the tax rate equation is quite small in magnitude and statistically insignificant. Unconditional grants are therefore not expected to cause a significant reduction in the tax rates of local residents. In fact, our finding is consistent with the provincial policy of providing the bulk of its grants to municipalities in the form of conditional transfers. The expenditure and tax effects of other variables conform to standard results in the literature.
5. Summary and conclusions This paper uses a median voter model to investigate the flypaper effect of unconditional grants to Ontario municipalities. In applying the model, grants are assumed to be endogenous and this assumption is supported by ‘weak’, ‘ strong’, and ‘super’ exogeneity test results. The empirical results provide a strong evidence of the flypaper effect, which contradicts recent Canadian studies. This suggests that a policy of using unconditional grants to reduce property taxes would be erroneous.
References Engle, R.F., D.F. Hendry and J.F. Richard, 1983, Exogeneity, Econometrica 51, March, 277-304. Gramlich, E.M. and H. Galper, 1973, State and local fiscal behaviour and federal grant policy, Brookings Papers on Economic Activity, 357-400. Inman, R.P., 1979. The fiscal performance of local governments: An Interpretative review, in: Peter Mieszkowski and Mahlon Straszheim, eds., Current issues in urban economics (Johns Hopkins University Press, Baltimore, MD) 270-321. Megdal, S.B., 1987. The flypaper effect revisited: An econometric explanation, Review of Economics and Statistics 66, no. 2, May, 347-351. Romer, T. and H. Rosenthal, 1980, An institutional theory of the effects of intergovernmental grants, National Tax Journal 33,451-458. Slack, E.N., 1980, Local fiscal response to intergovernmental transfers, Review of Economics and Statistics 63, 364-370. Stine, W.F., 1985, Estimating the responsiveness of local revenue to intergovernmental grants, National Tax Journal 38, no. 2, 227-234. White, H., 1980, A heteroscedasticity-consistent covariance matrix estimator and a direct test for heteroscedasticity, Econometrica 48, May, 817-838. Zampelli, E.M., 1986, Resource fungibility, the flypaper effect, and the expenditure impact of grants-in-aid, Review of Economics and Statistics 68, no. 1, 33-70.