31
THE ROLE OF GRANTS-IN-AID IN A
FEDERALIST SYSTEM
OF GOVERNMENTS
OPTIMAL FEDERALISM AND GRANTS-IN-AID:
NORMATIVE ANALYSIS
First-Best Policy Environment
Second-Best Policy Environment
ALTERNATIVE DESIGN CRITERIA
The LeGrand Guidelines
Applying LeGrand's Principles: Bradbury et al.
Redistributing Through Matching Grants
ESTIMATING THE DEMAND FOR STATE AND LOCAL
PUBLIC SERVICES
The Median Voter Model
Surveys
THE RESPONSE TO GRANTS-IN-AID
The Flypaper Effect
Possible Explanations of the Flypaper Effect
Project Grants and Bureaucrats
OPTIMAL FEDERALISM AND GRANTS-IN-AID:
NORMATIVE ANALYSIS
First-Best Policy Environment
Whether grants-in-aid have any role in an optimal, Wrst-best federalist system
of governments depends upon the underlying model used to establish the
notion of a social welfare optimum. Recall that in the conventional model of
optimal federalism redistributional policy is the sole responsibility of the
national government, whereas allocational functions reside in the lowest
level governments consistent with pareto optimality. Consequently, only
the national government is concerned with social welfare optimization as
traditionally deWned. The lower level governments care only about eYciency.
893
Grants-in-aid are unnecessary in this model, as long as the policy envir-
onment is truly Wrst best and a perfect correspondence of jurisdictions
exists for all allocational problems. The national government satisWes its
interpersonal equity conditions with lump-sum taxes and transfers among
individuals (and Wrms, with decreasing cost production), exactly as in the
single-government model of the public sector. Similarly, all governments,
whether national or ``local,'' interact only with the individual consumers and
Wrms within their jurisdictions when correcting for resource misallocations.
Thus, they simply follow the normative decision rules derived under the
assumption of a single government. There is no need for the grant-in-aid,
because no government need be directly concerned with any other jurisdic-
tions. In our view, this is yet another reason for rejecting the traditional
model of optimal federalism. It seems implausible that intergovernmental
relations would be of no consequence in a federalist system of governments,
even under Wrst-best assumptions.
Our alternative model of federalism, presented in Chapter 30, deWned the
social welfare optimum as an equilibrium in which each government maxi-
mized its own dynastic social welfare function, with the restriction that the
arguments of each government's social welfare function are the social welfare
functions of those governments immediately below it in the Wscal hierarchy.
Grants-in-aid are required in this model to resolve the distribution question,
since all but the lowest level governments must tax and transfer resources
lump sum among the governments immediately below them in the Wscal
hierarchy. In the parlance of grants-in-aid, these lump-sum grants would be
unconditional, nonmatching, and closed-ended: unconditional, because one
government cannot dictate to any other government how to dispose of the
funds, the ``states' rights'' criterion; nonmatching and closed-ended, because
the interpersonal equity conditions require straight resource transfers of
some Wnite amount. Notice, too, that the ``grants'' are negative for those
governments that must surrender resources.
Our alternative model shares with the conventional model the attribute
that grants-in-aid are not required for allocational purposes in a Wrst-best
policy environment with a perfect correspondence of local functions.
Simultaneously with satisfying all possible interpersonal equity conditions,
satisfying all necessary pareto-optimal conditions proceeds government-
by-government in the usual manner. To develop a further role for grants-
in-aid, then, requires introducing some second-best distortion into the policy
environment.
Second-Best Policy Environment
Imperfect Correspondence
A second-best restriction commonly analyzed in the literature is a main-
tained imperfect correspondence for an externality-generating activity, which
894 OPTIMAL FEDERALISM AND GRANTS-IN-AID: NORMATIVE ANALYSIS

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