Public Finance, 2nd Edition

grants-in-aid are unlikely to be pareto optimal. And even if pareto optimality

could be achieved by the grants-in-aid, it may not be the most direct Wscal

tool. Not surprisingly, grants-in-aid are most appropriate for publicly pro-

vided services.

Consider the example of a production site located in community A.

Suppose its external diseconomies aVect both citizens in A and those in

other neighboring towns. If town A taxes the producer, it will undoubtedly

base the tax on the marginal damages only to its own citizens. The next

highest government could design a negative conditional matching grant (i.e.,

a tax) levied on town A that would optimally adjust for the broadened scope

of the external diseconomy, but an additional direct tax on the producer

would seem less cumbersome. Other more complex situations, such as the

individualized pollution example in which production at multiple sites along

a river generates external diseconomies for the other Wrms, can best be solved

by producer taxes established by a higher level government and not by a set of

grants-in-aid to a number of localities. There is no compelling reason to

involve lower level governments as intermediaries in correcting for private

sector externalities.

ALTERNATIVE DESIGN CRITERIA

That actual grants-in-aid bear little relationship to theoretical design criteria

is hardly surprising, because the theory is so diYcult to apply in this instance.

In terms of our alternative model, distributional norms based on social

welfare functions can never be more than suggestive to the policymaker.

In terms of imperfect correspondences for externality-generating public

services, varying matching formulas across ``local'' governments on the

basis of marginal external beneWt or harm may be unconstitutional.

Faced with these realities, economists have resorted to developing practical

design criteria that are at least roughly consistent with the underlying

theory.

A surprising feature of the more practical literature is that it has tended

to focus on distributional concerns, more in line with our alternative model of

optimal distribution under federalism than with the mainstream position. A

principal question is how to design grants to correct for perceived resource

imbalances either across states (for federal grants) or across localities (for

state grants). This focus makes sense at a practical level because many federal

and state grants in the United States do attempt to direct aid disproportio-

nately toward poorer states and localities. Examples are the federal grants to

support states' public assistance payments under Temporary Assistance to

Needy Families (TANF) and Medicaid and state grants to support local

public school expenditures.

898 ALTERNATIVE DESIGN CRITERIA

The LeGrand Guidelines

In the mid-1970s, Julian LeGrand suggested three sensible practical guide-

lines for grant-in-aid programs whose goals are redistributional.

2

First, the

grants must be a function of the real income or wealth of the receiving

government, commonly referred to as its Wscal capacity. LeGrand argues

that jurisdictions with Wscal capacities below some target level should receive

aid and jurisdictions above the target should pay a tax (receive a negative

grant). In contrast, existing grant-in-aid programs always give something to

all governments. The political motivations behind giving something to every-

one are clear, but such grants tend by their very nature to have limited

redistributional power. Note, also, that Wscal capacity accounts for diVer-

ences in prices across communities, the relative expenditures required to

achieve comparable levels of public services.

LeGrand's second guideline is that the amount of aid received (tax paid)

should be independent of any expenditure decisions made by the receiving

government. This guideline honors two principles: Redistributional policy

ought properly be concerned with each government's overall initial level of

resources, and, consistent with the federalist ideal, the grantor should not

attempt to inXuence the speciWc spending decisions of lower level govern-

ments.

LeGrand's third guideline states that grants should vary directly with the

receiving government's Wscal eVort, the idea being that governments with less

interest in providing public services should receive correspondingly less aid.

This criterion is somewhat troublesome because it tends to contradict the

second guideline. It implies that the grantor will try to inXuence the overall

level of public services beyond the giving or taking of resources, although not

the composition of these services. In any case, it is a commonly accepted

principle. The U.S. Congress has frequently incorporated eVort parameters

into aid formulas.

3

LeGrand shows that basing grants-in-aid on diVerences in Wscal

capacity automatically incorporates each community's Wscal eVort. To see

this let:

T

i

 total taxes per capita collected by government i.

P

i

 a price index of public services provided by government i.

E

i

 the eVective tax rate in government i, the eVort parameter

Y

i

 the per capita tax base in government i.

2

J. LeGrand, ``Fiscal Equity and Central Government Grants to Local Authorities,''

Economic Journal, September 1975.

3

When Congress replaced Aid to Families with Dependent Children (AFDC) with TANF it

stipulated that the states could not reduce the expenditures on public assistance that they had

been making under AFDC.

31. THE ROLE OF GRANTS-IN-AID IN A FEDERALIST SYSTEM OF GOVERNMENTS 899