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Economic theory predicts that unconditional intergovernmental grant
income and private income are perfectly fungible. Despite this
prediction, the literature on fiscal federalism documents that
grant and private income are empirically non-equivalent. A large
scale school finance reform in New Hampshire--the typical school
district experienced a 200 percent increase in grant
income--provides an unusually compelling test of the equivalence
prediction. Most theoretical explanations for non-equivalence focus
on mechanisms which produce public good provision levels which
differ from the decisive voter's preferences. New Hampshire
determines local public goods provision via a form of direct
democracy--a setting which rules out these explanations. In
contrast to the general support in the literature for
non-equivalence, the empirical estimates in this paper suggest that
approximately 92 cents per grant dollar are spent on tax reduction.
These results not only document that equivalence holds in a setting
with a strong presumption that public good provision decisions
reflect the preferences of voters, but also directly confirm the
prediction of the seminal work of Bradford and Oates (1971) that
lump-sum grant income is equivalent to a tax reduction. In
addition, the paper presents theoretical arguments that grant
income capitalization and heterogeneity in the marginal propensity
to spend on public goods may generate spurious rejections of the
equivalence prediction. The heterogeneity argument is confirmed
empirically. Specifically, the results indicate that lower income
communities spend more of the grant income on education than
wealthier communities, a finding interpreted as revealing that the
Engel curve for education is concave.
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