The Impact of Intergovernmental Grants on Cost Efficiency: Theory and Evidence from German Municipalities

In this paper we use a simple bureaucracy model of fiscal illusion to analyze the impact of intergovernmental grants on cost efficiency of local jurisdictions. We find that a higher degree of redistribution within a system of fiscal equalization or an increase in the amount of grants received by a local jurisdiction leads to an extension of organizational slack or X-inefficiency in that jurisdiction. This theoretical prediction is tested by carrying out an empirical analysis using a broad panel of German municipalities. The results of the empirical analysis are consistent with the theoretical findings and therefore support the existence of a negative incentive effect of intergovernmental grants on local authorities’ cost efficiency.