Relying on the private sector: The income distribution and public investments in the poor

a r t i c l e i n f o JEL classification: D78 H42 H75 I24 O15 Keywords: Fiscal federalism Local government expenditures Political economy Education policy Municipalities What drives governments with similar revenues to provide very different amounts of goods with private sector substitutes? Education is a prime example. I use exogenous shocks to Brazilian municipalities' revenue during 1995–2008 generated by non-linearities in federal transfer laws to demonstrate two things. First, municipalities with higher income inequality or higher median income allocate less of a revenue shock to education and are less likely to expand public school enrollment. They are more likely to invest in public infrastructure that is broadly enjoyed, like parks and roads, or to save the shock. Second, I find no evidence that the quality of public education suffers as a result. If anything, unequal and high-income areas are more likely to improve public school inputs and test scores following a revenue shock, given their heavy use of private education. I further provide evidence that an increase in public sector revenue lowers private school enrollment. What drives governments with similar revenues to publicly provide very different amounts of goods with private sector substitutes? Education and health care are prime examples; in almost all countries, the public and the private sectors simultaneously provide versions of each. Because access to them may have profound impacts on growth and poverty, it is important to understand what factors lead governments to provide more of the public version versus relying more on the private version. This is especially so since the poor frequently cannot afford a private version. I show that in areas with higher income inequality or higher median income, governments allocate less of an exogenous revenue shock to goods with private substitutes (specifically , education) and more to goods without private substitutes (like parks and roads), which are more broadly enjoyed. Unequal and high-income areas are also more likely to save a revenue shock, running a budget surplus rather than raising consumption in the short run. Importantly, however, I find no evidence that the quality of public education suffers due to this lower propensity to invest in it. If anything, unequal and high-income areas are more likely to use a revenue shock to improve public school inputs and standardized test scores, since their heavy use of private education ensures that public education resources are spread less thinly. My results …