IMPACT OF GRANTS ON TAX EFFORT OF LOCAL GOVERNMENT

Abstract

This paper examines the impact of State-local grants on tax effort of rural local governments (panchayats) for Kerala state. The results from data for 1993-94 show, after controlling for tax capacity, a greater and more uniform negative impact on own tax revenue of lumpsum "untied " grants that are predictable and unvarying than in the case of a more widely defined grants total including components with year-to-year variability. An increase in the untied grant to panchayats by one rupee reduces own tax revenue in twelve out of fourteen districts by more than one rupee, and in eight of these by more than two rupees. The reduction in own tax revenue has to have been the result of a selective slackening of tax effort since refunds of panchayat-level taxes in proportion to incidence are ruled out. The post-grant pattern of incidence will therefore be less transparent than the nominal pattern, less preserving of voter preferences, and possibly driven by corruption towards greater regressivity. Given also the balanced budget constraint on panchayats, there is a corollary contradiction of the flypaper effect found in other contexts. The two districts for which the general result does not hold are also the most ethnically fragmented. This result has implications dissimilar to those in the received literature on the fiscal effects of ethnic fragmentation.