Intergovernmental transfers and fiscal effort in Peruvian local governments

The purpose of this paper is to identify the causal relationship between intergovernmental transfers and fiscal effort. Empirical evidence from Peruvian municipalities supports a negative relation. The substitution effect is decreasing on the level of municipalities’ expenditure and tends to disappear for high-expenditure localities. Given this phenomenon, devolving responsibilities to sub-national governments might reduce fiscal effort and deteriorate fiscal balance especially among localities with lower fiscal capacity. A possible solution might be the inclusion of fiscal effort indicators in the intergovernmental transfer design.