Propensity to Invest and the Additionality of Capital Transfers: A Country Panel Perspective

This paper takes stock of the last 80 years of theoretical and policy literature on the issue of capital grants. In addition, we provide empirical evidence on changes in the relative importance of capital grants, and their impact on fiscal outcomes for a large number of countries. In particular, our empirical analysis explores two claims often used to justify capital grants in practice: 1) Due to political economy reasons, local governments tend to underinvest relative to the level desired by the national government. We test this claim by comparing the propensity to invest of subnational vis-à-vis national governments. 2) The administrative and efficiency costs of earmarking grants for capital use are justified by their effect of inducing additional investments by subnational governments. We test this claim by comparing the propensity to invest of local governments out of capital grants compared to their propensity to invest out of general purpose (non-earmarked) grants and own resources.