RAISING TAXES THROUGH EQUALIZATION

A simple theory suggests that a common form of federal horizontal equalization grants shouldcause subnational governments to levy higher tax rates, distorting local tax bases and soincreasing federal transfers. To test this, I examine Canadian provincial tax policies in the1972-2002 period. Consistent with the theory, provinces respond to expansions ofequalization transfers by increasing their own tax rates. I estimate that on average tax rates ingrant-receiving provinces were substantially and significantly higher as a consequence of thetransfer formula.