The Income Effect of Unconditional Grants: A Reduction in the Collection Effort of Municipalities

This paper presents research on the effect of unconditional grants on local government revenue in Chile: the receipt of transfers may engender an income effect that reduces the collection effort of municipalities. Grants are endogenous and we exploit a kink in a component of the Chilean formula for resource distribution for a panel of 340 Chilean municipalities from 1990 to 2007. We find empirical evidence that for Chilean municipalities, unconditional grants have a negative effect on local revenue. Specifically, an increase in per capita grant amount of one standard deviation is associated with a decrease of between 0.25 and 0.32 standard deviations in local per capita revenue.