INTERGOVERNMENTAL GRANTS IN THE PRESENCE OF DISTORTIONARY TAXATION AND FOREIGN OWNERSHIP

This article analyzes intergovernmental transfers in a federal setting where lower level governments use distortionary taxation. Transfer po licy is modeled ina federation with two states:foreign ownership of la nd and endogenously determined tar rates. The article concludes that u nder these circumstances, the standard result in the literature requir es modification. Not only will the federal government be unable to ach ieve the national output-maximizing solution through the use of transf er payments, but the prescription for equating net fiscal benefits acr oss states will, in general, not even achieve a second best.