Friday, March 23, 2012

The Flypaper Effect and LGA

Local Government Aid is a touchy subject in Minnesota for a number of reasons. Many oppose it on ideological grounds, decrying the policy as socialist. Others dislike it because it appears to disproportionately benefit big cities. Proponents of LGA tell a story about the cost to property tax payers if LGA were to disappear, as LGA money can be spent for any legal purpose, and can be used therefore to reduce property tax revenues. In a way, these concerns are all interrelated. Before we can make any policy decisions about LGA we must study the effects that lump-sum grants have on the cities that receive them. In this post I will be exploring a specific economic effect of grants: the Flypaper Effect.

Local governments, like individual actors, spend money based on their marginal propensities to spend and save. A marginal propensity to save equal to $0.7 implies that an actor will spend $0.3 of every additional dollar received, and save $0.7 of every dollar (or, in the case of a local government, cut taxes by a proportional amount). Theoretically, the amount spent and saved by a recipient government should not differ based on the source of income. The Flypaper Effect is observed when a grant or other revenue transfer from one level of government to a lower level results in the recipient government increasing spending in a greater proportion than would be caused by an equivalent rise in local income. Essentially, if there are two sources of income, an increase from both sources should have an equivalent effect on spending. What we typically observe, however, is that grants have a more stimulative affect on city expenditures than increases in the median income of that city. The table below is the result of a Minnesota Department of Revenue literature review. It summarizes empirical studies of the Flypaper Effect, and its observed magnitude.Click the image for a larger view.

Where Gz is government spending from grant increases, Gt is government spending out of community income increases, and H is the ratio of Gz/Gt. Column 'FPE' records y where the researcher observed the flypaper effect, and n otherwise.

So what does this mean for the State of Minnesota? A forthcoming study by the Minnesota Department of Revenue indicates that a dollar increase in LGA leads to an expenditure increase of $0.73 by the recipient city. When Governor Dayton said last year that a dollar cut in LGA would lead to a $0.60 increase in property taxes, he might not have been far off the mark. It is not known if the Flypaper Effect works equally on increases and decreases, but trends in research indicate that this question is being taken seriously by professional economists and policymakers.

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