Association for Public Policy Analysis & Management

We marry the literature on distribution of federal grants and financial management of subnational governments in this paper. Grant dependency of subnational governments on federal government can lead to their engagement in less prudent financial management practices. Given the information asymmetry between grantor and grantee governments, this unintended consequence can result from both moral hazard and adverse selection problems. Specifically, if a grantee government routinely receives fiscal transfer from other levels of government, it may choose less prudent financial management. On the other hand, if a grantee government chooses less prudent financial management, it is more likely to be hit harder by fiscal shocks and thus receive more grants. In both cases, we shall observe a negative correlation between grant dependency and prudence of financial management of grantee government.

Since fiscal capacity, economic conditions, and demand for public services faced by grantee governments, among others, affect both grant dependency and financial management practices, we employ an instrumental variable approach to deal with the endogeneity problem. The federal political and institutional factors such as party, ideology, and political representation in congressional committees are widely recognized to affect the distribution of federal grants. Under the assumption that these factors will not affect the financial management of grantee governments other than via the distribution of federal grants, we use them as instrumental variables.

We measure grant dependency by federal grant as a percentage of own source revenue of grantee governments. The prudence of financial management is measured by 1) the use of financial slack in the form of unreserved fund balance and 2) the annual surplus (deficits). As a first step, we use a sample of cities and counties in the U.S.  between 1989 and 2013 to test our hypothesis. We will match the data on distribution of federal grants to cities and counties from the Catalogue of Federal Domestic Assistance with the data on unreserved fund balances and annual surplus from their Comprehensive Annual Financial Reports from the Financial Indicators Database by the Government Finance Officers Association.

The findings would contribute to our understanding of both intergovernmental fiscal relations and public financial management. By moving beyond expenditure changes and program evaluation of subnational governments in response to federal grants, this study may draw attention of academics and practitioners to the managerial implications of intergovernmental grant dependency.