The Effects of an Inter-Regional Transfer with Empire-Building Regional Governments

This paper is concerned primarily with the economic and welfare consequences of federal redistributive grants to regional governments. We use a model that has two regions, each with households, firms, and a regional government as well as a federal government. The households, firms, and regional governments are all optimizers - households maximize utility, firms maximize profits, and we assume that regional governments are empire-builders in that they choose their expenditure and tax levels so as to maximize total expenditure - the size of their empire. Labor is free to move between regions in response to utility differences and does so until such differences have been eliminated. Interregional migration and federal government redistribution are the main sources of interconnectedness between the two regions. The model is linearized in log-differences and simulated using Australian state-level data. We find that the welfare effects of intergovernmental transfers are trivial but that all other variables of interest change substantially - consumption, employment, taxes, wages, output, and government expenditure. The welfare effects of a federal transfer are little influenced by the choice of empire-building rather than beneficent regional governments, but the influence on other variables is substantial.