This paper addresses the welfare effects of conditional grants when there is government failure on the subordinate (hereafter regional) level. Government failure on the regional level may occur due to the influence of regional pressure groups and bureaucrats, poorly informed regional voters, lacking incentives to imitate superior solutions from other regions and ideological preference of regional governments. Regardless of the origin, government failure leads regional authorities to apply inadequate policy solutions in policy fields where they have the autonomy to choose between different solutions. In order to set incentives for the regions to apply (more) adequate solutions, the supra-ordinate government may not use orders. However, conditional grants distributed upon application may be an appropriate means. They initiate a competition for grants in which the regional authorities offer to apply superior policy solutions in order to attract conditional grants. On the other hand, substantial resources are used up for grant-seeking. This paper provides a theoretical model to assess the net effect on welfare. Increasing the share of conditional grants and lowering the share of potential recipients increases both changes in policy solutions and grant-seeking expenditures. We show that there is an optimal grant-distribution scheme that maximizes net welfare. It depends on the preferences of the regional authorities, the number of regions, the regional production function and the total funds available. When regional disparities in output are irrelevant, conditional grants are always efficiency-enhancing. The optimal share of conditional grants is higher the higher the potential gains while concentrating all means to a small number of regions is never optimal because it boosts grant-seeking effort. If interregional disparities matter, the welfare-maximizing share of conditional grants is much lower, in many cases even zero. At the same time, grants are optimally concentrated to a small number of regions. Welfare gains are larger when the central government can limit the social costs of grant-seeking through credible institutional arrangements (e.g. double-blind grant allocation procedures, application fees). In any case, conditional grants should be restricted to situations where a) the potential recipients are free in their choice of policy solutions and policy changes can only be achieved by appropriate incentives and b) the requirements to apply ex post performance based grants are not met.
Bischoff, Ivo (2008), Conditional Grants, Grant-Seeking and Welfare when there is Government Failure on the Subordinate Level, ZEW Discussion Paper No. 08-031, Mannheim. Download