How do local governments decide on public policy in fiscal federalism? Tax vs. expenditure optimization

Previous literature widely assumes that taxes are optimized in local public finance while expenditures adjust residually. This paper endogenizes the choice of the optimization variable. In particular, it analyzes how federal policy toward local governments' influences the way local governments decide on public policy. Unlike the usual presumption, the paper shows that local governments may choose to optimize over expenditures. The result holds when federal policy subsidizes local taxation. The results offer a new perspective of the efficiency implications of federal policy toward local governments and, thereby, enable a more precise characterization of local government behavior in fiscal federalism.

► Previous literature usually assumes that taxes are optimized in local public finance.
► The paper analyzes how federal policy influences local government behavior.
► It shows that local governments may choose to optimize over expenditures.
► The result holds when federal transfer policy subsidizes local taxation.