Regional Heterogeneity of Preferences and Intergovernmental Transfers

Abstract

We develop a model with optimal shares of inter-governmental transfers, and we apply a simulation analysis of our model for the case of Mexico. The main outcomes of this paper are: first, we provide exact estimates of optimal shares of intergovernmental funds to be allocated in each state considering the regional distribution of benefits of local public spending in Mexico. Second, our estimates show that the regional heterogeneity of preferences across regions should be an important determinant of federal funds allocated to state governments. Third, the current system of finance relies on a tax revenue sharing accord that emphasizes nationwide tax collection issues as main determinants of intergovernmental transfers and local spending. Our analysis provides a contrast between how fiscal policy is conducted and feasible choices of policy reform. Fourth, our analysis of simulation provides estimates of winners and losers from policy reform, hence our analysis contributes to a better understanding of advantages and shortcomings of the current policy of intergovernmental transfers and provide feasible ways to improve outcomes of sub national government spending.