The Incentive Effect of Equalization Grants on Tax Collection

Equalization grants that are inversely related to collected revenue increase the marginal cost of collecting because they tax the collection itself. The main finding is evidence for Chilean municipalities that equalization grants have this incentive effect on local revenue. In order to identify this effect, we exploit that today's collected revenue could affect grants received 2, 3, or 4 years later, as determined by the equalization grant's distribution formula. This formula has undergone changes in the 1990-2006 period. We find a negative relationship between the equalization grant's implicit tax and collected local revenue, and this effect is greater when the period of time between collection and the corresponding distribution of grants is shorter and when the political coalition to which the incumbent mayor belongs has a high likelihood of winning the next election and therefore paying this implicit tax in the coming years.