An Implicit Contract Theory of Intergovernmental Grants

A central puzzle in the economic analysis of intergovernmental grants in a federal polity is the conflict between the predictions of the standard theory and empirical observation. Standard theory has no explanation for the widely observed fact that "money sticks where it hits, " that is, for the "'flypaper effect" from specific, non-matching grants. This effect is observed when grants that apparently are the economic equivalents of general revenue grants have the consequences to be expectedfrom matching specific grants. We propose a resolution. Most grants are accompanied by an implicit as well as an explicit contract between grantor and recipient. The purpose of these contracts is to influence the behavior of the recipient, by making the size of the stream of grants conditional upon the recipient's responses to the wishes of the donor.