Fiscal Equalization and Yardstick Competition

Abstract: A model of yardstick competition is presented where relative performance evaluation on the part of voters reduces the incentives for incumbents to divert resources away from public good provision to personal gain. Into this model, a horizontal inter-governmental transfer scheme is introduced where equalization entitlements depend on a noisy assessment of fiscal capacities. By reducing the informational content of the com-parison across jurisdictions, this system tilts the incumbent politician’s trade-off between current rents and the probability of winning the elections towards more rent diversion. Based on this effect, it is shown that the amount of rents taken in a symmetric Nash equilibrium increases in the intensity of the equalization system