The role of federal funding on the demand for state and local government spending

Federal aid to state and local governments lowers the perceived tax price of state and local government output and, in this way, affects the demand for state and local government. After reviewing some theoretical models, an empirical investigation using data from 1960–89 shows that federal aid makes the demand for state and local government spending more income-elastic. State and local government expenditures have grown more rapidly than federal government expenditures since 1960 and there is some empirical support for the idea that federal aid was an important contributing factor.