August 22, 2008

Do Federal Matching Funds Inhibit State Growth?

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To obtain Federal Matching Funds (FMFs), state governments must increase their own expenditures. Most frequently, the additional expenditures are consumption expenditures, which have a well documented negative effect on growth (Barro 1991.) To test the hypothesis that FMFs might be harmful to state economic growth, we propose two forecast models to estimate the effect of FMFs on the growth rate of the state’s GDP per capita for the state of Texas. The first model looks at the immediate impact of increased FMF expenditures and the second looks at long-term effects. We also hypothesize that increases in FMFs have a negative effect on local tax revenues. To test this effect on the state’s budget, we develop a third model that relates the Matching Funds’ growth rate to the first difference of growth rates in real tax revenues. We used the results of the three different models to evaluate whether or not the state should try to maximize FMFs.

Employing data for the state of Texas from 1963 through 2006, we conclude that increases in FMFs lead to lower state economic growth. We also conclude that FMFs have both an immediate and a long-term impact, which suggests that a policy of maximizing FMFs is detrimental to longer-run growth. Finally, we find that increases in FMFs are associated with decreases in real local tax revenues.