Finance and Economics Discussion Series: The Flypaper Effect Unstuck: Evidence on Endogenous Grants From the Federal Highway Aid Program

Contrary to simple theoretical predictions, previous empirical research has found that state government public spending is increased far more, often dollar-for-dollar, by federal grant receipts than by equivalent increases in constituent private income. This anomaly has come to be known as the flypaper effect. First, a legislative bargaining model developed in this paper provides a critique of this empirical finding. The model demonstrates a positive correlation between constituent preferences for public goods and intergovernmental grant receipts, and this correlation has likely biased the existing literature towards finding a flypaper effect. The model also motivates using measures of the political power of state congressional delegations as an instrument for grant receipts. Second, after correcting for the endogeneity of grant receipts, the results demonstrate that constituent private income and grants have similar effects on public spending.