When a biased index of tax effort instils regional inequity in the local financing system: findings from a DEA on rural municipalities of Spain

In the academic literature on intergovernmental transfers and equalization grants, one relevant topic is the possible disincentivizing effect of these mechanisms on the tax efforts of subnational governments. To prevent this moral hazard, distribution schemes for vertical transfers are often based on fiscal capacity instead of actual revenues. Moreover, some schemes include tax effort as a criterion for distribution; this is the case in Spain as regards the central government’s scheme for general transfers to municipalities, which employs a municipal tax effort indicator calculated by the Ministry of Finance. To assess the potential biases of this indicator vis-à-vis rural municipalities, we construct an alternative measure of tax effort through data envelopment analysis (DEA). Our research bundles both relative homogeneity and notable size into the sample, bearing in mind outlier identification and testing the existence of constant versus variable returns of scale. Analysis of the average regional results shows that the Ministry’s indicator tends to overestimate the municipal tax effort in regions with high per capita income, such as the Balearic Islands, Catalonia, and Madrid. At the same time, it underestimates the tax effort in relatively poor regions. By taking as differences in tax effort what are in fact differences in tax effort and capacity, the Ministry’s indicator shows greater disparity in tax efforts between regions than is actually the case. Significant policy implications may be drawn from these findings.