DP8133 | Interregional Redistribution and Regional Disparities: How Equalization Does (Not) Work

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Do inter-governmental transfers such as equalization grants reduce interregional disparities? This paper studies both theoretically and empirically the impact of interregional redistribution on interregional inequality. We set up a model with residential choice and equalization grants between regions, and show that interregional transfer payments prevent convergence promoting migration. We test our model in using cross-country data and panel data for 22 highly developed OECD countries. The evidence suggests a positive relationship between interregional transfers and regional disparities both across countries and over time from 1982 to 2000. In the cross-section data, we find that countries with higher levels of interregional redistribution in the past show a subsequent increase in interregional disparity, while countries with lower levels of grants and transfers show less divergence or even convergence. The panel reveals a similar picture: countries who have increased their sub-governmental transfers and grants have experienced more divergence (less convergence) over time than countries who have lowered their transfers.