A Theoretical Rationale for the Fiscal-Gap Model of Equalization Transfers

This paper develops a formal framework to explain the rationale of the model of the fiscal gap (the difference between a jurisdiction's expenditure needs and fiscal capacity), arguably the most popular model used by countries globally, recommended by applied economists for equalization transfer program design. The framework addresses the problem of accountability and follows a normative approach to derive the conventional fiscal-gap formula and the optimal conditions for its implementation. We conclude that the fiscal-gap model of equalization, which relies only on estimates of expenditure needs and fiscal capacity, is sufficient to efficiently allocate available funds across jurisdictions.