An empirical study of matching grants: The "cap on CAP"

Funding mechanisms for social expenditures are currently being reformed in many countries. While the theoretical implications of these changes are often easily identified, their empirical magnitude is not always as clear. For example, in federal systems social expenditure is often funded by matching grants, and estimates of the effect of varying matching rates on expenditures by sub-national governments vary widely. The ambiguity is due in part to inherent difficulties identifying price and income effects of federal grants given the structure of the funding mechanisms in most countries. In this paper, we examine a recent reform in Canada, in which federal grants for welfare expenditures were `capped' (converted from an open-ended to a closed-ended matching grant). Importantly, the cap applied to only three of ten provincial governments. Our empirical strategy exploits the time series-cross section variation in the funding mechanism provided by the differential application of the reform. This approach potentially surmounts some of the difficulties which have beset earlier studies. We find that the affected provinces did respond to the reform by reducing the growth rate of expenditures. They were 6 to 8 percentage points lower than predicted in the absence of the cap over the medium term.