# 1. **Introduction**

A wide literature documents the importance of and the challenges involved in increasing government revenues in developing countries (for example, see Besley and Persson 2014). The way in which revenues are spent— programmatically, as well as by whom and where—is the other part. During the 1980s and 1990s, countries around the world moved toward transferring earmarked resources to subnational governments with the objective of providing public services locally, including health care, education, and social infrastructure, such as water and sanitation services or support for urbanization (Habibi et al. 2003; Jiménez-Rubio 2011; Litvack, ‐ Ahmad, and Bird 1998; Martinez-Vazquez, Lago Peñas, and Sacchi 2015; Musgrave 1983; Oates 1972; Ostrom et al. 1993; Wallis and Oates 1988). The success of decentralization has been associated with various factors. These include the design and implementation of reforms, the incentives facing local and national stakeholders, local accountability and responsiveness, the budgetary process, and the availability of adequate local capacity (Ahmad et al. 2005; Loayza, Rigolini, and Calvo-González 2014; Martinez-Vazquez and Vaillancourt 2011; Robinson 2007).

The empirical evidence on the effects of decentralization on poverty and inequality is mixed. Some studies suggest that the informational gains of decentralization can have a positive impact on pro-poor spending and targeting (Alderman 2002; Bardhan and Mookherjee 2005; Galasso and Ravallion 2005), while others show that, by enhancing access to basic services, decentralization can contribute to poverty reduction (Caldeira, Foucault, and Rota-Graziosi 2016). Decentralization may not lead to poverty eradication in locations where there is substantial corruption, limited local checks and balances, a lack of political commitment and policy coherence, and insufficient capacity (Steiner 2005). In poor countries with weak institutions, such as postconflict countries, decentralization may worsen poverty (Jütting et al. 2004). The effects on the poor have also been tied to the sequencing and pace of fiscal, administrative, and political decentralization (von Braun and Grote 2009). Some studies find that decentralization has an equalizing impact (Sepúlveda and MartinezVazquez 2011; Tselios et al. 2012), while others show the opposite (Sacchi and Salotti 2014).

This paper aims to contribute to the literature by identifying the causal effects of a fiscal transfer fund on social welfare. To explore the distributional effects of fiscal federalism, the paper examines the case of a large earmarked social infrastructure fund in Mexico, the Social Infrastructure Transfer Fund ( _Fondo de Aportaciones para la Infraestructura Social,_ FAIS), equivalent to 2.53 percent of “assignable federal tax revenues” ( _Recaudación Federal Participable)_ .<sup>1</sup> Estimating the effects on poverty and inequality of earmarked funds is relevant in numerous developing economies, including those in which a large share of the funding of subnational governments is generated by the taxation of national resources. This paper exploits a novel dataset of 20 years of municipal poverty maps by combining the dataset with local public finance variables. The dataset also includes information from the population and establishment censuses to proxy local economic activity. The results are important for identifying who benefits within municipalities and which part of the distribution is affected and for differentiating effects between urban and rural areas, as well as in terms of the monetary and nonmonetary components of welfare.

> 1 These “assignable federal tax revenues” correspond to taxes collected from federal income tax, value added tax, and ordinary taxes and fees from oil extraction and production. In practice, with the exception of extraordinary fees from oil and other extraordinary fiscal revenues by the federal government, most of the federal taxes are subject to sharing with subnational governments through earmarked and unconditional fiscal transfers.

2