Equalizing aid can be used by the federal government to equalize fiscal outcomes or resources among subnational governments, or by states to equalize outcomes or resources among local governments. Although equalizing aid can sometimes be justified in part on efficiency grounds, we focus on its primary function, namely, to achieve equity objectives. The equity objective of a donor government can take many forms. The central theme of this paper is that the appropriate design for an equalizing aid program depends on the form of this objective.

Intergovernmental aid is not, of course, the only tool higher-level governments can use to assist poor or troubled lowerlevel governments. State governments, for example, can achieve equity objectives by altering the fiscal arrangements within which local governments operate. A state could take over from local governments the financing of certain services, such as social services, that place large burdens on a few jurisdictions, or, to counter fiscal disparities in education financing, a state could encourage the merger of school districts. Hence, intergovernmental aid should be viewed as only one tool, and not always the best tool, to achieve fiscal equity.

We place equity objectives into two classes: categorical equity, which relates to public sector spending, either on specific functions or on all functions, and distributional equity, which is aimed at equalizing the real incomes of local residents. In the following discussion, we focus on state aid to local governments.