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OPTIMAL FISCAL FEDERALISM Two of the major problems in public goods provision are:  Preference revelation: Difficult to design democratic institutions to cause individuals to reveal

Chapter 6 State and Local

Government Expenditures

Public Finance and Public Policy

 Optimal fiscal federalism is the question of

which activities should take place at which

level of government

 For example, welfare programs were

historically financed at the federal and state

level, while education is largely financed at the state and local level

FISCAL FEDERALISM IN THE U.S

AND ABROAD

 Early in the history of the United States, the

federal government played a relatively limited role.

 The last amendment of the Bill of Rights of the United States Constitution states:

“The powers not delegated to the United

States by the Constitution, nor prohibited

by it to the states, are reserved to the

states respectively, or to the people.”

 Figure 1 shows the spending patterns over time.

In 1902, the federal government accounted for only 34% of total government spending; local governments accounted for 58%.

Federal government was responsible

for national defense, foreign relations, judicial functions, and the

postal service.

State and local governments were responsible for education, police, roads, sanitation, welfare, health,

hospitals, and so on.

The role of the federal government grew with the introduction of the federal income tax and the New Deal programs of the Great Depression.

The share of state financing coming

from the federal government has grown because of joint program like cash welfare and Medicaid.

Figure 1

FISCAL FEDERALISM IN THE U.S

AND ABROAD

 The largest element of state and local

spending is education, followed by health care and public safety

 For federal spending, the largest elements are health care, Social Security, and national

defense

Spending and Revenue of State and

Local Governments

 The major source of revenue at the state and

local level is the property tax, the tax on land

and any building on it

 Property taxes raised $253 billion in revenue in

2001, and accounted for almost one-half of the non-grant revenues of local governments

Fiscal Federalism Abroad

 The U.S sub-national governments collect a much larger share of total government

revenue than in other countries, and spend a somewhat larger share of total government spending

 Table 1 shows this

Table 1

Subnational government spending/revenue

as a share of total government

collect 40%.

On the spending side, the differences are slightly less

dramatic.

Fiscal Federalism Abroad

 The higher level of centralization in other

nations exists because state/local

governments have almost no legal power to tax citizens

 Many countries practice fiscal equalization,

whereby the national government distributes grants to sub-national government in an effort

to equalize differences in wealth

Fiscal Federalism Abroad

 There has been a move toward

decentralization around the world

 In the U.S., there have been increased efforts

to shift control and financing of public

programs to the states, such as with welfare reform in 1996

OPTIMAL FISCAL FEDERALISM

 What is the optimal division of responsibilities across different levels of government?

 A theory of how the efficiency of public goods provision may differ at different levels of

government helps answer this questions

OPTIMAL FISCAL FEDERALISM

 Two of the major problems in public goods

provision are:

 Preference revelation: Difficult to design

democratic institutions to cause

individuals to reveal their preferences honestly.

 Preference aggregation: Difficult to

aggregate individual preferences into a social decision.

The Tiebout Model

 Tiebout (1956) showed that the inefficiency in public goods provision came from two missing

factors: shopping and competition.

 Shopping induces efficiency in private

markets

 Competition induces the right prices and

quantities in private markets

The Tiebout Model

 With public goods provided at the local level,

competition naturally arises because individuals

can vote with their feet by moving to another

town without much disruption.

 This induces fiscal discipline for local

governments and creates a new preference

revelation device: mobility.

 Tiebout argued that the threat of exit can

induce efficiency in local public goods

production.

 Under certain (unrealistic) conditions public

goods provision will be fully efficient at the local

level.

The Tiebout Model

 Tiebout’s formal model assumes the following:

 Large number of individuals, who divide themselves up across towns that provide different levels of public goods.

 Town i has Ni residents who all demand

Gi of the public good.

 Uniform tax of Gi/Ni.

The Tiebout Model

 Tiebout’s model solves two problems:

 Preference revelation: There is no

incentive to lie With a uniform tax on

all residents, the consumer saves 1/Ni in

tax but receives 1/Ni less of the public good.

 Preference aggregation is solved

because everyone in the town wants the

same level of public goods, Gi.

Problems with the Tiebout

Problems with the Tiebout

Model

 Tiebout competition may not hold because:

 It requires perfect mobility.

 It requires perfect information on the

benefits individuals receive and the

taxes they pay.

 It requires enough choice of towns so that individuals can find the right levels

of public goods.

Problems with the Tiebout

Model

 Tiebout financing is problematic because:

 It requires lump-sum taxes that are

independent of a person’s income This

is viewed as highly inequitable.

 It is more common for towns to finance public goods through proportional taxes

on homes, leading to the problem of the

poor chasing the rich.

 The use of zoning can ameliorate this

problem.

Problems with the Tiebout

Model

 Zoning regulations protect the tax base of

wealthy towns by pricing lower income

individuals out of the housing market

 For example, a town that prohibits multifamily dwelling such as apartments lowers the

available amount of housing, and thus inflates the value of existing housing, keeping the poor out

Problems with the Tiebout

 Some public goods, like a public park,

probably violate this assumption.

Evidence on the Tiebout Model

 Even given the problems of the Tiebout model the basic intuition that individuals vote with their feet is still a strong one Two types of

tests reveal this:

 Resident similarity

 Capitalization

Evidence on the Tiebout Model

 A clear prediction of the Tiebout model is that residents in a local community will have

similar preferences for local public goods

 The more local communities and choices, the more residents can sort themselves into

Evidence on the Tiebout Model

 Very little actual mobility is required for the

Tiebout mechanism to operate because people not only vote with their feet

 They also vote with their pocketbook

 Tiebout model predicts that any differences in

fiscal attractiveness will be capitalized into

house prices.

Evidence on the Tiebout Model

 That is, the price of any house reflects the

costs (including local property taxes) and

benefits (including local public goods) of living there

 Holding taxes constant, higher levels of public goods raise housing prices

 Hold public good levels constant, raising taxes lowers housing prices

 Housing prices are a reflection of people voting with their pocketbook

Evidence for capitalization from

California’s Proposition 13

 Proposition 13 was a voter initiative passed in

1978 that limited the ability of localities to levy property taxes.

 It limited the tax rate to 1% of a home’s

assessed value

 More importantly, it limited the tax base–the

house’s value The base could increase by only 2% per year, unless the home was sold

 A typical Los Angeles home saw its property tax increase 80% in the four years prior to

Evidence for capitalization from

California’s Proposition 13

 Rosen (1982) studied 60 municipalities in the San Francisco area, before and after Proposition 13.

property tax rates prior to Proposition 13.

tax rates.

 Using this approach, Rosen found that for every $1

of property tax reduction house values increased by about $7, which implies close to full capitalization.

 The fact that house prices rose by almost the

present discounted value of the taxes suggests that Californians did not think that they would lose many valuable public goods and services when taxes fell.

Evidence for capitalization from

California’s Proposition 13

 In reality, many localities were forced to

drastically cut services

 San Jose, California laid off art and music

teachers in elementary schools, cut bus transportation, fired school nurses and guidance counselors, and shortened the school day from 6 to 5 periods

 Even so, in 1983, the school district became

the first American public school system in 40 years to declare bankruptcy

Optimal Fiscal Federalism

 What are the normative implications of the

Tiebout model?

 That is, what should be the principles that

guide the provision of public goods at different levels of government?

 The extent to which public goods should be

provided at the local level is determined by:

 Tax-benefit linkages

 Positive externalities or spillovers

 Economies of scale

Optimal Fiscal Federalism

 First, the model implies that the extent to which

public goods should be provided at the local level is

determined by tax-benefit linkages.

 Strong linkages (such as local roads) means most

residents benefit, and the good should be provided locally.

 Weak linkages (such as welfare payments) means

that most residents do not benefit, and the good

should be provided at a higher level.

 If residents can see directly the benefits they are

buying with their property tax dollars, they will be

willing to pay local taxes Otherwise, they may “vote with their feet.”

Optimal Fiscal Federalism

 The second factor that determines the optimal level of decentralization is the extent of

positive externalities

 If the local public good has spillovers to other communities, they will be underprovided In this case, higher levels of government have a role in promoting the provision of these public goods

Optimal Fiscal Federalism

 The third factor that determines the optimal level of decentralization is the economies of scale in production

 Public goods with large economies of scale,

like national defense, are not efficiently

provided by many competing local

jurisdictions

 Public goods without large economies of scale, like police protection, may be provided more efficiently in Tiebout competition

Optimal Fiscal Federalism

 The Tiebout model therefore predicts that local spending should focus on broad-based

programs with few externalities and relatively low economies of scale

 Examples include road repair, education,

garbage collection, and street cleaning

REDISTRIBUTION ACROSS

COMMUNITIES

 The Tiebout model allows us to consider one of the most important problems in fiscal

federalism: Should there be redistribution of

public funds across communities?

 There is currently enormous inequality in the ability and perhaps desire for communities to finance public goods

 Gaps in per-pupil spending arise because of

differences in the local property tax rate, but more importantly, from differences in property values

Should We Care?

 The question then becomes should higher

levels of government mandate redistribution across lower levels to offset these differences

Should We Care?

 To the extent that Tiebout does not perfectly describe reality, however, there are two

arguments for redistribution

 The first is failures of the Tiebout

mechanism For example, even if one

desires to be in a high benefit

community, a household may be priced out of it by zoning restrictions, etc.

 The second is externalities It is possible

that local public goods, like education,

have spillovers to other communities.

Tools of Redistribution: Grants

 When higher levels of government redistribute,

they do so through grants–cash transfers from

one level of government to another

 Between 1960 and 2003, grants to lower levels

of government grew from 7.6% to 17.9% of

federal spending

Tools of Redistribution: Grants

 Higher levels of government tend to use three types of grants:

 Matching grants–which ties the amount of funds

transferred to the community to the amount of

spending it currently allocates to public goods.

 Block grants–a fixed amount of money with no

mandate on how it is to be spent

 Conditional block grants–a fixed amount of

money with a mandate that it be spent in a

particular way.

 The consequences of these grants are

illustrated in Figure 2 Figure 2.

that can only be spent on education.

Such a grant acts as an income effect, but keeps the price ratio at 1

rather than ½.

Such a grant might mandate that the

city can spend receive up to

As long as the city is already spending more than $375,000 on

education, it is equivalent to a block

grant and has no effect on behavior.

But the block grant also allows other

choices, and utility is higher at IC3, which entails less education.

A one-for-one “matching grant”

changes the price of education and

the price ratio to ½.

The flypaper effect

 As shown in Figure 2 Figure 2, block grants are simply income increases to communities if they are either unconditional or conditional but below the city’s desired spending on the public good

 The city should therefore reduce its own

spending, a type of crowding out, so that

spending on the public good goes up by only a fraction of the total grant amount

The flypaper effect

 Researchers have compared the spending of states that receive larger and smaller grants from the federal government, to assess

whether they largely crowd out state spending,

as the theory predicts

 Surprisingly, after reviewing the evidence Hines and Thaler (1995) found that crowd out

is often close to zero, so total spending rises almost one-for-one

The flypaper effect

 This finding has been described as the

flypaper effect, because “money sticks

where it hits.”

 These older empirical studies suffer from potential bias, however States that value public goods the most may be the most successful at lobbying for federal grants

 Thus, the positive correlation is not because of the flypaper effect, but rather spending preferences differ.

The flypaper effect

 A number of recent studies, that use more

convincing quasi-experimental approaches find evidence that is inconsistent with the flypaper effect

 These studies suggest that the traditional

conclusion of substantial crowd-out from block grants is supported by the evidence

Redistribution in Action: School

Finance Equalization

 School finance equalization laws mandate

redistribution across communities in a state to ensure more equal financing of schools

 Local districts receive about 45% of the

funding from local sources, primarily from local property taxes This dependence can lead to vast disparities due to the wide variation in

property values across towns

 In Texas, for example, per-pupil

spending varies by more than a factor

of four from the lowest to highest

district.