State and Local Government Expenditures

Breakdown of T otal Government SpendingFederal State Local In 1902, the federal government accounted for only 34% of total government spending; local governments accounted for 58%.. OPTI

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

Breakdown of T otal Government Spending

Federal State Local

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

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 grant revenues of local governments

non-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

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 N i residents who all demand G i of the public good.

„ Uniform tax of G i /N i.

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/N i in tax but receives 1/N i less of the public good.

„ Preference aggregation is solved because everyone in

the town wants the same level of public goods, G i.

Problems with the Tiebout Model

„ There are a number of problems with the model, however, related to:

„ Tiebout competition

„ Tiebout financing

„ Spillovers

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 Model

„ Tiebout model is also problematic because of the assumption of no externalities or spillovers:

„ Model assumes public goods only have effects in a given town, and that they do not spill over to

neighboring towns.

„ 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 similar groupings

„ Gramlich and Rubenfeld (1982) found greater

sorting in larger metropolitan areas (where mobility costs would be smaller), and greater satisfaction with public goods provision

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

„ 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.

80% in the four years prior to Proposition 13.

Evidence for capitalization from

area, before and after Proposition 13.

„ The treatment group were the towns with high property tax rates prior to Proposition 13.

„ The control group were the towns with low property 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

„ 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

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

„ 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 in spending?

„ In a perfect Tiebout world, communities would

have formed for the efficient level of public goods, and redistribution would impede that efficiency

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.

A final alternative is a conditional

block grant, a fixed amount of money

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

Redistribution in Action: School Finance

Equalization

„ Since 1970, every state has made at least one

attempt at school finance equalization, some

prompted by state courts, others by the voting public

Redistribution in Action: School Finance

$200 above the lowest district

„ On the other hand, New Jersey gives matching

grants to localities with property values below the

85th percentile

Redistribution in Action: School Finance

Equalization

„ Empirical work suggests that equalization laws have had the intended effect of:

„ Equalizing spending across districts.

„ Equalizing student outcomes like SAT scores.