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10
10.1 Fiscal Federalism in the United States and Abroad
10.2 Optimal Fiscal Federalism
10.3 Redistribution Across Communities
10.4 Conclusion
State and Local Government Expenditures
10
Fiscal Federalism: No Child Left Behind Act
In 2002, President Bush signed into law the No Child Left Behind (NCLB) Act.
The goal of NCLB was to address the poor educational opportunities for low income and minority students by requiring standardized testing.
NCLB required schools to publish scores, and penalties were to be imposed on schools that did not show student progress.
10
Fiscal Federalism: No Child Left Behind Act
Intense controversy existed during the first few years between states and the federal government.
Proponents of the Act felt states had ignored educational quality for low income and minority students while opponents felt the states knew best how to address any educational deficiencies in its student population.
In 2015, the House passed a rewrite which reduces the federal role in supervising education. The bill prohibits federal government from mandating or encouraging specific curricula among a host of other revisions.
10
Fiscal Federalism
The United States has a federal system, dividing activity between a national government and state and local governments.
Education, for example, is often provided by state governments.
Optimal fiscal federalism: The question of which activities should take place at which level of government.
10.1
The distribution of government spending has changed dramatically over time in the United States.
1902: Federal government accounted for about 34% of total government spending.
2012: Federal government accounted for about 65% of total government spending.
Local and state spending have declined considerably.
Much state and local spending is now supported by intergovernmental grants.
Intergovernmental grants: Payments from one level of government to another.
Fiscal Federalism in the United States and Abroad
10.1
State and Local Spending in the United States, 1902 2012
10.1
Three primary factors are behind the change in the composition of government spending.
Sixteenth amendment which allowed the federal government to levy income taxes on citizens
New Deal programs of the 1930s in response to the Great Depression
Introduction of social insurance and welfare programs
Fiscal Federalism in the United States and Abroad
10.1
The type of spending by state and local governments differ from that of the U.S. federal government.
State and local governments spend the majority of revenue on education, followed by health care and public safety.
The federal government spends the majority of revenue on health care, social security, and national defense.
Spending and Revenue of State and Local Governments
10.1
State and local governments rely on multiple sources of revenues.
State governments use sales and income taxes primarily.
Local governments use property taxes heavily. They comprise about half of local government revenue.
Property tax: The tax on land and any buildings on it, such as commercial businesses or residential homes.
Spending and Revenue of State and Local Governments
10.1
Spending and Revenue of State and Local Governments
Spending Revenue State $/PC State $/PC
Education spending AK 4,672 Income taxes NY 2,431
MA 2,848 MT 854
TN 1,993 Many 0
Health care spending DC 10,349 Sales taxes DC 1,904
LA 6,759 Iowa 698
UT 5,031 Many 0
Expenditures and revenues vary greatly across states.
10.1
Fiscal Federalism Abroad
Spending (% of all) Revenue (% of all)
Greece 0.0 0.8
Portugal 13.7 5.5
France 20.3 12.1
Norway 33.5 11.9
United States 47.0 36.8
Denmark 63.3 24.7
OECD Average 30.8 27.2
Compared to subnational governments of other nations, U.S. state and local governments account for a relatively large portion of total government activity.
10.1
Fiscal Federalism Abroad
Higher levels of centralization exist in many countries because subnational governments have no power to tax citizens.
Many countries engage in fiscal equalization.
Fiscal equalization: Policies by which the national government distributes grants to subnational governments in an effort to equalize differences in wealth.
In many other countries, the central government redistributes a much larger share of revenues to subnational governments.
10.2
What determines how much and how efficiently local governments provide public goods
The private market provides the optimal amount of private goods.
Why does the market do so well for private goods but not public goods
Tiebout’s insight: shopping and competition are missing from the market for pubic goods.
Optimal Fiscal Federalism: The Tiebout Model
10.2
There is neither shopping nor competition for public goods provided by the federal government.
But, when public goods are provided at the local level, competition arises.
Individuals can “vote with their feet.”
This threat of exit can induce efficiency in local public goods production.
Under certain conditions, public goods provision at the local level will be fully efficient.
The Tiebout Model: Shopping and Competition
10.2
Competition across towns can lead to the optimal provision of public goods.
Towns determine public good levels and tax rates.
People move freely across towns, picking their preferred locality.
People with similar tastes end up together, paying the same amount in taxes and receiving the same public goods.
There is no free riding because everyone pays the same amount in each town.
Optimal Fiscal Federalism: The Formal Model
10.2
The Tiebout model requires a number of assumptions that may not hold in reality.
People are perfectly mobile.
People have full information on taxes and benefits.
People must be able to choose among a range of towns that might match their taste for public goods.
The provision of some public goods requires sufficient scale or size.
There must be enough towns so that individuals can sort themselves into groups with similar preferences for public goods.
Problems with Tiebout Competition
10.2
The Tiebout model requires equal financing of the public good among all residents.
Lump-sum tax: A fixed taxation amount independent of a person’s income, consumption of goods and services, or wealth.
Lump-sum taxes are often infeasible/unfair, so taxes are income or wealth based.
But then the rich pay more than the poor, so the poor chase the rich.
Problems with Tiebout Financing
10.2
To keep poor people from chasing rich people, towns enact zoning.
Zoning: Restrictions that towns place on the use of real estate.
Zoning regulation establishes, for example, minimum lot sizes.
Zoning regulations protect the tax base of wealthy towns by pricing lower-income people out of the housing market.
Problems with Tiebout Financing
10.2
The Tiebout model assumes that public goods have effects only in a given town and that the effects do not spill over to neighboring towns.
Many local public goods have similar externality or spillover features: police, public works, education.
If there are spillovers, then low-tax, low-benefit municipalities can free-ride off of high-tax, high-benefit ones.
Problems with the Tiebout Model:
No Externalities/Spillovers
10.2
Tiebout competition works through sorting.
A testable implication: When people have more choice of local community, the tastes for public goods will be more similar among town residents than when people do not have many choices.
Comparing larger and smaller metropolitan areas (with more and less choice), this seems to be true.
Evidence on the Tiebout Model:
Resident Similarity Across Areas
10.2
People not only vote with their feet, they also vote with their pocketbook, in the form of house prices.
House price capitalization: Incorporation into the price of a house the costs (including local property taxes) and benefits (including local public goods) of living in the house.
Areas with relatively generous public goods (given taxes) should have higher house prices.
Evidence on the Tiebout Model: Capitalization of Fiscal Differences into House Prices
Evidence on the Tiebout Model:
California’s Proposition 13
10.2
California’s Proposition 13 became law in 1978.
Set the maximum amount of any tax on property at 1% of the “full cash value.”
Full cash value: Value as of 1976, with annual increases of 2% at most.
Reduced property taxes immensely in some areas, little change in others.
10.2
Each $1 of property tax reduction increased house values by about $7, about equal to the PDV of a permanent $1 tax cut.
In principle, the fall in property taxes would result in a future reduction in public goods and services, which would lower home values. This occurred in San Jose where the public school system declared bankruptcy.
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. This was the case in areas such as San Francisco.
Evidence on the Tiebout Model:
California’s Proposition 13
10.2
Tiebout model implies that three factors should determine local public good provision:
Tax-benefit linkages: Goods with strong tax-benefit linkages should be provided locally.
Cross-municipality spillovers: If local public goods have large spillover effects on other communities, the goods will be underprovided by any locality.
Economies of scale: Public goods with large economies of scale are not efficiently provided by many competing local jurisdictions.
Optimal Fiscal Federalism
10.2
Tiebout model predicts that local spending should focus on broad-based programs with few externalities and relatively low economies of scale. Local communities should play a limited role in providing public goods that are redistributive, have large spillovers, and have large economies of scale.
If taxes and benefits are linked, and there are no spillovers or economies of scale, then local public good provision is close to optimal.
Optimal Fiscal Federalism
10.3
Enormous inequality in revenue across municipalities:
Carlisle, MA raises $22,472/student while Lakeville, MA raises $13,932.
Should we care about the inequality
If Tiebout is right, then this reflects optimal sorting and financing. If a town has low revenues or low spending, it is because residents chose to provide low level of public goods. This is efficient given their tastes and redistribution should not occur.
Redistribution Across Communities
10.3
Should we care about the inequality
If Tiebout does not perfectly reflect reality, redistribution from high-revenue, high-spending communities to low-revenue, low-spending communities is supported for two reasons:
People may not be able to “vote with their feet.”
Externalities may be present.
Redistribution Across Communities
10.3
The main tool of redistribution is intergovernmental grants—cash transfers from one level of government to another.
Grants are a large and growing share of federal spending and come in multiple forms, with different implications.
Matching grant: A grant, the amount of which is tied to the amount of spending by the local community.
Block grant: A grant of some fixed amount with no mandate on how it is to be spent.
Conditional block grant: A grant of some fixed amount with a mandate that the money be spent in a particular way.
Tools of Redistribution: Grants
Private goods spending (thousands)
Education spending (thousands)
0
Tools of Redistribution: Grants
10.3
$1,000
500
500
$1,000
A
B
X
IC1
Consider a community’s budget constraint AB and spending at point X.
$2,000
Private goods spending (thousands)
Education spending (thousands)
0
$1,000
500
500
1,000
A
B
X
IC1
IC2
Y
750
625
C
Matching Grants
10.3
A matching grant reduces the cost of education by half. The budget constraint pivots from AB to AC and increases spending to point Y. Both income and substitution effects occur.
E
1,375
D
$2,000
Private goods spending (thousands)
Education spending (thousands)
0
1,000
500
500
1,000
A
B
X
IC1
IC3
Y
750
625
C
Z
575
800
$1,375
Income effect
Substitution effect
Block Grant
10.3
A block grant shifts budget constraint from AB to DE and increases spending to point Z. Only income effect occurs.
$2,000
Private goods spending (thousands)
Education spending (thousands)
0
1,000
500
500
1,000
A
B
X
IC1
IC3
Y
750
625
C
Z
E
1,375
575
800
$1,375
D
Income effect
Substitution effect
10.3
F
375
Conditional Block Grant
A conditional block grant shifts budget constraint from AB to AFE and increases spending to point Z. Effect of conditional grant depends on the amount the town would have spent without the condition.
10.3
Implications of Different Grant Types
Different grant types affect incentives in different ways.
Matching grants rotate out the budget constraint, acting like a subsidy.
Help with externalities, since they are targeted.
Block grants shift out the entire budget constraint, raising spending on all goods.
Good for redistribution.
Conditional block grants only differ from block grants if the amount of the grant is greater than the initial educational spending.
10.3
School finance equalization: Laws that mandate redistribution of funds across communities in a state to ensure more equal financing of schools.
Generally, studies conclude that spending equalization has led to an equalization in student outcomes.
Finance equalization schemes differ across states:
California redistributes effectively all revenues.
New Jersey redistributes most revenue from towns with revenue above the 85th percentile.
Redistribution in Action: School Finance Equalization
10.3
Different structures result in different tax prices.
Tax price: For school equalization schemes, the amount of revenue a local district would have to raise in order to gain $1 more of spending.
If half of revenue is redistributed, tax price is $2.
If all revenue is redistributed, tax price is infinite.
Evidence suggests that extreme equalization schemes with very high tax prices may lead to an overall reduction in per-pupil spending.
Redistribution in Action: School Finance Equalization
10.3
Theory implies that conditional grants crowd-out local spending one-for-one. Do they
When examining how states spend grant money, the flypaper effect seems to matter: “The money sticks where it hits.”
However, the positive correlation between grants and spending may be because states that get grants are the ones that like spending the most.
Redistribution in Action: The Flypaper Effect
Redistribution in Action: The Flypaper Effect
10.3
Knight attempted to measure the importance of the flypaper effect.
Looked at how spending changes as states’ congressional delegations gain or lose power.
Each additional $1 of federal grant money increase due to rising congressional power leads to a $0.90 reduction in the state’s own spending.
Additional studies also find evidence inconsistent with the flypaper effect.
10.3
If residents perceived that property taxes were “too high” in California, why did they wait until 1978 to lower them
Proposition 13 was actually a response to school finance equalization in California.
Taxes no longer financed local school spending; just taxes, rather than prices. Tax price became infinite.
Voters were happy to limit property taxes once those taxes no longer brought them any benefit.
APPLICATION: School Finance Equalization and Property Tax Limitations in California
10.4
Central governments collect only part of total tax revenues and spend only part of total public spending.
The United States places a large share of governmental responsibilities on its subnational governments relative to other developed countries.
The Tiebout model suggests that the spending should be done locally when:
Spending is on goods for which local preferences are relatively similar.
Most residents can benefit from those goods.
Conclusion
10.4
Conclusion
Higher levels of government may not believe the conclusions of the idealized Tiebout model.
They will want to redistribute across lower levels of government.
If the higher-level government decides that it wants to redistribute across lower levels, it can do so through several different types of grants.
Appropriate choice of grants depends on goal of government financing.

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