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Chapter 10: State and Local Public Finance
10 - 1
Chapter 10
State and Local Public Finance
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 10: State and Local Public Finance
10 - 2
Optimal Federalism when household incomes are similar
Optimal Federalism when household incomes differ
The property tax
Grants from a higher government to lower governments
Introduction
Chapter 10: State and Local Public Finance
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State and Local Public Finance
Figure 10.1
State/local revenues (% of total revenue)
Source: Bureau of Economic Analysis NIPA tables: Table 3.16.
Federal Grants, 11%
Property Tax, 21%
Federal Grants, 20%
Other, 21%
Income Tax, 15%
2006
Chapter 10: State and Local Public Finance
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State and Local Public Finance
Figure 10.1
State/local spending (% of total spending)
Source: Bureau of Economic Analysis NIPA tables: Table 3.16.
Social Services,
9%
Public Order and Safety, 10%
Social Services,
7%
Chapter 10: State and Local Public Finance
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• The assignment of some government spending programs and taxes to federal, state, and local governments
Federalism
Optimal Federalism• The assignment of spending and taxes that best promotes the well being of the citizenry
State and Local Public Finance
How do we determine optimal federalism?
Chapter 10: State and Local Public Finance
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• Satisfies the preferences of residents
• Local governments compete to attract and retain citizens by offering varying packages of goods.
This competitive process:
• Promotes the efficient provision of public services
Optimal Federalism when Household Incomes are Similar
• Promotes innovation and experimentation by local governments
The Tiebout process creates capitalization.
The Tiebout Process
Chapter 10: State and Local Public Finance
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• Local governments may levy taxes that do not – or at least appear not to – burden local residents.
Tax exporting
• Race to the bottom
The Tiebout Process
• To attract firms and jobs, business taxes may be cut below other local governments
Tax competition
Chapter 10: State and Local Public Finance
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Competition among local governments would not produce optimal outcomes in two cases:
• Second, when there are economies of scale
State Government for Local Externalities or Scale Economies
• First, when there are externalities
State government can improve outcomes through intervening in two ways:
• Second, by giving a categorical matching grant to local governments
• First, by providing the service itself
Chapter 10: State and Local Public Finance
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Residential location when incomes differ: the separation process
• The non-affluent try to follow
Optimal Federalism when Household Incomes Differ
• The affluent try to move away from the non-affluent
The Tiebout process and the separation process operate simultaneously.
• The affluent use zoning laws to maintain their separation
Chapter 10: State and Local Public Finance
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Should a city government try to tax suburbanites?
• Source-based taxation
Optimal Federalism when Household Incomes Differ
• City governments can tax suburbanites, but should they?
Should a city tax economic activity that occurs in the city?
• A progressive tax may be counter-productiveShould a city set a high tax rate on affluent residents?
• Residence-based taxation
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State redistribution to cities that benefits high-income suburbanites
• Agglomeration economies
The Role of State Government when People Separate by Income
• Suburbanites benefit from the city
State redistribution that benefits low-income city residents
• Adopt policies that promote efficiency then compensate those who lose with redistribution
A strategy: efficiency plus redistribution
• City residents benefit from tax revenue transferred to the city
Chapter 10: State and Local Public Finance
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…is the most important source of revenue for local governments.
The Property Tax
• Each property has an assessed value, and the property owner pays a flat percentage of the assessed value.
The mechanics of the property tax
• Property value growth compared to income growth
The distribution of a residential property tax across households
• The combination of assessed value and tax rate matters to property owners.
• Life cycle
Chapter 10: State and Local Public Finance
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Who Bears the Burden of the Residential Property Tax?
• A property tax shifts the demand curve down
• The burden is split between the builders and owners and the home buyers
D’
$210,000
The traditional approach
P
D
S
Homes
$250,000
Figure 10.2A
$50,000
Chapter 10: State and Local Public Finance
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D’
$240,000
• The burden of the tax depends on relative elasticities
• Property taxes are partially capitalized into the price of the home
Who Bears the Burden of the Residential Property Tax?
P
D
S
Homes
Figure 10.2B
$250,000
The traditional approach
$50,000
Chapter 10: State and Local Public Finance
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• The property owner benefits from the public services that the tax finances• Benefits from the property taxes are partially capitalized into the price of the home
Who Bears the Burden of the Residential Property Tax?
The benefit approach
The capital approach• A property tax is a tax on wealth accumulation
Economists agree that there is merit to all three approaches!
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Do Renters Bear a Burden from the Property Tax?
$1,050
S’• A property tax would shift the supply curve up
• The burden is split between the owners and the renters
P
D
S
Apartments
Figure 10.3A
$1,000
The traditional approach
$200
Chapter 10: State and Local Public Finance
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Do Renters Bear a Burden from the Property Tax?
$1,150 $200
• The burden of the tax depends on relative elasticities
P
D
S
Apartments
Figure 10.3B
$1,000
The traditional approach
S’
• The benefit approach would predict that the D curve would shift up
Chapter 10: State and Local Public Finance
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• Land has property value • The supply of land is inelastic
The Burden of a Property Tax on Land
• The burden of the tax depends upon the elasticity of demand
• Consumers, workers, and business owners bear the burden of a property tax on business firms
The Burden of a Property Tax on Business Firms
Chapter 10: State and Local Public Finance
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• Burden on retirees
The Property Tax
• Does not discourage economic activity• Generates predictable revenue
Arguments for the residential property tax
Criticisms of the residential property tax• Paid only once or twice a year, cash-flow problem
• Easy to administer• Benefits vary directly with the value of the property• Property value reflects ability-to-pay• Unique tax helps residents keep track
• Based on a rough estimate of the property’s value
Chapter 10: State and Local Public Finance
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Grants from a Higher Government to Lower Governments
Three main rationales for grants from higher to lower governments:
Purpose of grants
• the existence of a positive externality• achieving a goal of the higher government• redistribution
• Open-ended categorical matching grant Different grants for different purposes
• Unconditional block grant• Closed-ended categorical matching grant• Incremental matching grant
Chapter 10: State and Local Public Finance
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Optimal Federalism when household incomes are similar
Optimal Federalism when household incomes differ
The property tax
Grants from a higher government to lower governments
Summary
Chapter 10: State and Local Public Finance
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What schools do
Elementary and secondary education
Higher education
Preview of Chapter 11:
Education
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