Intergovernmental Relations

Chapter 17

Benefits of centralized government• Fixed costs of uniform provision of public goods so per

capita costs of public goods vary inversely with population using them

• Minimizes spatial spillovers onto neighboring jurisdictions• No inefficient duplication of services by autonomous

jurisdictions • More equal distribution of public resources

– Education– Public Health– Sanitation

• Interjurisdictional competition means less than efficient quantity of public goods provided

Benefits of decentralized government

• Congestion means club goods have positive marginal cost, fewer economies of scale

• Local public goods are not like clothing: Once size doesn’t fit all.

• Jurisdictions can negotiate among themselves regarding interregional spillovers

• Central governments often funnel revenues from low-income rural areas to help higher-income urban areas

• Interjurisdictional competition forces provision at lowest cost, thus minimizes regional disparities and discourages rent-seekers.

Is Decentralization Efficient?• Theory of fiscal federalism the jurisdiction

most efficiently decides the level of services and the tax rate

• Principle of subsidiarity only the smallest jurisdiction able to finance a public good that lacks spillovers will do so and internalize all externalities.

• The decision-makers whose constituents bear the costs of the services will make more efficient decisions.

• Laffer curve of decentralization? (Duret and Ventelou)

Laffer curve

Coordination

Proximity of decision-makers to constituents

Principal-agent issues in governmental hierarchies

• Local decision makers have two simultaneous roles:– The agent for their constituency

• incentive to not increase taxes and to provide acceptable public goods.

– An agent for higher government levels. • expected to obey the injunctions of the higher

government levels, even if these injunctions are unpopular among the local constituency

Mandates

• Programs required by one level of government but financed by another level.

• Funded mandates: Central government can control local policy by earmarking grants for certain goods (70% of such aid is spent elsewhere)

• Unfunded mandates: Central governments require localities to operate programs but do not provide financing. (Almost impossible to enforce)

Intergovernmental grants

• Traditional public finance theory: criteria of intergovernmental grants: efficiency and equity.

• Grants encourage localities to provide an optimal quantity of goods with spillover benefits.

• Principal-agent issues: – incentive to distort facts concerning local tax capacity – political repercussions regarding their choice of local

tax rates. – Game-playing by competing local governments

affects transfers paid or received

Revenue Sharing

• Funds collected by a higher-level government and distributed to lower levels

• Local government shift the cost of a program to residents of other jurisdictions.

• Inefficient incentives for local governments– Underuse their own tax bases – Artificially inflate their budgets to claim more

revenues.

Fiscal illusion

• Voters/taxpayers have no idea the true cost of a public good– Vertical imbalances

• Higher level government must rescue extravagant local government that cannot pay debts.

– Public good is consumed where MB = MC to locality but costs of public good are subsidized and MC is artificially low.

• Over-provision of public good

Inefficiency due to revenue sharing

Fiscal disparities

• Central government responsibility– Benefits of redistribution spill beyond

jurisdictional boundaries as low-income people relocate

• Optimal intergovernmental redistribution is lump-sum with the following conditions:– Complete transparency,– Absence of any budget constraint, and– Absence of interregional spillovers.

Fiscal equalization

• Goal: horizontal equity– Household incomes unchanged– Suppression of spatial disparities

• Localities cannot change tax rates

• Adverse selection problem– Central government cannot measure the

sincerity of local government’s attempts to collect taxes, fight tax evasion, or appropriately assess property values.

City-Suburb Disparities

• Argument for subsidization of central cities:– The central cities have a high (daytime) population

density and their residents pay for public goods that benefit suburbanites.

– Without extra revenues, cities cannot generally provide an optimal quantity of local public goods (safety).

– Tax rates increase, tax base falls as firms/residents relocate to suburbs

– Solution: interregional transfers between the suburbs and the central city.

City-Suburb Disparities

• Argument against subsidization– The densely populated cities do not need to

be subsidized because they are beyond their optimal level of agglomeration

– Diseconomies of agglomeration increase wages, land rents and population density.

– High population density increases per capita cost of public service provision.

Overlapping tax bases• Vertical fiscal externality: taxes or expenditures

of one level of government affect the budget constraint of another level of government.

• When two levels of government impose taxes on the same tax base, the governments may end up on the downward sloping sector of the Laffer curve.

• Tax bases are common property resources to the public sector. Equivalent to the overexploitation of common fishing grounds, overexploitation can reduce the tax revenues.

Laffer Curve

State rateState + Federal rate

Interjurisdictional Competition

• Spillover (externality) model of spatial interaction among governments– Expenditures on local public services may

produce positive or negative externalities in the neighboring jurisdictions.

– Horizontal fiscal externalities: the effect of one jurisdiction’s taxes on the welfare of people in other jurisdictions.

Interjurisdictional competition

• Race to the bottom: local officials hold down tax rates and adopt lax environmental regulations to attract new businesses (jobs). – Creates distortions by taxing capital at too low

a rate and by under providing public services. – Decline in public services and lower

standards for environmental quality.

Interjurisdictional competition• Tiebout hypothesis (1956) maintains that tax competition

is efficient when individual households can move costlessly among jurisdictions. – Reduces the taxing power of a local government thereby

promotes welfare. The amount of local taxes paid and local goods consumed will be exactly what each resident wanted.

• Public choice theory of a utility maximizing manager – Government: perfectly price discriminating monopoly that usurps

the entire amount of consumer surplus. – Managers derive utility from status, so bureaucracy tends to

produce a quantity of public goods that is larger than the socially optimum level.

Mimicry and yardstick competition

• Mimicry: Spatial expenditures and tax rates are correlated over space because of – fiscal shocks common to entire region.– Interjurisdictional tax competition– Yardstick competition

• Yardstick competition: residents use the performance of another jurisdiction as a yardstick to evaluate their own, so politicians adopt policies similar to those of their neighbors.