International Review of Law and Economics 26 (2006) 33–41

Interjurisdictional competition and the allocationof constitutional rights: A research note

Klaus Heine ∗

Freie Universitat Berlin, Fachbereich Wirtschaftswissenschaft, Institut fur Management,Garystr. 21, 14195 Berlin, Germany

Abstract

The advantages or disadvantages of interjurisdictional competition are a hotly discussed topic ininstitutional economics. While the academic discussion is often concerned with the properties of aninstitutional meta-frame to avoid a “race to the bottom” of taxes and regulatory standards, in thiscommentary a closer look is given to the “inner” constitution of jurisdictions that face interjurisdic-tional competition. With the help of club-theory and the new property rights theory of the firm it isargued that residual constitutional rights should be allocated to immobile individuals. An allocation ofconstitutional rights that makes a difference between mobile and immobile individuals helps to avoidcertain problems of interjurisdictional competition that have yet to be solved from the perspective ofan institutional meta-framework. Some new ideas on the deregulation of politics fit into the proposedlogic.© 2006 Elsevier Inc. All rights reserved.

JEL classification: K 10; K 11

Keywords: Interjurisdictional competition; Constitutional economics; Residual rights of control; Factor mobility

1. The constitutional logic of interjurisdictional competition

The advantages or disadvantages of interjurisdictional competition are a hotly discussedtopic in economics, especially in institutional economics. The advocates of the positiveeffects of interjurisdictional competition claim that it will enhance incentives for institu-

∗ Tel.: +49 30 838 52151; fax: +49 30 838 54559.E-mail address: kheine@wiwiss.fu-berlin.de.

0144-8188/$ – see front matter © 2006 Elsevier Inc. All rights reserved.doi:10.1016/j.irle.2006.05.002

34 K. Heine / International Review of Law and Economics 26 (2006) 33–41

tional innovations (institutional evolution), politicians will be set under pressure to serve forthe citizens’ preferences, and the cost/price-ratio for public goods and regulations wouldbecome more efficient (Siebert & Koop, 1990; Van den Bergh, 2000; Vihanto, 1992). On theother hand, supporters of the negative effects of interjurisdictional competition assert by andlarge that in the area of public goods and regulations it is not possible to introduce compe-tition on the level of jurisdictions. This type of competition must fail, and the consequencewill be an underprovision of public goods and safe standards of regulations (Sinn, 1994,1997, 2004). The crucial point in this controversy seems to be the institutional meta-framethat serves as a competitive-order (Heine & Kerber, 2002; Stephan, 2000; Vanberg, 2000).Such a competitive-order may be seen as the institutional framework that provides the rulesof the game under which a healthy interjurisdictional competition can take place. Surely, itis not yet obvious what the appropriate meta-rules might be, but it seems intuitively clear tosearch for such meta-rules. However, the real problem with the proposed competitive-orderis its implementation. That is, to have a properly working competitive-order it is indispens-able that this order is enforced, but up to now there is no clear idea in which way a centralagency may serve as such a central monitor.

To be sure, in the real world there are federations like the United States, Switzerland and,in some respect, the European Union that have overcome the problem of implementing acompetitive-order, which is a guidepost to the jurisdictions’ relations. Such federal relationscan take various forms, which more or less lead to interjurisdictional competition; e.g. theGerman federalism relies more on cooperation than on competition between jurisdictions.On the other hand, the federalism of the United States is more competitive. So, we may thinkof “federal islands” that have overcome the problem of implementing a competitive-order.However, as these federations are in competition with other jurisdictions the problem ofa competitive-order arises anew. For example, the interjurisdictional competition betweenthe United States, the European Union, China and Japan lacks an explicit competitive-order. Perhaps there may spontaneously evolve a self enforcing order like the medievalLex Mercatoria (Law Merchant) but that is also a controversially discussed topic (for anoverview see Benson, 1998).1

Because of the problems to design and to implement a supranational competitive-orderwe will try to get another perspective on the subject: We will focus on the internal consti-tutional properties of a jurisdiction that faces interjurisdictional competition. This paradig-matic switch of the constitutional perspective may be useful to overcome the intellectuallydeadlocked discussion of the proponents and opponents of interjurisdictional competition.To reach this goal we will use some basic insights of constitutional economics on the onehand and on the other, we will employ the new property rights theory of the firm with itsapproach of residual rights of control. By doing so this paper deals with two questionswhich may be sorted to two different levels of constitutional thinking. The first question is:who is the legitimate body to decide on a constitutional design? The second question is:which constitutional design is the appropriate one that should be implemented by a juris-diction of prudent inhabitants? To solve these questions the approach of residual rights ofcontrol is employed to sketch out how the immobile can delegate authority to politicians inan efficient manner.

1 For the possibility of a spontaneous ordering of fiscal federalism see Aoki (2001, pp. 165 and 220).

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2. Of clubs and firms

As a starting point, it is possible to interpret jurisdictions as clubs (Buchanan, 1965).The jurisdictional club provides public goods and regulations to its members who have topay taxes and fees for their membership. As a jurisdiction’s members, we can identify itscitizens, but beside these physical persons we can also identify legal entities like corporationsas virtual persons. The introduction of the latter category of membership results from the factthat in the case of more than one jurisdiction it simply cannot be assumed that a corporation,which has its principal seat of business in one jurisdiction, is held by citizens of the samejurisdiction. Often a corporation will be held by citizens of other jurisdictions. In order togive these outside citizens a representation legal entities like corporations also have to beseen as club members. Moreover, to interpret corporations as club members gives weight tothe fact that jurisdictions give services not only to human beings but also to organisationsthat have legal capacity.

The club analogy makes clear that we do not have to deal with pure public goods butinstead impure public goods, because it is possible to exclude someone from a club’s ser-vices. Nevertheless, if it is possible to control access to a club’s services there is on the onehand the need to have rules that are guiding the access to the club and on the other hand theneed to have rules with which the rules of access may be changed. This two-stage settingof rulemaking is the typical setting of constitutional economics in which it is distinguishedbetween a constitutional level and a post-constitutional level. For that reason, it is no acci-dent that club-theory highlights the question of a jurisdiction’s constitution (Boudreaux &Holcombe, 1989). Additionally, from the perspective of interjurisdictional competition itis important that there is no single jurisdiction, but at least two competing jurisdictions.Therefore a jurisdiction’s constitution will need rules, which govern the relationship toother jurisdictions.

Besides the idea to interpret jurisdictions as clubs it is possible to interpret jurisdictionsin analogy to firms (Auster & Silver, 1979; Holmstrom, 1999; Marris, 1972), since firmsand jurisdictions must solve similar coordination problems. Like firms, jurisdictions mustset up a governance system that determines the rights and duties of its members as well asto decide how the jurisdictional surplus should be distributed among its stakeholders. Thereare several theoretical approaches to describe the problems a firm has to solve (Vanberg,1994). However, as mentioned earlier it seems to us that the new property rights theory of thefirm has the most valuable insight to our topic. In this approach the contractual nature of thefirm is stressed but because contracts remain more or less incomplete a firm’s performancedepends crucially on the allocation of property rights that give command over a firm’sphysical assets if contracts are silent (Hart, 1989, 1998). In other words, the new propertyrights theory of the firm asks what role do residual rights of control play. For example,imagine a contract between an automobile manufacturer and a supplier of car bodies; in thecontract a certain number of car bodies may be fixed. Now, the demand for automobiles mayrise and the manufacturer wants to increase the supply of car bodies. If this circumstance isnot outlined in the initial contract the supplier has the residual right to control the outcomeof a renegotiation of the initial contract, because he has the right to refuse a modificationof supply (Hart, 1993). From a normative point of view it is obvious that the allocation ofproperty rights (residual rights of control) should direct the agents actions efficiently, e.g.

36 K. Heine / International Review of Law and Economics 26 (2006) 33–41

agents should be motivated to invest in their human capital to make a maximum use of afirm’s physical assets.

The reasoning on the appropriate rules of a jurisdiction’s inner constitution from theperspective of the new property rights theory leads to the question: which agents should beentitled to decide on a jurisdiction’s constitutional rules, if jurisdictions face interjurisdic-tional competition? Or in broad terms: what difference does interjurisdictional competitionmake to the constitutional question of jurisdictions? As we shall see, this question is verysimilar to: who should pilot a firm through the gale of competition?

3. Who should pilot a jurisdiction?

To answer this question, initially one can employ the famous Tiebout-model (Tiebout,1956). In this model individuals “vote with their feet”, they choose the jurisdiction that bestfits to their preferences. In this model a permanent sorting of individuals to the appropriatejurisdictions ensures a pareto-optimal matching between the preferences of the individualsand the jurisdictional supply of public goods. Because individuals can always switch tothe jurisdiction that offers the most appropriate public good–tax bundle in regard to theindividual’s preferences, elections to adapt public good–tax bundles are futile. Or in termsof Hirschman (1970), the Tiebout-model relies only on the exit-mechanism but not on thevoice-mechanism.

The crucial thing in the Tiebout-model is that individuals are highly mobile and thatthere are no costs for mobility. From a constitutional economics point of view this leads to asituation in which individuals do not need the help of a protective state, because individualscan always easily switch to another jurisdiction. Their freedom is guaranteed by mobilityand therefore they must not face a hold-up problem, e.g. it is not possible that a jurisdictionraises its taxes over the promised rate, because in such a case individuals will immediatelyrelocate to another jurisdiction (Boudreaux & Holcombe, 1989).

One can draw the conclusion that protection by a constitution (protective state) is onlyrelevant for immobile individuals, because they have no exit-option. Going a step furtherit is reasonable to believe that immobile individuals have a strong incentive to bargain(voice-mechanism) for an efficient constitution, while mobile individuals do not. On thecontrary, mobile individuals may try to use the right to set up constitutions for their owninterests at the cost of immobile individuals, e.g. they may try to get side payments by thehelp of blackmailing. But what are mobile individuals looking for, if they do not need thehelp of a protective state? The answer is they only want a jurisdiction’s services on thepostconstitutional level, that is, they are interested mainly in the productive state. So wehave to distinguish between individuals with different constitutional interests: immobileindividuals have constitutional interest on the level of the protective state as well as on thelevel of the productive state, while mobile individuals have constitutional interest only on thelevel of the productive state. Furthermore, we may hypothesise that it is welfare enhancingif only the immobile get the right to participate in decisions concerning the protective state.

Of course, to say that the set up of constitutional rules on the level of the protective stateis an exclusive task for the immobile individuals is not to say that mobile individuals willalways have no need for constitutional protection. They need constitutional protection, too, if

K. Heine / International Review of Law and Economics 26 (2006) 33–41 37

they become temporarily immobile, e.g. building up a facility and having sunk investments.Therefore, a decisive factor for the attraction of mobile individuals and their capital is thegranting of reliable constitutional rights that secure these investments.

One may ask now where the difference lies between immobile and mobile individuals,if the latter also obtain constitutional rights on the level of the protective state. To clarifythis point we can gain insight from the new property rights theory of the firm, because adifference can be made if the residual right to change the constitution and to fill gaps of the(incomplete) contract between mobile and immobile individuals is exclusively allocatedto the immobile. That is, constitutional rights on the level of the protective state may begranted to mobile individuals by contract but they do not have the power to participatein the constitutional processes that generate the constitution or alter the constitution. Thisallocation of constitutional rights will allow the mobile to take part in votings, if the immobiledecide to grant this right to the mobile, but the mobile are not entitled to enlarge the scopeof their voting rights, which is exclusively for the immobile. The mobile can only indirectlyaffect the constitution by leaving the jurisdiction after amortisation of their investments,which serves as a signal that the granted constitutional rights are not appropriate.2 Hart(1989, p. 1766) explains this approach in a nutshell: “In a world of transaction costs andincomplete contracts, ex post residual rights of control will be important because, throughtheir influence on asset usage, they will affect ex post bargaining power and the division ofex post surplus in a relationship. This division in turn will affect the incentives of actors toinvest in that relationship.”

To be certain, the mobility of individuals and of capital is a matter of degree. In realitythere is obviously a continuum between complete mobility and immobility. So, if we makea clear difference between mobility and immobility we are idealising the situation. But indoing so it becomes much clearer in which way the allocation of constitutional rights affectthe behaviour of agents that face interjurisdictional competition. Also, to say that only theimmobile individuals have the residual right to alter the constitution is not to say that themobile individuals have no constitutional rights; they may have voting rights on certain top-ics, too. The crucial point is that mobile individuals do not have the competenz–competenzto alter the constitution and to enlarge the domain of their voting rights.

But although the immobile individuals are the holders of the residual rights of con-trol, it would be too costly for them to exercise these rights permanently. Due to this factit makes sense to delegate some of the political and constitutional tasks to a specializedand high-skilled jurisdictional management. From our point of view this management hasnot necessarily to be formed of politicians that are simultaneously citizens of the jurisdic-tion. It would also be possible to hire constitutional specialists from other jurisdictions,like managers in ordinary firms. This implication is very similar to the idea of deregulat-ing politics and creating an international market for politicians, in order to enhance theefficient allocation of politicians (Eichenberger, 2001; Eichenberger & Frey, 2002). Thisviewpoint on efficient management of jurisdictions makes clear that an effective jurisdic-tional management is not tied to the condition that one of the owners becomes part of the

2 The idea of different constitutional rights in dependence on the mobility of individuals is not so far from realityas it might seem at first glance. In most countries immigrants get full political rights only if they have stayed fora longer time in the host country.

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jurisdictional management, but that there are efficient governance structures to monitorpoliticians.

In order to illustrate the rationale for the delegation of constitutional powers a bit morewe can give an example (Hart, 2001). Although this example is very simple it will show thatthe allocation of jurisdictional ownership rights matters for the performance of a jurisdictionthat faces interjurisdictional competition.

To start with, imagine individuals, who have considerable sunk investments, which aretying these individuals to one jurisdiction. These immobile individuals have to be seen asjurisdictional owners. The owners of the jurisdiction are interested in hiring a jurisdictionalmanagement (political entrepreneur) that is capable to develop the jurisdiction. In orderto reach this goal jurisdictional owners and political entrepreneurs are interested in theattraction of mobile individuals, which will bring taxable human and financial capital to thejurisdiction.

Assume a political entrepreneur, who has developed a jurisdictional project that attractsmobile individuals and capital. The attraction of individuals and capital will yield a flow oftaxes $T but also a flow of private benefits $B to the political entrepreneur. Private benefitsB may be non-pecuniary but for simplicity we consider them to be cash equivalent. Theowners of the jurisdiction are mainly interested in the flow of taxes that the project willyield, while the jurisdictional entrepreneurs are interested in both the flow of taxes and theprivate benefits. What are the private benefits that may the political entrepreneurs accrue?The first benefit is the enhancement of reputation that the entrepreneur will gain if thejurisdictional project succeeds. In the future a successful political entrepreneur may get ahigher salary for his services. Other private benefits may be the personal psychic satisfactionfrom the success of the project or the possibility of patronage, e.g. the entrepreneur maygive friends access to the project’s cash flow and in turn these friends may give benefitsto the political entrepreneur. A special characteristic of private benefits is that they canonly be enjoyed by the political entrepreneur but not by the investors. A potential conflictbetween jurisdictional investors and political entrepreneurs derives from this asymmetry,because the political entrepreneur’s decisions depend on the tax flow as well as on the privatebenefits, while investors are interested in decisions that depend only on the maximisation ofadditional tax flow. So we end up with two different maximisation problems. First, considerthe political entrepreneur who gets a fraction Θ of the project’s tax flow. If we assume thatthe project starts in t0, when all decisions are made, and ends in t1, when all benefits arereceived, he will try to maximise his benefits from his fraction Θ of tax flows and his privatebenefits. The political entrepreneur’s maximisation problem is, therefore, Max ΘT + B. Onthe other hand the investors’ maximisation problem is Max(1 − Θ)T, which is equivalent toMax T. From a social planner’s point of view, who is interested in the maximisation of thesocial surplus the maximisation problem is Max T + B.

We can now ask which allocation of decision rights may drive a jurisdiction towards thedirection of the (fictive) social planner’s decision. Suppose for simplicity that the only deci-sion to be made at t1 is to determine whether a jurisdictional project should be terminatedor continued. If it is continued the entrepreneur’s private benefit is $100, but terminationwould save $200 of jurisdictional resources. The entrepreneur’s share in the tax flow maybe given with Θ = 0.1. From a social planner’s view the jurisdictional project should be ter-minated, because the jurisdiction’s loss of $200 exceeds the political entrepreneur’s private

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benefit of $100. It is obvious that the social planner’s decision will only be implemented ifthe residual right to control the project is with the jurisdictional owners.

Although this short example does not encompass all possibilities of jurisdictional man-agement it seems reasonable to give residual rights of constitutional control to the immobileindividuals, because most situations will be characterised by high stakes for jurisdictionalowners (“billions of tax-Dollars”) and a relatively small salary to political entrepreneurs(“millions of tax-Dollars”), which means that Θ is small. On the other hand private ben-efits for political entrepreneurs may be large enough to give political entrepreneurs falseincentives for political decisions in regard to the social planner’s optimum.

An example of governance-designs in which people can exercise their residual rights ofcontrol is direct democracy. That means if jurisdictional managers or politicians are actingagainst the will of the jurisdiction’s owners the owners can use their residual right to stoplegislation or to implement the constitutional rules they want. While direct democracy canserve as an instrument to stop the actions of politicians or to bring certain topics on thepolitical agenda there are also instruments which give politicians incentives to make greatefforts to act in accordance with the holders of the residual rights of control. This secondway to control politicians is especially favourable if a direct monitoring is relatively costly(Milgrom & Roberts, 1992, p. 187). In this regard a further idea might be the introductionof a sort of option-plan for hired politicians. If politicians reach their promised goals orif they, e.g. are able to reduce the cost for the provision of public goods, they will get apremium to their salary.3

4. Final remarks

It is widely accepted that there is a rationale for the creation of a so-called protective state,which enables a community of individuals to mutually receive gains from trade (Buchanan,1975). But is that the whole story on the formation of jurisdictions? From our point of viewthere is a more complex story that tells us of immobility, mobility and entrepreneurial politi-cians. In the latter story the allocation of jurisdictional ownership rights matters. Althoughthis story is not new, because it was invented by John Locke in his famous Second Trea-tise some hundred years ago (1690), it is nevertheless modern; especially in the context ofinterjurisdictional competition, when there is no supranational competitive-order available.

By all means, our approach raises a lot of questions. The most striking is how to determinewhen an individual is to be seen as mobile or immobile, when mobility is obviously amatter of degree. However, a prerequisite for immobility appears to be when an individualhas considerable sunk investments, which tie the individual to a jurisdiction. So one has todecide when sunk cost are high enough to characterise an individual as immobile. Althoughthis is not an easy question, there may exist proxies to deal with this problem. A first idea

3 To pay politicians for their performance certainly raises a lot of questions, e.g.: Will politicians hide informa-tion? Will they tend to disinvest in projects that may be crucial for the future growth options of a jurisdiction, butwhich are not important for the measurement of performance of a politician? This sort of managerial problems haveto be overcome by appropriate incentive schemes for politicians (for an overview see, e.g. Milgrom & Roberts,1992, p. 388).

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is to make a link between jurisdictional ownership and the possession of real estate. Sincereal estate cannot exit jurisdiction, one can argue that possession of real estate might bea qualification for immobility. Secondly, human capital that is bound to specific capitalmay also cause immobility of individuals and hence, qualify individuals as jurisdictionalowners. At last, capital that has been specifically invested for a long term may also qualifythe investors as jurisdictional owners.

Another question is how to allocate residual rights if exit-options are enlarged or mobilityincreases. For example, what happens if the rule of origin is consequently implemented andone can freely choose between product standards without leaving one’s jurisdiction? In caseof an enlargement of exit-options it may be reasonable to check the allocation of residualrights, and if necessary to reduce the number of jurisdictional holders of residual rights ofcontrol or to diminish the domain in which individuals can execute their residual rights ofcontrol.

Besides all these questions, which may arise, the analysis contributes to the debate ofinterjurisdictional competition in two ways: The first is to introduce some thoughts from thenew theory of the firm to constitutional economics, or as Holmstrom (1999, p. 76) has put it:“There is an obvious analogy between my vision of the firm as a regulator of trade and therole that a government plays in determining tax and other rules for an economy.” The otheris that a viable interjurisdictional competition needs some kind of competitive-order on themeta-level, but that is not the whole constitutional problem that has to be solved. There isalso an intrajurisdictional governance problem if interjurisdictional competition takes place.The latter problem has been addressed by making a difference between individuals that aremobile and individuals that are not. Although to make this difference is quite common, e.g.in the literature on international tax competition, we have proposed that the constitutionalinterests of these two groups differ a lot. Given that constitutional interests vary betweenthe two groups it is reasonable to allocate residual rights of control only to the immobile, inorder to generate competitive constitutions that serve the immobile as well as the mobile.This allocation of constitutional rights seems to be an interesting point as long as an effectivemeta-framework for a workable interjurisdictional competition is not available.

Acknowledgements

I would like to thank Reiner Eichenberger, Viktor Vanberg and two anonymous refereesfor very helpful comments.

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