public finance and public policy jonathan gruber third edition copyright © 2010 worth publishers 1...

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 30

State and Local Government Expenditures

10.1 Fiscal Federalism in the United States and Abroad

10.2 Optimal Fiscal Federalism

10.3 Redistribution across Communities

10.4 Conclusion


C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S

optimal fiscal federalism The question of which activities should take place at which level of government.



10.1

Spending and Revenue of State and Local Governments

Fiscal Federalism in the United States and Abroad



10.1

Fiscal Federalism Abroad

fiscal equalization Policies by which the national government distributes grants to subnational governments in an effort to equalize differences in wealth.


TABLE 10-2



5

Types of Taxation18 . 1




10.1

FIGURE 10-1



10.1

Spending and Revenue of State and Local Governments

property tax The tax on land and any buildings on it, such as commercial businesses or residential homes.


intergovernmental grants Payments from one level of government to another.



8

The Property Tax

In 2006, $320 billion collected in property taxes, almost all at the local level.

Plays key role in local public finance.

In many western states with public lands, feds make payment in lieu of taxes

Many non-profits also make payments in lieu of taxes



9



10

The Property Tax

Table 20.2 shows that effective tax rates on residential property vary widely.



11

Property tax and local governments

87,500 local governments in 2002 CensusSpecial districts increasing

“reserved powers” clause of 10th amendment to US ConstitutionStates can permit anything not excluded by FedsLocal governments are creatures of State govt.

Diversity of local government related to history, settlement patterns and state legislatures



12

Local government trends

Local government structure continues to evolveDe-volution or de-centralization trendsNumber and scope of local governmentsStyle of state legislaturePolitical culture of the state.

Local government will continue to be importantLocal government revenue will be neededProperty tax will continue to be important



13

History of property taxes

American system of local property taxes originates with British traditions

Importance linked to growth of frontier

Feasible source of revenue Equal taxation of wealthOverlapping and special districts had revenue sources

Colonial era had several taxesExcise and tariffs

Post revolutionary war saw a uniformity clause added to property taxation



14

Property taxes

Property taxes applied to real estate and personal property

Individuals paid for government services in proportion to their wealth



15

Evolution of the property tax system

In agricultural economy, wealth mostly tied to land and buildings

In modern commercial society, wealth in many other forms (stocks, bonds, investments,

Local assessors often played favorites with property valuations

Auditor, treasurer are separate elected offices

Wages and earnings as new form of wealth

Increased demands for revenues for services



16

Property tax history

Post WW2 saw dramatic changes in growth and demand for services

Assessments and revenues grew

Local programs and services also grew



17

California Tax Revolt

Proposition 13Froze assessments at 1975 levies (until next

transaction)Ceiling on the property tax rate any locality could

imposeForbade localities raising property taxes without a

2/3 majority

State stepped in with more revenue sharing



18

Why property taxes are controversial in US and IowaProperty tax is highly visible

Perceived as regressive

May be more accessible for changing

Iowa has uneven effective rates across classes of property



19



20

Iowa property tax system

Tax on real property in 5 classesResidentialAgricultural CommercialIndustrialUtilities



21



22

Property taxes

Properties are assessed every two yearsEach county has an assessor, towns over 10,000 may have

their ownHow do they assess?

Based on market valuationRecent sales, comparable properties

Assessments summed for each class of propertyState Dept. of Revenue equalizes among jurisdictions



23

Assessment process

Budgets are establishedTax rates are establishedCredits subtracted

Homestead, disabled, farmstead, veteransRollbacks appliedLevy and consolidated levyRoles of assessor, auditor, treasurerOpportunities for appeal



24

Property taxes: Rollbacks

—30 years ago high inflation led to limitations on valuation increases-residential and ag land received limitation formulaAg land assessed on productivityStatewide valuations limited to 4% for these 2 classesRollback from assessed valuations gives taxable

valuation.Residential rollback at 44.08% currently



25



26



27



28

Property tax reform proposal

Steady growth of rollback percentage means property tax bill shifting to commercial and industrial classes

Businesses want tax relief

HF2771 proposes to limit increases to commercial and industrial by linking increases across classes

Begin rollback on commercial property



29



30



31



32

Assessment of Iowa Taxes

Very average in terms of per capita and per income basis

State and local taxes declining on a per income basis

Slight increase on a percapita basis

Percapita spending also very average



34

Redistribution Across Communities10 . 3

There is currently enormous inequality in both the ability of local communities to finance public goods and the extent to which they do so.

Should We Care?

It depends on the extent to which the Tiebout model describes reality.

Tools of Redistribution: Grants

If higher levels of government decide to redistribute across lower levels of government, they do so through intergovernmental grants.



35

Intergovernmental Grants

Federal grants important source of revenue to states and localities.

Grants from federal and state government are about 34% of total local general revenues.



36



37

Table 1. State and Local Government Finances by Level of Government and by State: 2003-04

(Dollar amounts are in thousands. Coefficients of variation (CV) are expressed as percents. For meaning

of abbreviations and symbols, see note below table.)

Description

Iowa

State & local State & local State Local Local

government government government government government

amount1 CV amount amount1 CV

1 2 3 4 5

Population (July 2004, in thousands) 2,953 (X) 2,953 2,953 (X)

Revenue1 22,544,565 0.17 15,363,015 10,639,521 0.43

General revenue1 18,396,343 0.20 11,916,703 9,937,611 0.45

Intergovernmental revenue1 4,304,225 0.16 4,038,220 3,723,976 0.86

From Federal Government 4,304,225 0.16 3,911,906 392,319 1.78

From State government1 (1) 0.00 0 3,331,657 0.93

From local governments1 (1) 0.00 126,314 (1) 0.00

General revenue from own sources 14,092,118 0.25 7,878,483 6,213,635 0.56

Taxes 9,018,748 0.34 5,214,602 3,804,146 0.81

Property 3,188,869 0.44 0 3,188,869 0.44



38



39

Roles of Intergovernmental Grants

Correct for externalities (services or tax costs cross boundaries

Redistribution of resources among regions

Substituting one tax structure for another

Macroeconomic stabilizing tool (fiscal policy)



40

Economic effects of grants

Income effectsIncreasing the resources available for local services

Price effectsReducing marginal costs of providing the service



41


Essentially two types of grants: conditional and unconditional.

Conditional grantsAlso known as categorical grants.Donor specifies the purposes for which the

recipient may use the money.Usually earmarked

Several types of conditional grants:Matching grantMatching closed-ended grantNonmatching grant



42


Conditional grantsMatching grant

For every dollar given by the donor to support a particular activity, a certain sum must be expended by the recipient.

Changes relative price of the public good, G.Figure 22.4 illustrates the potential effects.



Figure 22.4



44


Conditional grantsMatching closed-ended grant

For every dollar given by the donor to support a particular activity, a certain sum must be expended by the recipient. Donor specifies ceiling, that is, a maximum contribution.

Changes relative price of the public good, G, on part of the budget constraint. Budget constraint is non-linear.

Figure 22.5 illustrates the potential effects.



Figure 22.5



46


Conditional grantsNonmatching grant

Donor gives fixed sum of money with the stipulation that it is spent on public good.

Does not change the relative price of the public good, G. Budget constraint is nonlinear.

Figure 22.6 illustrates the potential effects.



Figure 22.6



48


Unconditional grants (Block grant)Sometimes referred to as revenue sharing.

Money is unrestricted.Similar to budget constraint in Figure 22.6, except

that the budget line is now JM rather than AHM.



10.2

Optimal Fiscal Federalism

The Tiebout Model

What is it about the private market that guarantees optimal provision of private goods that is missing in the case of public goods?

Tiebout’s insight was that the factors missing from the market for public goods were shopping and competition.

The situation is different when public goods are provided at the local level by cities and towns. Competition will naturally arise because individuals can vote with their feet: if they don’t like the level of public goods provision in one town, they can move to the next town.

This threat of exit can induce efficiency in local public goods production.



10.2


The Tiebout Model

The Format Model

The main message of the model is that competition across local jurisdictions places competitive pressures on the provision of local public goods.



10.2


Problems with the Tiebout Model

Problems with Tiebout Competition

The Tiebout model requires a number of assumptions that may not hold in reality:

Individuals must not only want to vote with their feet, they must be able to actually carry out that vote.

Individuals have perfect information on the benefits they receive from the town and the taxes they pay.

Individuals must be able to freely choose among a range of towns that might match my 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.



10.2



Problems with Tiebout Financing

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.



10.2



Problems with Tiebout Financing

Towns typically finance their public goods instead through a property tax. The problem that property taxation causes is that the poor chase the rich.

zoning Restrictions that towns place on the use of real estate.

Zoning regulations protect the tax base of wealthy towns by pricing lower-income people out of the housing market.



10.2



No Externalities/Spillovers

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.



10.2


Evidence on the Tiebout Model

Resident Similarity across Areas

A testable implication of the Tiebout model is that 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.



10.2

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.


Evidence on the Tiebout Model

Capitalization of Fiscal Differences into House Prices

People not only vote with their feet, they also vote with their pocketbook, in the form of house prices.



10.2

EVIDENCE FOR CAPITALIZATION FROM CALIFORNIA’S PROPOSITION 13


California’s Proposition 13 became law in 1978. Proposition 13 mandated that the maximum amount of any tax on property could not exceed 1% of the “full cash value” of the property. The full cash value was defined as the value as of 1976, with annual increases of 2% at most.

Each $1 of property tax reduction increased house values by about $7.

Full capitalization of lower property taxes into house prices would imply that house prices should rise by the present discounted value of reduced future tax payments.

In principle, the fall in property taxes would result in a future reduction in public goods and services, which would lower home values.

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.

M P I R I C A L E V I D E N C E

E



10.2



tax-benefit linkages The relationship between the taxes people pay and the government goods and services they get in return.



10.3

Redistribution across Communities

Should We Care?

There is currently enormous inequality in both the ability of local communities to finance public goods and the extent to which they do so.

It depends on the extent to which the Tiebout model describes reality.


If higher levels of government decide to redistribute across lower levels of government, they do so through intergovernmental grants.



10.3



FIGURE 10-2



10.3

Matching Grants



matching grant A grant, the amount of which is tied to the amount of spending by the local community.



10.3

Matching Grants



FIGURE 10-3



10.3

Block Grant



block grant A grant of some fixed amount with no mandate on how it is to be spent.



10.3

Block Grant



FIGURE 10-4



10.3

Conditional Block Grant



conditional block grant A grant of some fixed amount with a mandate that the money be spent in a particular way.



10.3

Conditional Block Grant



FIGURE 10-5



10.3


Redistribution in Action: School Finance Equalization

school finance equalization Laws that mandate redistribution of funds across communities in a state to ensure more equal financing of schools.



10.3


M P I R I C A L E V I D E N C E

E

THE FLYPAPER EFFECT

Hines and Thaler found that the crowd-out of state spending by federal spending is low and often close to zero. Economist Arthur Okun described this as the flypaper effect because “the money sticks where it hits” instead of replacing state spending.

As Knight noted, states that get grants are the ones that like spending the most. He also noted that highway grants from the federal government to states are determined by the strength of the state’s political representatives.

Knight compared the level of spending in treatment states that see increases in the power of their congressional delegations with the level of spending in control states that see decreases in the power of their congressional delegations.

He found that 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, suggesting that the traditional conclusion of substantial crowd-out from block grants is supported by the evidence.



10.3

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.


The Structure of Equalization Schemes

School finance equalization schemes can take very different forms. Some states have systems that attempt to completely or nearly completely equalize spending across school districts.

The Effects of Equalization

Redistribution in Action: School Finance Equalization



10.3


School Finance Equalization and Property Tax Limitations in California

APPLICATION

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 a court case that led to school finance equalization in California. The key feature of this decision was that it broke the link between local property taxes and spending on schools.

Taxes were no longer a price: they were just taxes. As a result, it was natural for communities to vote to lower taxes, since they did not perceive any benefit from them anymore.

Wealthy voters would have opposed Proposition 13 in the absence of the school finance equalization because their high taxes were paying for schooling they desired for their town without subsidizing anyone else’s schooling. Thus, these wealthy taxpayers were happy to approve Proposition 13.



10.4

Conclusion

In every country, the central government collects only part of the total national tax revenues and does only part of the national public spending.

When spending is on goods for which local preferences are relatively similar, and where most residents can benefit from those goods, the Tiebout model suggests that the spending should be done locally.

When spending is for goods that benefit only a minority of the population, the Tiebout model suggests that it might be difficult to do this spending locally because the majority of people who do not benefit will “vote with their feet” and move elsewhere.

Higher levels of government may not believe the conclusions of the idealized Tiebout model, in which case 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.

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