Intergovernmental Relations

1. Intergovernmental Relations Chapter 17 1

2. 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 2

3. 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. 3

4. 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) 4

5. Laffer curve Coordination Proximity of decision-makers to constituents 5

6. 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 6

7. 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) 7

8. 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 8

9. 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. 9

10. 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 10

11. Inefficiency due to revenue sharing 11

12. 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. 12

13. 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. 13

14. 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. 14

15. 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. 15

16. 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. 16

17. Laffer Curve State rate State + Federal rate 17

18. 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. 18

19. 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. 19

20. 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 choicetheory 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. 20

21. 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. 21