Public Finance and Public Policy Jonathan

CopyrightGruber
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 State and Local
Government Expenditures 10
10.1 Fiscal Federalism in the United States and Abroad
10.2 Optimal Fiscal Federalism
10.3 Redistribution across Communities
10.4 Conclusion

PREPARED BY

Dan Sacks

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10
Fiscal Federalism

• The United States has a federal system, dividing activity

between a national government and state and local
governments.
• Education, for example, is often provided by state
governments.
• Optimal fiscal federalism: The question of which
activities should take place at which level of
government.

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10.1
Fiscal Federalism in the United States and Abroad

• The distribution of government spending has changed

dramatically over time in the United States.
• Local state and spending have declined considerably.
• Much state and local spending now supported by
intergovernmental grants.
o Intergovernmental grants: Payments from one
level of government to another.

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10.1
State and Local Spending in the United States,
1902−2010

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10.1
Spending and Revenue of State and Local
Governments

State and local governments rely on multiple sources of

revenues.
• State governments use sales and income taxes
primarily.
• Local governments use property taxes heavily.
o Property tax: The tax on land and any buildings on
it, such as commercial businesses or residential
homes.

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10.1
Spending and Revenue of State and Local
Governments

Spending Revenue
State $/PC State $/PC
Education AK 3,010 Income NY 2,311
spending MA 2,643 taxes MT 854
TN 1,50 Many 0
Health care DC 10,349 Sales DC 1,847
spending taxes
LA 6,759 Iowa 698
UT 5,031 Many 0

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10.1
Fiscal Federalism Abroad

Spending Revenue • Many countries engage

(% of all) (% of all) in fiscal equalization.
Greece 0.0 0.8 • Fiscal equalization:
Portugal 13.7 5.5 Policies by which the
France 20.3 12.1 national government
Norway 33.5 11.9 distributes grants to
subnational
United 50.0 35.7 governments in an
States
effort to equalize
Denmark 63.3 24.7 differences in wealth.
OECD 24.8 26.5
Average

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10.2
The Tiebout Model

What determines how much and how efficiently public

goods local governments provide?
• The market provides the optimal amount of private
goods.
• Why does the market do so well for private goods but
not public goods?
• Tiebout’s insight: shopping and competition.

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10.2
The Tiebout Model: Shopping and Competition

• There is neither shopping nor competition for national

government.
• But when public goods are provided at the local level
by cities and towns, competition arises
o Individuals can vote with their feet.
• This threat of exit can induce efficiency in local public
goods production.

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10.2
The Formal Model

Competition across towns can lead to the optimal

provision of public goods.
• Towns determine public good levels and tax rates.
• People move freely across towns, picking their
preferred locality.
• People with similar tastes end up together, paying the
same amount in taxes and receiving the same public
goods.
• There is no free riding because everyone pays the
same amount in each town.

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10.2
Problems with Tiebout Competition

The Tiebout model requires a number of assumptions

that may not hold in reality:
• People are actually be able to move.
• People have full information on taxes and benefits.
• People must be able to 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.

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10.2
Problems with Tiebout Competition: 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.
• Lump sum taxes are often infeasible/unfair, so taxes
are income or wealth based.
• But then the rich pay more than the poor, so the poor
chase the rich.

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10.2
Problems with Tiebout Competition: Financing

To keep poor people from chasing rich people, towns

enact zoning.
• Zoning: Restrictions that towns place on the use of
real estate.
• Zoning regulation establishes, for example, minimum
lot sizes.
• Zoning regulations protect the tax base of wealthy
towns by pricing lower-income people out of the
housing market.

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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.
• If there are spillovers, then low-tax, low-benefit
municipalities can free-ride off of high-tax, high-
benefit ones.

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10.2
Resident Similarity Across Areas

• Tiebout competition works through sorting.

• A testable implication: 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.
• Comparing larger and smaller metropolitan areas (with
more and less choice), this seems to be true.

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10.2
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.
• 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.
• Areas with relatively generous public goods (given
taxes) should have higher house prices.

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10.2
EVIDENCE: Evidence for Capitalization from
California’s Proposition 13

• California’s Proposition 13 became law in 1978.

o Set the maximum amount of any tax on property
at 1% of the “full cash value.”
o Full cash value: Value as of 1976, with annual
increases of 2% at most.
• Reduced property taxes immensely in some areas,
little change in others.

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10.2
EVIDENCE: Evidence for Capitalization from
California’s Proposition 13

• Each $1 of property tax reduction increased house

values by about $7, about equal to the PDV of a
permanent $1 tax cut.
• 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.

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10.2
Optimal Fiscal Federalism

• Tiebout model implies that three factors determine

local public good provision:
1. Tax-benefit linkages: The relationship between
the taxes people pay and the government goods
and services they get in return.
2. Cross-municipality spillovers in public goods.
3. Economy of scale in public good provision.
• If taxes and benefits are linked, and there are no
spillovers or economies of scale, then local public good
provision is close to optimal.

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10.2
Optimal Fiscal Federalism

• If taxes and benefits are linked, and there are no

spillovers or economies of scale, then local public good
provision is close to optimal.
• Otherwise, further intervention may be called for.
• Actual fiscal federalism does not necessarily line up:
o Are there enormous spillovers/externalities in
education?

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10.3
Redistribution across Communities

Enormous inequality in revenue across municipalities:

• Weston, MA raises $21,334/student while Lakeville
raises $11,800.
• Should we care?
o If Tiebout is right, then this reflects optimal sorting
and financing.
o But if not, redistribution might be called for.
o The main tool of redistribution is
intergovernmental grants, cash transfers from one
level of government to another.

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10.3
Matching Grants

Grants come in multiple forms, with different

implications.
• Block grant: A grant of some amount with no
mandate as to how it is spent.
• Conditional block grant: A grant of some amount with
a mandate as to how it is spent.
• Matching grant: A grant, the amount of which is tied
to the amount of spending by the local community.

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10.3
Tools of Redistribution: Grants

Private goods
spending
(thousands)

A
$1,000

500
X IC1

B
0 500 $1,000 Education spending
(thousands)

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10.3
Matching Grants

Private goods
spending
(thousands)

A
$1,000

Y
625
IC2
500
X
IC1

B C
0 500 750 1,000 $2,000 Education spending
(thousands)

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10.3
Block Grant

Private goods
spending
(thousands)
D
$1,375

A
1,000
Z
800
IC3
625
Y
500
X
IC1

B E C
0 500 575 750 1,000 1,375 $2,000 Education spending
(thousands)
Income effect Substitution effect

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10.3
Conditional Block Grant

Private goods
spending
(thousands)
D
$1,375

A F
1,000

800
Z

625 IC3
Y
500
X
IC1

B E C
0 375 500 575 750 1,000 1,375 $2,000 Education spending
(thousands)
Income effect Substitution effect

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10.3
Implications of Different Grant Types

Different grant types affect incentives in different ways.

• Matching grants rotate out the budget constraint,
acting like a subsidy.
o Help with externalities, since they are targeted.
• Block grants shift out the entire budget constraint,
raising spending on all goods.
o Good for redistribution.
• Conditional block grants only differ from block grants if
the amount of the grant is greater than the initial
educational spending.

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10.3
Redistribution in Action: School Finance Equalization

• Main kind of local redistribution is school finance

equalization.
• School finance equalization: Laws that mandate
redistribution of funds across communities in a state
to ensure more equal financing of schools.
• Finance equalization schemes differ across states:
o California redistributes effectively all revenues.
o New Jersey redistributes most revenue from towns
with revenue above the 85th percentile.

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10.3
Redistribution in Action: School Finance Equalization

Different structures result in different tax prices.

• 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.
• If half of revenue is redistributed, tax price is $2.
• If all revenue is redistributed, tax price is infinite.

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10.3
EVIDENCE: The Flypaper Effect

• The simple implies that conditional grants crowd-out

local spending one-for-one. Do they?
• Looking at how states spend grant money, the flypaper
effect seems to matter: “The money sticks where it
hits.”
• But states that get grants are the ones that like
spending the most.
• And highway grants from the federal government to
states are determined by the strength of the state’s
political representatives.

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10.3
EVIDENCE: The Flypaper Effect

Knight attempted to measure the importance of the

flypaper effect.
• Looked at how spending changes as states’
congressional delegations gain or lose power.
• 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.

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10.3
APPLICATION: School Finance Equalization and
Property Tax Limitations in California

If residents perceived that property taxes were “too high”

in California, why did they wait until 1978 to lower them?
• Proposition 13 actually a response to school finance
equalization in California.
• Taxes no longer financed local school spending; just
taxes, rather than prices. Tax price became infinite.
• Voters were happy to limit property taxes once those
taxes no longer brought them any benefit.

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10.4
Conclusion

• Central governments collect only part of total tax

revenues and spend only part of total public spending.
• The Tiebout model suggests that the spending should
be done locally when:
o Spending is on goods for which local preferences
are relatively similar.
o Most residents can benefit from those goods.

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10.4
Conclusion

• Higher levels of government may not believe the

conclusions of the idealized Tiebout model.
o They will want to redistribute across lower levels
of government.
o If the higher-level government decides that it
wants to redistribute across lower levels, it can do
so through several different types of grants.
o Appropriate choice of grants depends on goal of
government financing.

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