1
Chapter 20 – Public Finance
in a Federal System
Public Economics
2
Introduction
? This lesson will address questions related
to different levels of government:
– How should various responsibilities be
allocated to different levels of government?
– Is decentralized government decision making
desirable?
– Are locally raised taxes a good way to pay for
services provided locally?
3
Background
? A federal system consists of different
levels of government that provide public
goods and services,and have some
scope for making decisions.
? Fiscal federalism explores roles of
different levels of government,and how
they relate to one another.
4
Background
? The centralization ratio measures the
proportion of total direct government
expenditures made by the central
government.
? See Table 20.1
? Incorrectly measures power if state and
local governments are mandated to
spend money on certain programs.
Table 20.1
6
Background
? A number of activities are primarily run at
the state- and local-level.
– Education
– Public safety
– Highways
– Public welfare
7
Community Formation
? Think of communities as a club – a
voluntary association of people who band
together to share some kind of benefit.
8
Community Formation
? Public park example
– Members of the club have identical tastes
– Can costlessly exclude nonmembers
– Will share equally the use of park and costs
of park within the club
9
Community Formation
? For a park of a given size,the larger the club,
the smaller the costs per person.
? As more people join the club,congestion costs
rise.
? Community should expand membership until:
– Marginal decrease in membership fee equals the
marginal increase in congestion costs
10
Community Formation
? For a community of a given size,how
large should the park be?
? Larger park yields greater benefits,but at
a diminishing rate.
? Community should expand park size until:
– Each member’s marginal benefit just equals
the per-member marginal cost.
11
Community Formation
? Putting these two together:
– The optimal community is one in which the
number of members and level of services
simultaneously satisfy the condition that the
marginal cost equal the corresponding
marginal benefit.
12
The Tiebout Model
? Tiebout (1956) argued that the ability of
individuals to move across jurisdictions
produces a market-like solution to the local
public goods problem.
? People distribute themselves across
communities based on their demands for public
services (and pay taxes for these services).
? Equilibrium is Pareto efficient.
13
The Tiebout Model:
Some Key Assumptions
? Government activities generate no externalities
? Individuals are completely mobile,and have perfect
information with respect to each community’s public
services and taxes
? There are enough communities so that each individual can
find one with services meeting her demands
? Constant returns to scale technology
? Public services financed by a proportional property tax
? Communities can enact exclusionary zoning laws –
statutes that prohibit certain uses of land.
14
Optimal Federalism
? What is the optimal allocation of
economic responsibilities among levels of
government in a federal system?
? Will discuss the advantages and
disadvantages of a decentralized system.
15
Optimal Federalism
? Disadvantages of a Decentralized
System
– Several reasons why decentralization may
not lead to an efficient allocation of resources
– Externalities – communities may produce
negative or positive externalities for other
communities.
16
Optimal Federalism
? Disadvantages of a Decentralized
System
– Scale economies – increasing returns to
scale would suggest larger community could
provide good at lower average cost.
? Communities could jointly run some activities.
17
Optimal Federalism
? Disadvantages of a Decentralized
System
– Inefficient tax systems – capital may be
very immobile across countries but very
mobile across jurisdictions within a country,
Leads to tax rates that are,too low.”
18
Optimal Federalism
? Disadvantages of a Decentralized
System
– Scale economies in tax collection – it is
likely that larger agencies are more efficient
at collecting taxes.
19
Optimal Federalism
? Disadvantages of a Decentralized
System
– Equity Issues – Migration of the poor puts
extra demands on a community’s tax base,
and makes it difficult to redistribute.
20
Optimal Federalism
? Advantages of a Decentralized System
– Tailoring Outputs to Local Tastes – under
a decentralized system,individuals with
similar tastes for public goods group together.
– Related to this is the notion that a local
government’s proximity to the people makes
it more responsive to citizens’ preferences.
21
Optimal Federalism
? Advantages of a Decentralized System
– Fostering Intergovernment Competition –
If citizens can choose among communities,
then substantial mismanagement of
government resources may cause out-
migration.
– This threat may create incentive for
government managers to produce more
efficiently.
22
Optimal Federalism
? Advantages of a Decentralized System
– Experimentation and Innovation – For
many policies,not known what the,right”
answer is (if there is one).
– Diverse governments increases the likelihood
that new solutions to problems will be sought.
23
Optimal Federalism
? Public Education in a Federal System
– Total government spending in 1999 was
$566 billion,most of which was spent at the
local level.
– 9 out of 10 American children educated in
public schools
24
Optimal Federalism
? Public Education in a Federal System
– Parents have strong,diverse views about
their children’s education.
– Makes sense in this case for local
communities to take the lead in education.
– Financing could come from higher level of
government,but leads to additional
regulations.
25
Optimal Federalism
? Public Education in a Federal System
– Money for education raised largely through
local property tax,Wide variations in
property tax base (and funding) across
school districts.
– Intergovernmental grants play an important
role in educational finance.
26
Optimal Federalism
? Public Education in a Federal System
– Federal money devoted to two areas of
education:
? At elementary and secondary level,
disadvantaged and disabled children.
? In higher education,federal spending for
research.
27
The Property Tax
? In 1999,$240 billion collected in property
taxes,almost all at the local level.
? Plays key role in local public finance.
? Property tax liability is the product of the
tax rate and the property’s assessed
value.
– Value the jurisdiction assigns to property.
28
The Property Tax
? In many cases,assessed values
correspond to market values,but more
difficult if a property has not been sold
recently.
? The assessment ratio is the ratio of
assessed to market value,If assessment
ratios differ,then so does the effective tax
rate.
29
The Property Tax
? Table 20.2 shows that effective tax rates
on residential property vary widely.
Table 20.2
31
The Property Tax
? Incidence and Efficiency Effects
– Who ultimately bears the burden of the
property tax? Three views:
? Property tax as an excise tax
? Property tax as a capital tax
? Property tax as a user fee
32
The Property Tax
? Incidence and Efficiency Effects
– Property tax as an excise tax
? Tradition view
? Excise tax on land and structures
? Incidence depends on shapes of supply and
demand curves for land and structures
33
The Property Tax
? Incidence and Efficiency Effects
– The supply curve for land is viewed as being
perfectly inelastic,and thus the landowners
bear the entire burden of the tax.
– Figure 20.1 illustrates this.
Figure 20.1
35
The Property Tax
? Incidence and Efficiency Effects
– The supply curve for structures is viewed as
being perfectly elastic,and thus the tenants
bear the entire burden of the tax.
– National market for capital,construction
industry can obtain all the capital it demands
at the market price.
– Figure 20.2 illustrates this.
Figure 20.2
37
The Property Tax
? Thus,incidence falls partly onto
landowners and partly onto tenants.
38
The Property Tax
? Incidence and Efficiency Effects
– Property tax as a capital tax
? Takes general equilibrium perspective.
? General wealth tax,with some assets taxed at a below
average rate and others taxed at an above average
rate.
? General tax effect – viewed as a general factor tax on
capital.
? Excise tax effects – capital migrates to low tax areas,
Incidence depends on how production is organized,
structure of consumer demand,and mobility of factors.
39
The Property Tax
? Incidence and Efficiency Effects
– Property tax as a user fee
? Communities use property taxes to purchase
public services like education.
? Thus,not really a tax at all.
? Implications:
– Incidence is meaningless
– No excess burden
– Deductibility of property taxes subsidizes consumption of local public services.
40
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.
? Essentially two types of grants,
conditional and unconditional.
41
Intergovernmental Grants
? Conditional grants
– Also known as categorical grants.
– Donor specifies the purposes for which the recipient
may use the money.
? Usually earmarked
– Several types of conditional grants:
? Matching grant
? Matching closed-ended grant
? Nonmatching grant
42
Intergovernmental Grants
? Conditional grants
? Matching 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 20.3 illustrates the potential effects.
Figure 20.3
44
Intergovernmental Grants
? Conditional grants
? Matching 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 20.4 illustrates the potential effects.
Figure 20.4
46
Intergovernmental Grants
? Conditional grants
? Nonmatching 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 non-
linear.
? Figure 20.5 illustrates the potential effects.
Figure 20.5
48
Intergovernmental Grants
? Unconditional grants
– Sometimes referred to as revenue sharing,
Money is unrestricted.
– Similar to budget constraint in Figure 20.5,
except that the budget line is now JM rather
than AHM.
49
Intergovernmental Grants
? Flypaper effect
– The budget constraint analysis shows that much of
the money that was intended to be spent on the local
public good may actually be spent on other
consumption.
– Surprisingly,virtually all studies conclude that a dollar
received by the community in the form of a grant
results in greater public spending than a dollar
increase in community income.
–,Money seems to stick where it initially hits.”
50
Recap of Public Finance in a
Federal System
? Community Formation
? Tiebout Model
? Optimal Federalism
? Property Tax
? Intergovernmental Grants
Chapter 20 – Public Finance
in a Federal System
Public Economics
2
Introduction
? This lesson will address questions related
to different levels of government:
– How should various responsibilities be
allocated to different levels of government?
– Is decentralized government decision making
desirable?
– Are locally raised taxes a good way to pay for
services provided locally?
3
Background
? A federal system consists of different
levels of government that provide public
goods and services,and have some
scope for making decisions.
? Fiscal federalism explores roles of
different levels of government,and how
they relate to one another.
4
Background
? The centralization ratio measures the
proportion of total direct government
expenditures made by the central
government.
? See Table 20.1
? Incorrectly measures power if state and
local governments are mandated to
spend money on certain programs.
Table 20.1
6
Background
? A number of activities are primarily run at
the state- and local-level.
– Education
– Public safety
– Highways
– Public welfare
7
Community Formation
? Think of communities as a club – a
voluntary association of people who band
together to share some kind of benefit.
8
Community Formation
? Public park example
– Members of the club have identical tastes
– Can costlessly exclude nonmembers
– Will share equally the use of park and costs
of park within the club
9
Community Formation
? For a park of a given size,the larger the club,
the smaller the costs per person.
? As more people join the club,congestion costs
rise.
? Community should expand membership until:
– Marginal decrease in membership fee equals the
marginal increase in congestion costs
10
Community Formation
? For a community of a given size,how
large should the park be?
? Larger park yields greater benefits,but at
a diminishing rate.
? Community should expand park size until:
– Each member’s marginal benefit just equals
the per-member marginal cost.
11
Community Formation
? Putting these two together:
– The optimal community is one in which the
number of members and level of services
simultaneously satisfy the condition that the
marginal cost equal the corresponding
marginal benefit.
12
The Tiebout Model
? Tiebout (1956) argued that the ability of
individuals to move across jurisdictions
produces a market-like solution to the local
public goods problem.
? People distribute themselves across
communities based on their demands for public
services (and pay taxes for these services).
? Equilibrium is Pareto efficient.
13
The Tiebout Model:
Some Key Assumptions
? Government activities generate no externalities
? Individuals are completely mobile,and have perfect
information with respect to each community’s public
services and taxes
? There are enough communities so that each individual can
find one with services meeting her demands
? Constant returns to scale technology
? Public services financed by a proportional property tax
? Communities can enact exclusionary zoning laws –
statutes that prohibit certain uses of land.
14
Optimal Federalism
? What is the optimal allocation of
economic responsibilities among levels of
government in a federal system?
? Will discuss the advantages and
disadvantages of a decentralized system.
15
Optimal Federalism
? Disadvantages of a Decentralized
System
– Several reasons why decentralization may
not lead to an efficient allocation of resources
– Externalities – communities may produce
negative or positive externalities for other
communities.
16
Optimal Federalism
? Disadvantages of a Decentralized
System
– Scale economies – increasing returns to
scale would suggest larger community could
provide good at lower average cost.
? Communities could jointly run some activities.
17
Optimal Federalism
? Disadvantages of a Decentralized
System
– Inefficient tax systems – capital may be
very immobile across countries but very
mobile across jurisdictions within a country,
Leads to tax rates that are,too low.”
18
Optimal Federalism
? Disadvantages of a Decentralized
System
– Scale economies in tax collection – it is
likely that larger agencies are more efficient
at collecting taxes.
19
Optimal Federalism
? Disadvantages of a Decentralized
System
– Equity Issues – Migration of the poor puts
extra demands on a community’s tax base,
and makes it difficult to redistribute.
20
Optimal Federalism
? Advantages of a Decentralized System
– Tailoring Outputs to Local Tastes – under
a decentralized system,individuals with
similar tastes for public goods group together.
– Related to this is the notion that a local
government’s proximity to the people makes
it more responsive to citizens’ preferences.
21
Optimal Federalism
? Advantages of a Decentralized System
– Fostering Intergovernment Competition –
If citizens can choose among communities,
then substantial mismanagement of
government resources may cause out-
migration.
– This threat may create incentive for
government managers to produce more
efficiently.
22
Optimal Federalism
? Advantages of a Decentralized System
– Experimentation and Innovation – For
many policies,not known what the,right”
answer is (if there is one).
– Diverse governments increases the likelihood
that new solutions to problems will be sought.
23
Optimal Federalism
? Public Education in a Federal System
– Total government spending in 1999 was
$566 billion,most of which was spent at the
local level.
– 9 out of 10 American children educated in
public schools
24
Optimal Federalism
? Public Education in a Federal System
– Parents have strong,diverse views about
their children’s education.
– Makes sense in this case for local
communities to take the lead in education.
– Financing could come from higher level of
government,but leads to additional
regulations.
25
Optimal Federalism
? Public Education in a Federal System
– Money for education raised largely through
local property tax,Wide variations in
property tax base (and funding) across
school districts.
– Intergovernmental grants play an important
role in educational finance.
26
Optimal Federalism
? Public Education in a Federal System
– Federal money devoted to two areas of
education:
? At elementary and secondary level,
disadvantaged and disabled children.
? In higher education,federal spending for
research.
27
The Property Tax
? In 1999,$240 billion collected in property
taxes,almost all at the local level.
? Plays key role in local public finance.
? Property tax liability is the product of the
tax rate and the property’s assessed
value.
– Value the jurisdiction assigns to property.
28
The Property Tax
? In many cases,assessed values
correspond to market values,but more
difficult if a property has not been sold
recently.
? The assessment ratio is the ratio of
assessed to market value,If assessment
ratios differ,then so does the effective tax
rate.
29
The Property Tax
? Table 20.2 shows that effective tax rates
on residential property vary widely.
Table 20.2
31
The Property Tax
? Incidence and Efficiency Effects
– Who ultimately bears the burden of the
property tax? Three views:
? Property tax as an excise tax
? Property tax as a capital tax
? Property tax as a user fee
32
The Property Tax
? Incidence and Efficiency Effects
– Property tax as an excise tax
? Tradition view
? Excise tax on land and structures
? Incidence depends on shapes of supply and
demand curves for land and structures
33
The Property Tax
? Incidence and Efficiency Effects
– The supply curve for land is viewed as being
perfectly inelastic,and thus the landowners
bear the entire burden of the tax.
– Figure 20.1 illustrates this.
Figure 20.1
35
The Property Tax
? Incidence and Efficiency Effects
– The supply curve for structures is viewed as
being perfectly elastic,and thus the tenants
bear the entire burden of the tax.
– National market for capital,construction
industry can obtain all the capital it demands
at the market price.
– Figure 20.2 illustrates this.
Figure 20.2
37
The Property Tax
? Thus,incidence falls partly onto
landowners and partly onto tenants.
38
The Property Tax
? Incidence and Efficiency Effects
– Property tax as a capital tax
? Takes general equilibrium perspective.
? General wealth tax,with some assets taxed at a below
average rate and others taxed at an above average
rate.
? General tax effect – viewed as a general factor tax on
capital.
? Excise tax effects – capital migrates to low tax areas,
Incidence depends on how production is organized,
structure of consumer demand,and mobility of factors.
39
The Property Tax
? Incidence and Efficiency Effects
– Property tax as a user fee
? Communities use property taxes to purchase
public services like education.
? Thus,not really a tax at all.
? Implications:
– Incidence is meaningless
– No excess burden
– Deductibility of property taxes subsidizes consumption of local public services.
40
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.
? Essentially two types of grants,
conditional and unconditional.
41
Intergovernmental Grants
? Conditional grants
– Also known as categorical grants.
– Donor specifies the purposes for which the recipient
may use the money.
? Usually earmarked
– Several types of conditional grants:
? Matching grant
? Matching closed-ended grant
? Nonmatching grant
42
Intergovernmental Grants
? Conditional grants
? Matching 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 20.3 illustrates the potential effects.
Figure 20.3
44
Intergovernmental Grants
? Conditional grants
? Matching 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 20.4 illustrates the potential effects.
Figure 20.4
46
Intergovernmental Grants
? Conditional grants
? Nonmatching 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 non-
linear.
? Figure 20.5 illustrates the potential effects.
Figure 20.5
48
Intergovernmental Grants
? Unconditional grants
– Sometimes referred to as revenue sharing,
Money is unrestricted.
– Similar to budget constraint in Figure 20.5,
except that the budget line is now JM rather
than AHM.
49
Intergovernmental Grants
? Flypaper effect
– The budget constraint analysis shows that much of
the money that was intended to be spent on the local
public good may actually be spent on other
consumption.
– Surprisingly,virtually all studies conclude that a dollar
received by the community in the form of a grant
results in greater public spending than a dollar
increase in community income.
–,Money seems to stick where it initially hits.”
50
Recap of Public Finance in a
Federal System
? Community Formation
? Tiebout Model
? Optimal Federalism
? Property Tax
? Intergovernmental Grants
