Copyright © 2002 by Thomson Learning, Inc. Chapter 18 Fiscal Federalism and State and Local Government Finance Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN X

Copyright © 2002 by Thomson Learning, Inc. Levels of Government  Federal  State  County (called a Parish in Louisiana)  School, Water, Fire, Sanitation District  City, Town, Village

Copyright © 2002 by Thomson Learning, Inc. Grants-in-Aid  The federal government sends 15% of its tax revenue to state and local governments.  Most of this money goes to fund Medicaid and TANF programs that states are required to provide.

Copyright © 2002 by Thomson Learning, Inc. Fiscal Federalism  Fiscal Federalism is the structure of the levels of governments in which each level has sources of revenues and responsibilities.

Copyright © 2002 by Thomson Learning, Inc. Local Public Goods Examples:  local streets  sewer and sanitation  parks  police protection  fire protection Local public goods are goods where there is no rivalry to the good within a certain geographic area.

Copyright © 2002 by Thomson Learning, Inc. Providing Local Public Goods Locally  The benefit of providing local public goods with local tax dollars is that the preferences of the population using the services can be matched with their willingness to pay taxes to receive them.  The problem with providing local public goods with local tax dollars is that differences in the ability to pay between local jurisdictions can cause differences in the provision of public goods that is seen as inequitable.

Copyright © 2002 by Thomson Learning, Inc. Centralized vs Decentralized Decisions  An important problem for a society is which goods and services should be provided at which level of government.  Are the equity concerns more or less important than the concerns of matching preferences to service levels? For instance, should primary and secondary education be provided nationally or locally?

Copyright © 2002 by Thomson Learning, Inc. Mobility between Jurisdictions: Voting with Your Feet  When local public goods are provided in differing amounts in different communities citizens can move from one jurisdiction to another to match their preferences for local public goods.  This concept is called the Tiebout model where people chose jurisdictions as they choose any good. Each jurisdiction provides services that come at a price (the tax rate) and people can choose how much government to consume by choosing where they want to live.

Copyright © 2002 by Thomson Learning, Inc. Interjurisdictional Externalities  There are costs or benefits accruing to citizens in one jurisdiction that result from the public goods choices of another jurisdiction.  A suburb with higher taxes to provide better parks may provide recreation to more than just its own citizens.

Copyright © 2002 by Thomson Learning, Inc. The Theory of Taxation with a Decentralized System The Tax Base  People being taxed can move to another jurisdiction as a result of a tax placed upon them. The elasticity of the tax base represents this as the percentage change in the tax base divided by the percentage change in the tax rate.  A new tax can therefore increase overall revenues or decrease overall revenues depending upon whether the new tax raises more revenue from a new base being taxed than is lost from existing taxes because people leave the jurisdiction.

Copyright © 2002 by Thomson Learning, Inc. Tax Base Elasticity, Tax Rates and Revenues Values of E T Changes in Tax Rates t Changes in Revenues (tB) E T > – 1 (inelastic) An increase in t A decrease in t Revenues increase Revenues decrease E T = – 1 (Unit elastic) Either an increase or a decrease in t No change in Revenues E T < – 1 (elastic) An increase in t A decrease in t Revenues decrease Revenues increase

Copyright © 2002 by Thomson Learning, Inc. Tax Competition and Tax Exporting  Jurisdictions attempt to lure residents and business to an area by offering them lower tax rates or tax abatements. This is called tax competition. For example, governments issue tax abatements to industries if they agree to move to their community.  When jurisdictions place a tax on a good that is consumed by people who do not live in the jurisdiction this is called tax exporting. For example, cities place a hotel tax on visitors to their communities.

Copyright © 2002 by Thomson Learning, Inc. Fiscal Capacity  Per capita income  Per capita retail sales  Per capita assessed valuation Fiscal capacity is a measure of a jurisdiction’s ability to raise revenue. Possible Measures

Copyright © 2002 by Thomson Learning, Inc. Revenue Effort  Revenue effort is a measure of how much revenue a jurisdiction is collecting relative to how much it could collect.  It is typically measured as the ratio of the tax collections from all sources in a jurisdiction to its per capita income.

Copyright © 2002 by Thomson Learning, Inc. Governmental Grants  Categorical Grants are grants by one level of government to another to support a specific program.  Matching Grants are grants by one level of government to another that must be matched by the receiving government in support of a program.  Unconditional Grants are grants by one level of government to another that may be used for any broad purpose. Sometimes called Block Grants or Revenue Sharing.  Because money not spent in one area when a grant is received can be spent in another, a restricted grant may serve unintended purposes. This is called fungibility.

Copyright © 2002 by Thomson Learning, Inc. Federal Grants in Aid YearGrants as a Percent of State and Local Outlays Federal Outlays GDP

Copyright © 2002 by Thomson Learning, Inc. The Theory of Grants  If you are in the role of the Federal Government you can  provide the good;  provide local governments with an incentive to provide the good themselves with matching grants;  provide local governments with the means to provide the good with categorical grants or with block grants.

Copyright © 2002 by Thomson Learning, Inc. Figure 18.1 Political Equilibrium: A Matching Grant Versus a Nonmatching Grant of Equal Value E' A M G E M' A' B'QP2QP2 Slope = – t i (1 – m) BC T1T1 QP1QP1 GG Slope = – t i Public Goods per Year Expenditures on Private Goods per Year

Copyright © 2002 by Thomson Learning, Inc. Impact of a Nonmatching Grant on the Political Equilibrium  A nonmatching grant would likely (depending on the preferences of the median voter) increase both the level of public goods produced as well as allow for lower taxes so that more private goods could be consumed.  Less of the grant is devoted to public goods with a nonmatching grant than with a matching grant.

Copyright © 2002 by Thomson Learning, Inc. Figure 18.2 Matching Grant 8 E* A E  MB N = MSB  MB L MSC Net Gain in Well-Being Grant per Unit of Abatement Local Cost per Unit of Abatement Pollution Abated per Year (Thousands of Pounds) Cost of Removal per Pound (Dollars)

Copyright © 2002 by Thomson Learning, Inc. Education Finance  What is the proper role of the federal government in school finance? The question is one of equity vs local control. Because some school districts are poor relative to others, a completely local system could be seen as inequitable. On the other hand, local control of the curriculum is seen as important as well.