McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 22 PUBLIC FINANCE IN A FEDERAL SYSTEM

22-2 Background  Federal system  Fiscal federalism  Centralization Centralization ratio = Central government expenditures Total government expenditures

22-3

22-4 Community Formation  Club – voluntary association of people who band together to finance and share some benefit  Optimal Club (or community)

22-5 The Tiebout Model  Voting with your feet  Tiebout’s assumptions Government activities generate no externalities Individuals are completely mobile People have perfect information with respect to each community’s public services and taxes There are enough different communities so that each individual can find one with public services meeting her demands The cost per unit of public services is constant so that if the quantity of public services doubles, the total cost also doubles Public services are financed by a proportional property tax Communities can enact exclusionary zoning laws—statutes that prohibit certain uses of land

22-6 Tiebout and the Real World  Critique of Tiebout  Empirical tests

22-7 Optimal Federalism  Macroeconomic functions  Microeconomic functions

22-8 Disadvantages of a Decentralized System  Efficiency issues Externalities  local public good Scale economies in provision of public goods Inefficient tax systems Scale economies in tax collection  Equity issues

22-9 Advantages of a Decentralized System  Tailoring outputs to local taxes  Fostering intergovernmental competition  Experimentation and information in locally provided goods and services

22-10 Implications  Purely decentralized systems cannot maximize social welfare  Dealing with community activities that create spillover effects that are not national in scope Combine communities under a single regional government Pigouvian taxes and subsidies  Division of responsibility in public good provision  Distributional goals and mobility

22-11 Public Education in a Federal System  Local control of schools  Financing education through property taxation  Federal role in education

22-12 Property Tax  How the property tax works Assessed value Assessment ratio City Effective Tax Rate* Newark 2.96% Detroit1.82 Atlanta1.79 New Orleans1.75 Chicago1.69 Charlotte1.13 New York1.12 Los Angeles1.08 *Figures are for Source: US Bureau of the Census [2006, p. 301] Residential Property Tax Rates (selected cities)

22-13 Incidence and Efficiency Effects – The Traditional View - Tax on Land Acres of land Rent per acre of land SLSL DLDL P0LP0L DL’DL’ PnLPnL P s L = P 0 L Price received by landowners falls by amount of the tax

22-14 Incidence and Efficiency Effects – The Traditional View - Tax on Land  Tax capitalized into price of land  Land not fixed in supply

22-15 Incidence and Efficiency Effects – The Traditional View - Tax on Structures Number of structures per year Price per structure SBSB DBDB P0BP0B DB’DB’ PnLPnL P n B = P 0 B B0B0 B1B1 PgBPgB Price paid by tenants increases by full amount of the tax

22-16 Summary and Implications of the Traditional View  Progressivity Land tax Structures tax  Empirical evidence Measuring income

22-17 The New View: Property Tax as a Capital Tax  Partial equilibrium versus general equilibrium  General Tax effect  Excise Tax effects  Long-run effects

22-18 Property Tax as a User Fee  The notion of the incidence of the property tax is meaningless  The property tax creates no excess burden  Federal income tax subsidizes consumption of local public services for individuals who itemize  Oates [1969]

22-19 Reconciling the Three Views  New view: Eliminating all property taxes and replacing them with a national sales tax  Traditional view: Lowering property tax rate and making up revenue from local sales tax  User fee view: Taxes and benefits jointly changed and people are sufficiently mobile

22-20 Why Do People Hate the Property Tax So Much?  Property tax levied on estimated value  Property tax highly visible  Property tax perceived as being regressive Circuit breakers  Property tax easier to attack

22-21 Ideas for Improving the Property Tax  Improve assessment procedures  Personal net worth tax

22-22 Intergovernmental Grants Relation of federal grants-in-aid to federal and state-local expenditures (selected fiscal years)

22-23 Why Have Intergovernmental Grants Grown So Much?  Mismatch theory

22-24 Conditional (Categorical) Grants G1G1 c1c1 E1E1 Units of public good (G) per year Consumption (c) per year A B Matching Grants RG2G2 c2c2 E2E2

22-25 Conditional (Categorical) Grants G1G1 c1c1 E1E1 Units of public good (G) per year Consumption (c) per year A B Matching Closed-Ended Grants RG3G3 c3c3 E3E3 D

22-26 Conditional (Categorical) Grants G1G1 c1c1 E1E1 Units of public good (G) per year Consumption (c) per year A B Nonmatching Grants RG2G2 c4c4 E4E4 H J

22-27 Unconditional Grants  Revenue sharing  Measuring Need Tax effort

22-28 The Flypaper Effect  Whose indifference curves?  Median voter theorem  Flypaper effect

22-29 Intergovernmental Grants for Education  Serrano v Priest [1971]  Foundation aid  District power equalization grants  Issues Educational outcomes Impact of centralized financing on voters’ support for public education