Chapter 10 State and Local Government Expenditures Public Finance and Public Policy Author: Jonathan Gruber Instructor: Yigang Zhang

Introduction Bush’s No Child Left Behind Act “This is about who controls education-the state or Washington.” -- by Utah State Senator Thomas Hatch; “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” – Amendment X in the Bill of Rights of the United States Constitution;

Introduction Optimal fiscal federalism which activities should take place at which level of government; Education: local provision .vs. state provision: Local provision allows communities to choose the package of services that best matches the tastes of their residents, potentially improving the efficiency of public goods delivery. State provision would more suit national interest, while in some cases, matching local interests may not be in the national interest.

Roadmap Fiscal federalism across time and across nations: Fiscal centralization .vs. fiscal decentralization Optimal fiscal federalism How the efficiency of public goods provision may differ at different levels of government?

(Realistic) Fiscal Federalism United states across time: In 1902, state (federal) accounted for 34% of total government spending and local (state and local) accounted for 66% of total government spending; In 2001, state (federal) accounted for 60% of total government spending and local (state and local) accounted for 40% of total government spending; Also, in 1902 less than 1% of local revenues came from federal grants; while in 2008 24% of local revenues came from federal grants; Intergovernmental grants are payments from one level of government to another.

(Realistic) Fiscal Federalism Across OECD countries: Subnational Government Spending as Share of Total Government Spending in 2001: Greece, 5%; Portugal, 12.8%; France, 18.6%; Norway, 38.8%; United States, 40%; Denmark, 57.8%; Centralization is the fact while decentralizing is ongoing. Fiscal equalization; Fiscal equalization refers to policies by which the national government distributes grants to subnational governments in an effort to equalize differences in wealth.

Optimal Fiscal Federalism The Tiebout Model; Shopping and competition; Dollar voting and foot voting; Federal government – (domestic) monopolist; Local governments – competitive firms; Moving to another town costs much less than moving to another country. Mobility reveals preference as purchase does in private market.

Assumptions for the Tiebout Model Mobile Consumers. Complete information. Many communities to choose from. Commuting is not an issue. Public Goods do not spill over in terms of benefits/costs from one community to the next. An optimal city size exists: Economies of scale. Communities try to achieve "optimal size". Communities are rational and try to keep the public 'bad' consumers away.

Setup of the Tiebout Model Many towns, each provide a different level of public good. Towns finance the public good provision through a uniform tax. Individuals choose the town providing the same level of public good as they demand. Solve preference revelation problem and preference aggregation problem. (Lindahl pricing works here.)

Problems with the Tiebout Model Problems with Tiebout Competition: Moving is still costly. It is also costly for individuals to obtain information about public good provision and delivery. There may not be “many” town available to choose. Metropolitan .vs. rural Constrained by commuting cost Conflict between many towns and optimal city size.

Problems with the Tiebout Model Problems with Tiebout Financing: Uniform tax is not favored by the public. Margaret Thatcher’s resignation in 1990 Lump-sum tax is independent of individuals’ income. Realistically towns finance their public good provision through property tax. Property tax is levied proportionally to the value of homes, which is a good proxy for income. Problems of property tax: poor chase the rich .vs. zoning;

Problems with the Tiebout Model Other problems with the Tiebout Model: No externality; Park. Undersupply due to standard free riding. No spillover; Police. Criminals may move. Education. Talents may move. A higher level of government is more capable to internalize the externalities.

Evidence on the Tiebout Model Resident Similarity Across Areas: When people have more choices of local community, the tastes for public goods will be more similar among town residents than when people do not have many choices. In urban/suburban areas, residents were much more satisfied with the level of public goods spending than in nonurban areas. In Michigan suburbs the provision of local public goods appeared to satisfy the efficiency condition.

Evidence on the Tiebout Model Capitalization of Fiscal Differences into House Prices: Any differences in the fiscal attractiveness of a town will be capitalized into house prices given property tax scheme. Converge of dollar voting and foot voting. California’s Proposition 13 Reductions in property taxes resulted in increases in house values. Each $1 of property tax reduction increased house values by about $7.

Optimal Fiscal Federalism Factors in determining local provision or state provision: Tax-benefit linkages The relationship between the taxes people pay and the government goods and services they get in return. The extent of positive externalities, or spillovers, in public goods provision. The economy of scale in the nature of public goods.

Optimal Fiscal Federalism Local spending should focus on broad -based programs with few externalities and relatively low economies of scale, such as road repair, garbage collection, and street cleaning. Similarly, local communities should play a more limited role in providing public goods that are redistributive (such as cash welfare), have large spillovers (such as education), and have very large economies of scale (such as national defense).

Redistribution Across Communities Should We Care? Should this inequality in revenue across communities concern public policy makers? It depends on the extent to which the Tiebout model describes reality. Reasons for redistribution: Failures of the Tiebout mechanism. Externalities.

Redistribution Across Communities Tools of Redistribution: Grants Matching Grants Block Grant Conditional Block Grant Redistribution in Action: School Finance Equalization Why? Externality of education.