1. 1 Chapter 22– Public Finance in a Federal System Public Finance McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. 2 Introduction This chapter 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. 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. Table 20.1 The average state/local government collects 22% of total government revenue, while those in the U.S. collect 40%.The average state/local government collects 22% of total government revenue, while those in the U.S. collect 40%.

5. 5 Table 20.2 Subnational government spending/revenue as a share of total government spending/revenue,2001 Spending %Revenue % Greece5.03.7 Portugal12.88.3 France18.613.1 Norway38.820.3 United States40.040.4 Denmark57.834.6 OECD Average32.221.9 The average state/local government collects 22% of total government revenue, while those in the U.S. collect 40%.The average state/local government collects 22% of total government revenue, while those in the U.S. collect 40%. On the spending side, the differences are slightly less dramatic.On the spending side, the differences are slightly less dramatic.

6. 6 Fiscal Federalism Abroad The higher level of centralization in other nations exists because state/local governments have almost no legal power to tax citizens. Many countries practice fiscal equalization, whereby the national government distributes grants to sub-national government in an effort to equalize differences in wealth.

7. 7 Fiscal Federalism Abroad There has been a move toward decentralization around the world. In the U.S., there have been increased efforts to shift control and financing of public programs to the states, such as with welfare reform in 1996.

8. 8 OPTIMAL FISCAL FEDERALISM Public goods provision problem compounded with issues of split levels of government What is the optimal division of responsibilities across different levels of government? A theory of how the efficiency of public goods provision may differ at different levels of government helps answer this questions.

9. 9 OPTIMAL FISCAL FEDERALISM Two of the major problems in public goods provision are: –Preference revelation: Difficult to design democratic institutions to cause individuals to reveal their preferences honestly. –Preference aggregation: Difficult to aggregate individual preferences into a social decision.

10. 10 The Tiebout Model A number of activities are run primarily at the state and local levels. –Education –Public safety –Highways –Public welfare

11. 11 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. Tiebout showed that the inefficiency in public goods provision came from two missing factors: shopping and competition. Shopping induces efficiency in private markets. Competition induces the right prices and quantities in private markets.

12. 12 The Tiebout Model With public goods provided at the local level, competition naturally arises because individuals can vote with their feet by moving to another town without much disruption. This induces fiscal discipline for local governments and creates a new preference revelation device: mobility. Tiebout argued that the threat of exit can induce efficiency in local public goods production. Under certain (unrealistic) conditions public goods provision will be fully efficient at the local level.

13. 13 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

14. 14 Problems with the Tiebout Model Tiebout competition may not hold because: –It requires perfect mobility. –It requires perfect information on the benefits individuals receive and the taxes they pay. –It requires enough choice of towns so that individuals can find the right levels of public goods.

15. 15 Problems with the Tiebout Model Tiebout financing is problematic because: –It requires lump-sum taxes that are independent of a person’s income. This is viewed as highly inequitable. –It is more common for towns to finance public goods through proportional taxes on homes, leading to the problem of the poor chasing the rich. –The use of zoning can ameliorate this problem.

16. 16 Optimal Federalism: what level should provide which services? 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.

17. 17 Optimal Fiscal Federalism First, the model implies that the extent to which public goods should be provided at the local level is determined by tax- benefit linkages. Strong linkages (such as local roads) means most residents benefit, and the good should be provided locally. Weak linkages (such as welfare payments) means that most residents do not benefit, and the good should be provided at a higher level. If residents can see directly the benefits they are buying with their property tax dollars, they will be willing to pay local taxes. Otherwise, they may “vote with their feet.”

18. 18 Optimal Fiscal Federalism The second factor that determines the optimal level of decentralization is the extent of positive externalities. If the local public good has spillovers to other communities, they will be underprovided. In this case, higher levels of government have a role in promoting the provision of these public goods.

19. 19 Optimal Fiscal Federalism The third factor that determines the optimal level of decentralization is the economies of scale in production. Public goods with large economies of scale, like national defense, are not efficiently provided by many competing local jurisdictions. Public goods without large economies of scale, like police protection, may be provided more efficiently in Tiebout competition.

20. 20 Optimal Fiscal Federalism The Tiebout model therefore predicts that local spending should focus on broad-based programs with few externalities and relatively low economies of scale. Examples include road repair, education, garbage collection, and street cleaning.

21. 21 The Property Tax In 2005, $320 billion collected in property taxes, almost all at the local level. Plays key role in local public finance. In many western states with public lands, feds make payment in lieu of taxes Many non-profits also make payments in lieu of taxes

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23. 23 The Property Tax Property tax liability is the product of the tax rate and the property’s assessed value. –Value the jurisdiction assigns to property. In many cases, assessed values correspond to market values, but more difficult if a property has not been sold recently. Wide range of credits and rollbacks can change the effective tax rate

24. 24 The Property Tax Table 20.2 shows that effective tax rates on residential property vary widely.

25. Table 20.2

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27. 27 Property taxes American system of local property taxes originates with British traditions Importance linked to growth of frontier Feasible source of revenue –Equal taxation of wealth –Overlapping and special districts had revenue sources Colonial era had several taxes –Excise and tariffs Post revolutionary war saw a uniformity clause added to property taxation

28. 28 Property taxes Property taxes applied to real estate and personal property Individuals paid for government services in proportion to their wealth

29. 29 Property tax and local governments 87,500 local governments in 2002 –Special districts increasing “reserved powers” clause of 10 th amendment to US Constitution –States can permit anything not excluded by Feds –Local governments are creatures of State govt. Diversity of local government related to history, settlement patterns and state legislatures

30. 30 Local government trends Local government structure continues to evolve –De-volution or de-centralization trends –Number and scope of local governments –Style of state legislature –Political culture of the state. Local government will continue to be important –Local government revenue will be needed –Property tax will continue to be important

31. 31 Evolution of the property tax system In agricultural economy, wealth mostly tied to land and buildings In modern commercial society, wealth in many other forms (stocks, bonds, investments, Local assessors often played favorites with property valuations Auditor, treasurer are separate elected offices Wages and earnings as new form of wealth Increased demands for revenues for services

32. 32 Property tax history Post WW2 saw dramatic changes in growth and demand for services Assessments and revenues grew Local programs and services also grew

33. 33 California Tax Revolt Proposition 13 –Froze assessments at 1975 levies (until next transaction) –Ceiling on the property tax rate any locality could impose –Forbade localities raising property taxes without a 2/3 majority State stepped in with more revenue sharing

34. 34 Why property taxes are controversial in US and Iowa Property tax is highly visible Perceived as regressive May be more accessible for changing Iowa has uneven effective rates across classes of property

35. 35 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

36. 36 The Property Tax Incidence and Efficiency Effects –Property tax as an excise tax Traditional view Excise tax on land and structures Incidence depends on shapes of supply and demand curves for land and structures

37. 37 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 22.1 illustrates this.

38. Figure 22.1

39. 39 The Property Tax: Value-adding structures 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 22.2 illustrates this.

40. Figure 22.2

41. 41 The Property Tax Thus, incidence falls partly onto landowners and partly onto tenants.

42. 42 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.

43. 43 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.

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45. 45 Table 1. State and Local Government Finances by Level of Government and by State: 2003-04 (Dollar amounts are in thousands. Coefficients of variation (CV) are expressed as percents. For meaning of abbreviations and symbols, see note below table.) Description Iowa State & local State Local government amount 1 CVamountamount 1 CV 12345 Population (July 2004, in thousands)2,953(X)2,953 (X) Revenue 1 22,544,5650.1715,363,01510,639,5210.43 General revenue 1 18,396,3430.2011,916,7039,937,6110.45 Intergovernmental revenue 1 4,304,2250.164,038,2203,723,9760.86 From Federal Government4,304,2250.163,911,906392,3191.78 From State government 1 (1)0.0003,331,6570.93 From local governments 1 (1)0.00126,314(1)0.00 General revenue from own sources14,092,1180.257,878,4836,213,6350.56 Taxes9,018,7480.345,214,6023,804,1460.81 Property3,188,8690.4403,188,8690.44

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47. 47 Roles of Intergovernmental Grants Correct for externalities (services or tax costs cross boundaries Redistribution of resources among regions Substituting one tax structure for another Macroeconomic stabilizing tool (fiscal policy)

48. 48 Economic effects of grants Income effects –Increasing the resources available for local services Price effects –Reducing marginal costs of providing the service

49. 49 Intergovernmental Grants Essentially two types of grants: conditional and unconditional. 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

50. 50 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 22.4 illustrates the potential effects.

51. Figure 22.4

52. 52 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 22.5 illustrates the potential effects.

53. Figure 22.5

54. 54 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 nonlinear. Figure 22.6 illustrates the potential effects.

55. Figure 22.6

56. 56 Intergovernmental Grants Unconditional grants (Block grant) –Sometimes referred to as revenue sharing. Money is unrestricted. –Similar to budget constraint in Figure 22.6, except that the budget line is now JM rather than AHM.

57. 57 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.”

58. 58 Recap of Public Finance in a Federal System Community Formation Tiebout Model Optimal Federalism Property Tax Intergovernmental Grants

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60. 60 Revenue Picture: Iowa’s Ranking for State and Local Taxes Measuring per capita taxes Assessing financial burden on state residents

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63. 63 Tax burden (tax as % of personal income)

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68. 68 Iowa property tax system Tax on real property in 5 classes –Residential –Agricultural –Commercial –Industrial –Utilities

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70. 70 Property taxes Properties are assessed every two years Each county has an assessor, towns over 10,000 may have their own How do they assess? –Based on market valuation –Recent sales, comparable properties Assessments summed for each class of property State Dept. of Revenue equalizes among jurisdictions

71. 71 Assessment process Budgets are established Tax rates are established Credits subtracted –Homestead, disabled, farmstead, veterans Rollbacks applied Levy and consolidated levy Roles of assessor, auditor, treasurer Opportunities for appeal

72. 72 Property taxes: Rollbacks —30 years ago high inflation led to limitations on valuation increases –-residential and ag land received limitation formula –Ag land assessed on productivity –Statewide valuations limited to 4% for these 2 classes –Rollback from assessed valuations gives taxable valuation. –Residential rollback at 46.28% currently

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76. 76 Property tax reform proposal Steady growth of rollback percentage means property tax bill shifting to commercial and industrial classes Businesses want tax relief HF2771 proposes to limit increases to commercial and industrial by linking increases across classes

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80. 80 Assessment of Iowa Taxes Very average in terms of per capita and per income basis State and local taxes declining on a per income basis Slight increase on a percapita basis Percapita spending also very average