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Intergovernmental Relations
Chapter 17
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Benefits of centralized government
• Fixed costs of uniform provision of public goods so per capita costs of public goods vary inversely with population using them
• Minimizes spatial spillovers onto neighboring jurisdictions• No inefficient duplication of services by autonomous
jurisdictions • More equal distribution of public resources
– Education– Public Health– Sanitation
• Interjurisdictional competition means less than efficient quantity of public goods provided
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Benefits of decentralized government
• Congestion means club goods have positive marginal cost, fewer economies of scale
• Local public goods are not like clothing: Once size doesn’t fit all.
• Jurisdictions can negotiate among themselves regarding interregional spillovers
• Central governments often funnel revenues from low-income rural areas to help higher-income urban areas
• Interjurisdictional competition forces provision at lowest cost, thus minimizes regional disparities and discourages rent-seekers.
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Is Decentralization Efficient?
• Theory of fiscal federalism the jurisdiction most efficiently decides the level of services and the tax rate
• Principle of subsidiarity only the smallest jurisdiction able to finance a public good that lacks spillovers will do so and internalize all externalities.
• The decision-makers whose constituents bear the costs of the services will make more efficient decisions.
• Laffer curve of decentralization? (Duret and Ventelou)
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Laffer curve
Coordination
Proximity of decision-makers to constituents
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Principal-agent issues in governmental hierarchies
• Local decision makers have two simultaneous roles:– The agent for their constituency
• incentive to not increase taxes and to provide acceptable public goods.
– An agent for higher government levels. • expected to obey the injunctions of the higher
government levels, even if these injunctions are unpopular among the local constituency
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Mandates
• Programs required by one level of government but financed by another level.
• Funded mandates: Central government can control local policy by earmarking grants for certain goods (70% of such aid is spent elsewhere)
• Unfunded mandates: Central governments require localities to operate programs but do not provide financing. (Almost impossible to enforce)
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Intergovernmental grants
• Traditional public finance theory: criteria of intergovernmental grants: efficiency and equity.
• Grants encourage localities to provide an optimal quantity of goods with spillover benefits.
• Principal-agent issues: – incentive to distort facts concerning local tax capacity – political repercussions regarding their choice of local
tax rates. – Game-playing by competing local governments
affects transfers paid or received
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Revenue Sharing
• Funds collected by a higher-level government and distributed to lower levels
• Local government shift the cost of a program to residents of other jurisdictions.
• Inefficient incentives for local governments– Underuse their own tax bases – Artificially inflate their budgets to claim more
revenues.
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Fiscal illusion
• Voters/taxpayers have no idea the true cost of a public good– Vertical imbalances
• Higher level government must rescue extravagant local government that cannot pay debts.
– Public good is consumed where MB = MC to locality but costs of public good are subsidized and MC is artificially low.
• Over-provision of public good
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Inefficiency due to revenue sharing
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Fiscal disparities
• Central government responsibility– Benefits of redistribution spill beyond
jurisdictional boundaries as low-income people relocate
• Optimal intergovernmental redistribution is lump-sum with the following conditions:– Complete transparency,– Absence of any budget constraint, and– Absence of interregional spillovers.
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Fiscal equalization
• Goal: horizontal equity– Household incomes unchanged– Suppression of spatial disparities
• Localities cannot change tax rates
• Adverse selection problem– Central government cannot measure the
sincerity of local government’s attempts to collect taxes, fight tax evasion, or appropriately assess property values.
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City-Suburb Disparities
• Argument for subsidization of central cities:– The central cities have a high (daytime) population
density and their residents pay for public goods that benefit suburbanites.
– Without extra revenues, cities cannot generally provide an optimal quantity of local public goods (safety).
– Tax rates increase, tax base falls as firms/residents relocate to suburbs
– Solution: interregional transfers between the suburbs and the central city.
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City-Suburb Disparities
• Argument against subsidization– The densely populated cities do not need to
be subsidized because they are beyond their optimal level of agglomeration
– Diseconomies of agglomeration increase wages, land rents and population density.
– High population density increases per capita cost of public service provision.
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Overlapping tax bases
• Vertical fiscal externality: taxes or expenditures of one level of government affect the budget constraint of another level of government.
• When two levels of government impose taxes on the same tax base, the governments may end up on the downward sloping sector of the Laffer curve.
• Tax bases are common property resources to the public sector. Equivalent to the overexploitation of common fishing grounds, overexploitation can reduce the tax revenues.
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Laffer Curve
State rateState + Federal rate
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Interjurisdictional Competition
• Spillover (externality) model of spatial interaction among governments– Expenditures on local public services may
produce positive or negative externalities in the neighboring jurisdictions.
– Horizontal fiscal externalities: the effect of one jurisdiction’s taxes on the welfare of people in other jurisdictions.
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Interjurisdictional competition
• Race to the bottom: local officials hold down tax rates and adopt lax environmental regulations to attract new businesses (jobs). – Creates distortions by taxing capital at too low
a rate and by under providing public services. – Decline in public services and lower
standards for environmental quality.
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Interjurisdictional competition
• Tiebout hypothesis (1956) maintains that tax competition is efficient when individual households can move costlessly among jurisdictions. – Reduces the taxing power of a local government thereby
promotes welfare. The amount of local taxes paid and local goods consumed will be exactly what each resident wanted.
• Public choice theory of a utility maximizing manager – Government: perfectly price discriminating monopoly that usurps
the entire amount of consumer surplus. – Managers derive utility from status, so bureaucracy tends to
produce a quantity of public goods that is larger than the socially optimum level.
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Mimicry and yardstick competition
• Mimicry: Spatial expenditures and tax rates are correlated over space because of – fiscal shocks common to entire region.– Interjurisdictional tax competition– Yardstick competition
• Yardstick competition: residents use the performance of another jurisdiction as a yardstick to evaluate their own, so politicians adopt policies similar to those of their neighbors.