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Chapter 18 Fiscal Federalism and State and Local Government Finance


Levels of Government

Federal State County (called a Parish in Louisiana) School, Water, Fire, Sanitation District City, Town, Village



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.3

Fiscal Federalism

Fiscal Federalism is the structure of the levels of governments in which each level has sources of revenues and economic or fiscal responsibilities.


Local Public GoodsLocal public goods are goods that create no rivalry to the good within a certain geographic area. Examples: local streets sewers and sanitation systems parks police protection fire protection


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: This is sometimes seen as inequitable.6

Centralized vs Decentralized Decisions

An important problem for a society: which goods and services should be provided at which level of government? Are 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?7

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, in which people choose 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.


The Global Economy and Federalism

The European Union (EU): pushed federalism beyond national borders by agreeing to establish uniform regulations and tax systems to establish more integrated economies. eliminated border and customs controls between member nations. replaced individual currencies with the Euro The U.S. Infrastructure and education have increasingly become the responsibility of state and local government. Tax competition among states often limits their ability to raise revenue


Interjurisdictional Externalities

Costs or benefits accrue 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.


The Theory of Taxation with a Decentralized SystemThe 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.


Tax Base Elasticity, Tax Rates and RevenuesValues of ET ET > 1 (inelastic) ET = 1 (Unit elastic) ET < 1 (elastic) Changes in Tax Rates t An increase in t A decrease in t Changes in Revenues (tB) Revenues increase Revenues decrease

Either an increase No change in or a Revenues decrease in t An increase in t A decrease in t Revenues decrease Revenues increase12

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.13

Fiscal CapacityFiscal capacity is a measure of a jurisdictions ability to raise revenue. Possible Measures Per capita income Per capita retail sales Per capita assessed valuation


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.15

Interstate Tax Exportation

Many state governments do succeed in exporting their tax burden to residents of other states. Tax exportation arises in a variety of ways:

Tax out-of-state input owners who employ their inputs in the state Tax goods and services purchased by out-of-state individual Tax hotels and entertainment activities

The federal deductibility of state and local income and property taxes from taxable income under the income tax amounts to tax exportation. 16

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. 17

Federal Grants in AidYear Grants as a Percent of State and Local Outlays 1970 1980 1990 2002 19.0 26.3 18.7 26.3 Federal Outlays 12.3 15.5 10.8 17.5 GDP

2.4 3.5 2.5 3.4


The Theory of GrantsIf 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, or provide local governments with the means to provide the good with categorical grants or with block grants.


Figure 18.1 Political Equilibrium: A Matching Grant Versus a Nonmatching Grant of Equal ValueExpenditures on Private Goods per Year

G A' A T1 G M M' Slope = ti(1 m) E E'

{QP1 QP2 B

Slope = ti B' C20

Public Goods per Year

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.


Figure 18.2 Matching GrantA Net Gain in Well-Being E 10 8Grant per Unit of Abatement

Cost of Removal per Pound (Dollars)



Local Cost per Unit of Abatement

100 150 Pollution Abated per Year (Thousands of Pounds)22

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.23