CHAPTER 22

Public Finance in a Federal System

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

22-2

Background

•  Federal system •  Fiscal federalism •  Centralization

– Centralization ratio = Central government expenditures Total government expenditures

22-3

Distribution of All U.S. Expenditures by Government Level

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 2.03%

Detroit 2.01

Atlanta 1.75

New Orleans 1.75

Chicago 1.58

Charlotte 1.20

Los Angeles 1.10

New York .66 *Figures are for 2006.

Source: US Bureau of the Census [2009, p. 276]

Residential Property Tax Rates (selected cities)

22-13

Incidence and Efficiency Effects – The Traditional View - Tax on Land

Acres of land

Ren

t per

acr

e o

f lan

d SL

DL

P0L

DL’

PnL

PsL = P0

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

Pric

e pe

r s

truct

ure

SB

DB

P0B

DB’

PnL

PnB = P0

B

B0 B1

PgB

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)

*Amounts are converted to 2007 dollars using the GDP deflator. Source: Computed from Economic Report of the President, 2009 [pp. 377, 381].

22-23

Why Have Intergovernmental Grants Grown So Much?

•  Mismatch theory

22-24

Conditional (Categorical) Grants

G1

c1 E1

Units of public good (G) per year

Con

sum

ptio

n (c

) pe

r yea

r

A

B

Matching Grants

R G2

c2 E2

22-25

Conditional (Categorical) Grants

G1

c1 E1

Units of public good (G) per year

Con

sum

ptio

n (c

) pe

r yea

r

A

B

Matching Closed-Ended Grants

R G3

c3 E3 D

22-26

Conditional (Categorical) Grants

G1

c1 E1

Units of public good (G) per year

Con

sum

ptio

n (c

) pe

r yea

r

A

B

Non-matching Grants

R G2

c4 E4

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