PUBLIC FINANCE IN A FEDERAL SYSTEM

Chapter 22

Background

• Federal system• Fiscal federalism• Centralization

– Centralization ratio = Central government expendituresTotal government expenditures

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Distribution of All U.S. Expenditures by Government Level

22-3

Source: Figures for 1900 through 1980 are from Pommerehne [1977]. Figures after 1980 are computed from various editions of the US Bureau of the Census, Statistical Abstracts of the United States , and from US Bureau of the Census [2012b].

Community Formation

• Club – voluntary association of people who band together to finance and share some benefit

• Optimal Club (or community)

22-4

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

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Tiebout and the Real World

• Critique of Tiebout• Empirical tests

22-6

Optimal Federalism

What is the optimal allocation of economic responsibilities among levels of government?•Macroeconomic functions•Microeconomic functions

22-7

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

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Advantages of a Decentralized System

• Tailoring outputs to local taxes• Fostering intergovernmental competition• Experimentation and information in locally

provided goods and services

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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

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Public Education in a Federal System

• Local control of schools• Financing education through property taxation• Federal role in education

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Property Tax

• How the property tax works– Assessed value– Assessment ratio

Residential Property Tax Rates (selected cities)

City Effective Tax Rate (%)

Indianapolis 2.75

Detroit 2.11

Jackson 1.70

New Orleans 1.40

Oklahoma City 1.25

Boston 1.06

Seattle 0.79

New York 0.62

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

Acres of land

Rent

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

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

• Tax capitalized into price of land• Land not fixed in supply

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Incidence and Efficiency Effects – The Traditional View – Tax on Structures

Number of structuresper year

Pric

e pe

r s

truc

ture

SB

DB

P0B

DB’

PnL

PnB = P0

B

B0B1

PgB

Price paid by tenants increases by full amount of

the tax

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Summary and Implications of the Traditional View

• Progressivity– Land tax– Structures tax

• Empirical evidence– Measuring income

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The New View: Property Tax as a Capital Tax

• Partial equilibrium versus general equilibrium• General Tax effect• Excise Tax effects• Long-run effects

22-17

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

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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

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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

22-20

Ideas for Improving the Property Tax

• Improve assessment procedures• Personal net worth tax

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Intergovernmental Grants

Source: Computed from Economic Report of the President, 2012 [pp. 320, 415].

22-22

Total Grants Grants as % Grants as %Billions of Of Total Federal of State & Local

Year 2010 $ Outlays Spending1970 88 9.6 17.11980 168 12.3 21.91990 171 8.8 15.22000 309 13.2 19.32010 532 14.4 25.4

• Possible explanation for growth: Mismatch Theory

Conditional (Categorical) Grants

G1

c1E1

Units of public good (G) per year

Cons

umpti

on (c

) pe

r yea

r

A

B

Matching Grants

RG2

c2E2

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Conditional (Categorical) Grants

G1

c1E1

Units of public good (G) per year

Cons

umpti

on (c

) pe

r yea

r

A

B

Matching Closed-Ended Grants

RG3

c3

E3D

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Conditional (Categorical) Grants

G1

c1E1

Units of public good (G) per year

Cons

umpti

on (c

) pe

r yea

r

A

B

Non-matching Grants

RG2

c4

E4

H

J

22-25

Unconditional Grants

• Revenue sharing• Flypaper Effect

– Whose indifference curves?– Median voter theorem– Flypaper effect

22-26

Chapter 22 Summary• In a federal system of government, different governments provide

difference services, although advantages and disadvantages of centralized government exist

• The club model of community formation indicates that community size and quantity of public goods depend on tastes

• According to the Tiebout model, a Pareto efficient allocation of public goods is possible under certain conditions through “voting with your feet”

• The property tax is an important revenue source for state and local governments

• Various types of grants from the federal and state government are other sources of revenue for state and local governments

22-27