PUBLIC FINANCE IN A FEDERAL SYSTEM Chapter 22

Background Federal system Fiscal federalism Centralization Centralization ratio = Central government expenditures Total government expenditures

Distribution of All U.S. Expenditures by Government Level 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)

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

Tiebout and the Real World Critique of Tiebout Empirical tests

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

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

Advantages of a Decentralized System Tailoring outputs to local taxes Fostering intergovernmental competition Experimentation and information in locally provided goods and services

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

Public Education in a Federal System Local control of schools Financing education through property taxation Federal role in education

Residential Property Tax Rates (selected cities) How the property tax works Assessed value Assessment ratio 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 22-12

Incidence and Efficiency Effects – The Traditional View – Tax on Land Rent per acre of land SL Price received by landowners falls by amount of the tax PsL = P0L P0L PnL DL DL’ Acres of land

Incidence and Efficiency Effects – The Traditional View – Tax on Land Tax capitalized into price of land Land not fixed in supply

Price paid by tenants increases by full amount of the tax Incidence and Efficiency Effects – The Traditional View – Tax on Structures Price per structure Price paid by tenants increases by full amount of the tax PgB PnB = P0B P0B SB PnL DB DB’ Number of structures per year B1 B0

Summary and Implications of the Traditional View Progressivity Land tax Structures tax Empirical evidence Measuring income

The New View: Property Tax as a Capital Tax Partial equilibrium versus general equilibrium General Tax effect Excise Tax effects Long-run effects

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

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

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

Ideas for Improving the Property Tax Improve assessment procedures Personal net worth tax

Intergovernmental Grants Total Grants Grants as % Billions of Of Total Federal of State & Local Year 2010 $ Outlays Spending 1970 88 9.6 17.1 1980 168 12.3 21.9 1990 171 8.8 15.2 2000 309 13.2 19.3 2010 532 14.4 25.4 Source: Computed from Economic Report of the President, 2012 [pp. 320, 415]. Possible explanation for growth: Mismatch Theory

Conditional (Categorical) Grants Matching Grants Consumption (c) per year A E2 c2 E1 c1 G1 G2 B R Units of public good (G) per year

Conditional (Categorical) Grants Matching Closed-Ended Grants Consumption (c) per year A E3 c3 D E1 c1 G1 G3 B R Units of public good (G) per year

Conditional (Categorical) Grants Non-matching Grants Consumption (c) per year J A H E4 c4 E1 c1 G1 G2 B R Units of public good (G) per year

Unconditional Grants Revenue sharing Flypaper Effect Whose indifference curves? Median voter theorem Flypaper effect

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