Chapter 19 Fiscal Federalism Intermediate Public Economics

Arguments for multi-level government Fiscal federalism is the division of revenue collection and expenditure responsibilities between different levels of government. Arguments for multi-level government Information of local preferences; Provision equally by a national government may sacrifice efficiency; Tiebout hypothesis: heterogeneous preferences. Distributive arguments: equalization.

The costs of uniformity

Figure 19.1 The costs of uniformity

Conclusion

Optimal structure: Efficiency versus Stability Trade off: scale economies against diversity of preference. A simple model: Assume a line segment [0,1], with points on the line representing different geographical locations. The public good can be located anywhere along the line and each individuals is characterized by their ideal location for the public good. And individuals are uniformly distributed. Compare centralized and decentralized.

Figure 19.2: Centralization and decentralization

Compare

Compare: majority voting

Conclusion

Accountability A government is “accountable” if voters can discern whether it is action in their interest and sanction them appropriately if they are not, so that incumbents anticipate that they will have to render accounts for their past action. Problem: information problem-agency problem.

Political accountability and voter welfare The payoff matrix: the first number in each cell is the government payoff and the second number is voters welfare. If the government is re-elected it gets the extra value V>r.

Quandary The government knows the prevailing conditions but all that citizens observe is their current welfare. Quandary If the voters set the standard for re-election too high,say at 3, then the incumbent has the incentive to obtain the rent r and leave office; If the voters set the standard lower, say at 1, the incumbent will be able to divert rent when conditions happen to be good and be re-elected by giving voters less than what they could obtain.

Decentralization

Political perspective Federalism Authoritarianism

A fundamental political dilemma A fundamental dilemma faces a government attempting to build and protect markets: It must be strong enough to enforce the legal rights and rules necessary to maintain the economy; It must be strong enough to commit itself credibly to honoring such rules. (Montinola et al.,1995)

Market-preserving federalism F1: A hierarchy of government with a delineated scope of authority exists so that each government is autonomous within its own sphere of authority; F2: The subnational governments have primary authority over the economy within their jurisdictions; F3: The national government has the authority to police the common market and to ensure the mobility of goods and factors across subgovernment jurisdictions;

Market-preserving federalism F4: Revenue sharing among governments is limited and borrowing by governments is constrained so that all governments face hard budget constraints; F5: The allocation of authority and responsibility has an institutionalized degree of durability so that it cannot be altered by the national government either unilaterally or under the pressures from subnational governments. (Montinola et al.,1995)

Market- preserving authoritarianism M1: Subject to changing international and domestic constraints, in particular competitive pressures, senior leaders (or the dominant party) perceive that it is in their interests to preserve the market to facilitate catching-up; M2: Senior leaders (or the dominant party) are able to make their policy on market-based catching-up more credible by imposing self-constraints through allocating sufficient autonomy (including authority, information, and resources) to a large set of political and, more importantly, economic decision makers in an institutionalized way;

Market- preserving authoritarianism M3: Senior leaders (or the dominant party) are able to control agency problems of bureaucrats, businessmen, as well as other politicians by imposing constraints on them through designing and fostering institutions such as incentive schemes, checks, coordination and enforcement devices, and to balance autonomy and control. (Shuhe Li et al.,1999)

Decentralization Decentralization of information and authority and interjurisdictional competition, can provide a more credible commitment to secure economic rights and preserve markets. (Yingyi Qian et al.,1997)

Self-enforcing federalism The twin dilemmas of federalism Dilemma 1: What prevents the national government from destroying federalism by overawing its constituent units? Dilemma 2: What prevents the constituent units from undermining federalism by free riding and other forms of failure to cooperate? (De Figueiredo et al.,2005)

A model of Bottom-Up Federalism Trade-off: mechanisms to mitigate one dilemma typically exacerbate the other.

Institutional GameRepeated Game BASIC FEATURES Choose constitution Set of trigger points for disciplining center Definition of “institutional power ” of center KEY QUESTIONS What triggers chosen? How strong is center? BASIC FEATURES Federalism ongoing, repeated States choose to contribute, shirk or exit Center determines how much to provide for public goods and how to enforce penalties KEY QUESTIONS Can federalism be an equilibrium? What factors determine set of equilibrium federations?

Conclusion For a federation to overcome the shirking problem, the center must have sufficient monitoring resources and penalizing capacity to punish shirkers; To police the center’s tendency to overawe the states, states must coordinate on punishment strategies, perhaps chosen at the constitutional or design stage of a federation. Appropriately designed punishment strategies limit the center’s ability to extract resources from the states, increase the provision of public goods, and result in higher public welfare;

Conclusion Exit costs shift rents to the center; In choosing the optimal amount of institutional power granted to the center, designers can effectively resolve the two dilemmas. (De Figueiredo et al.,2005)

A top-down federation The threat of separation: the possibility of secession has been a powerful force to limit the ability of the central government to exploit peripheral minorities of voters for the sake of the majority of the population. The threat of secession of rich regions; Asymmetry fiscal federalism.