Chapter 6 State and Local Government Expenditures Public Finance and Public Policy

Introduction Optimal fiscal federalism is the question of which activities should take place at which level of government. For example, welfare programs were historically financed at the federal and state level, while education is largely financed at the state and local level.

FISCAL FEDERALISM IN THE U.S. AND ABROAD Early in the history of the United States, the federal government played a relatively limited role. The last amendment of the Bill of Rights of the United States Constitution states: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the states, are reserved to the states respectively, or to the people.” Figure 1 shows the spending patterns over time.

Figure 1 In 1902, the federal government accounted for only 34% of total government spending; local governments accounted for 58%. State and local governments were responsible for education, police, roads, sanitation, welfare, health, hospitals, and so on. Federal government was responsible for national defense, foreign relations, judicial functions, and the postal service. The role of the federal government grew with the introduction of the federal income tax and the New Deal programs of the Great Depression. The share of state financing coming from the federal government has grown because of joint program like cash welfare and Medicaid.

FISCAL FEDERALISM IN THE U.S. AND ABROAD The largest element of state and local spending is education, followed by health care and public safety. For federal spending, the largest elements are health care, Social Security, and national defense.

Spending and Revenue of State and Local Governments The major source of revenue at the state and local level is the property tax, the tax on land and any building on it. Property taxes raised $253 billion in revenue in 2001, and accounted for almost one-half of the non-grant revenues of local governments.

Fiscal Federalism Abroad The U.S. sub-national governments collect a much larger share of total government revenue than in other countries, and spend a somewhat larger share of total government spending. Table 1 shows this.

On the spending side, the differences are slightly less dramatic. Table 1 Subnational government spending/revenue as a share of total government spending/revenue Spending % Revenue % Greece 5.0 3.7 Portugal 12.8 8.3 France 18.6 13.1 Norway 38.8 20.3 United States 40.0 40.4 Denmark 57.8 34.6 OECD Average 32.2 21.9 On the spending side, the differences are slightly less dramatic. The average state/local government collects 22% of total government revenue, while those in the U.S. collect 40%.

Fiscal Federalism Abroad The higher level of centralization in other nations exists because state/local governments have almost no legal power to tax citizens. Many countries practice fiscal equalization, whereby the national government distributes grants to sub-national government in an effort to equalize differences in wealth.

Fiscal Federalism Abroad There has been a move toward decentralization around the world. In the U.S., there have been increased efforts to shift control and financing of public programs to the states, such as with welfare reform in 1996.

OPTIMAL FISCAL FEDERALISM What is the optimal division of responsibilities across different levels of government? A theory of how the efficiency of public goods provision may differ at different levels of government helps answer this questions.

OPTIMAL FISCAL FEDERALISM Two of the major problems in public goods provision are: Preference revelation: Difficult to design democratic institutions to cause individuals to reveal their preferences honestly. Preference aggregation: Difficult to aggregate individual preferences into a social decision.

The Tiebout Model Tiebout (1956) showed that the inefficiency in public goods provision came from two missing factors: shopping and competition. Shopping induces efficiency in private markets. Competition induces the right prices and quantities in private markets.

The Tiebout Model With public goods provided at the local level, competition naturally arises because individuals can vote with their feet by moving to another town without much disruption. This induces fiscal discipline for local governments and creates a new preference revelation device: mobility. Tiebout argued that the threat of exit can induce efficiency in local public goods production. Under certain (unrealistic) conditions public goods provision will be fully efficient at the local level.

The Tiebout Model Tiebout’s formal model assumes the following: Large number of individuals, who divide themselves up across towns that provide different levels of public goods. Town i has Ni residents who all demand Gi of the public good. Uniform tax of Gi/Ni.

The Tiebout Model Tiebout’s model solves two problems: Preference revelation: There is no incentive to lie. With a uniform tax on all residents, the consumer saves 1/Ni in tax but receives 1/Ni less of the public good. Preference aggregation is solved because everyone in the town wants the same level of public goods, Gi.

Problems with the Tiebout Model There are a number of problems with the model, however, related to: Tiebout competition Tiebout financing Spillovers

Problems with the Tiebout Model Tiebout competition may not hold because: It requires perfect mobility. It requires perfect information on the benefits individuals receive and the taxes they pay. It requires enough choice of towns so that individuals can find the right levels of public goods.

Problems with the Tiebout Model Tiebout financing is problematic because: It requires lump-sum taxes that are independent of a person’s income. This is viewed as highly inequitable. It is more common for towns to finance public goods through proportional taxes on homes, leading to the problem of the poor chasing the rich. The use of zoning can ameliorate this problem.

Problems with the Tiebout Model Zoning regulations protect the tax base of wealthy towns by pricing lower income individuals out of the housing market. For example, a town that prohibits multifamily dwelling such as apartments lowers the available amount of housing, and thus inflates the value of existing housing, keeping the poor out.

Problems with the Tiebout Model Tiebout model is also problematic because of the assumption of no externalities or spillovers: Model assumes public goods only have effects in a given town, and that they do not spill over to neighboring towns. Some public goods, like a public park, probably violate this assumption.

Evidence on the Tiebout Model Even given the problems of the Tiebout model the basic intuition that individuals vote with their feet is still a strong one. Two types of tests reveal this: Resident similarity Capitalization

Evidence on the Tiebout Model A clear prediction of the Tiebout model is that residents in a local community will have similar preferences for local public goods. The more local communities and choices, the more residents can sort themselves into similar groupings. Gramlich and Rubenfeld (1982) found greater sorting in larger metropolitan areas (where mobility costs would be smaller), and greater satisfaction with public goods provision.

Evidence on the Tiebout Model Very little actual mobility is required for the Tiebout mechanism to operate because people not only vote with their feet. They also vote with their pocketbook. Tiebout model predicts that any differences in fiscal attractiveness will be capitalized into house prices.

Evidence on the Tiebout Model That is, the price of any house reflects the costs (including local property taxes) and benefits (including local public goods) of living there. Holding taxes constant, higher levels of public goods raise housing prices. Hold public good levels constant, raising taxes lowers housing prices. Housing prices are a reflection of people voting with their pocketbook.

Evidence for capitalization from California’s Proposition 13 Empirical Evidence Proposition 13 was a voter initiative passed in 1978 that limited the ability of localities to levy property taxes. It limited the tax rate to 1% of a home’s assessed value. More importantly, it limited the tax base–the house’s value. The base could increase by only 2% per year, unless the home was sold. A typical Los Angeles home saw its property tax increase 80% in the four years prior to Proposition 13.

Evidence for capitalization from California’s Proposition 13 Empirical Evidence Rosen (1982) studied 60 municipalities in the San Francisco area, before and after Proposition 13. The treatment group were the towns with high property tax rates prior to Proposition 13. The control group were the towns with low property tax rates. Using this approach, Rosen found that for every $1 of property tax reduction house values increased by about $7, which implies close to full capitalization. The fact that house prices rose by almost the present discounted value of the taxes suggests that Californians did not think that they would lose many valuable public goods and services when taxes fell.

Evidence for capitalization from California’s Proposition 13 Empirical Evidence In reality, many localities were forced to drastically cut services. San Jose, California laid off art and music teachers in elementary schools, cut bus transportation, fired school nurses and guidance counselors, and shortened the school day from 6 to 5 periods. Even so, in 1983, the school district became the first American public school system in 40 years to declare bankruptcy.

Optimal Fiscal Federalism What are the normative implications of the Tiebout model? That is, what should be the principles that guide the provision of public goods at different levels of government? The extent to which public goods should be provided at the local level is determined by: Tax-benefit linkages Positive externalities or spillovers Economies of scale

Optimal Fiscal Federalism First, the model implies that the extent to which public goods should be provided at the local level is determined by tax-benefit linkages. Strong linkages (such as local roads) means most residents benefit, and the good should be provided locally. Weak linkages (such as welfare payments) means that most residents do not benefit, and the good should be provided at a higher level. If residents can see directly the benefits they are buying with their property tax dollars, they will be willing to pay local taxes. Otherwise, they may “vote with their feet.”

Optimal Fiscal Federalism The second factor that determines the optimal level of decentralization is the extent of positive externalities. If the local public good has spillovers to other communities, they will be underprovided. In this case, higher levels of government have a role in promoting the provision of these public goods.

Optimal Fiscal Federalism The third factor that determines the optimal level of decentralization is the economies of scale in production. Public goods with large economies of scale, like national defense, are not efficiently provided by many competing local jurisdictions. Public goods without large economies of scale, like police protection, may be provided more efficiently in Tiebout competition.

Optimal Fiscal Federalism The Tiebout model therefore predicts that local spending should focus on broad-based programs with few externalities and relatively low economies of scale. Examples include road repair, education, garbage collection, and street cleaning.

REDISTRIBUTION ACROSS COMMUNITIES The Tiebout model allows us to consider one of the most important problems in fiscal federalism: Should there be redistribution of public funds across communities? There is currently enormous inequality in the ability and perhaps desire for communities to finance public goods. Gaps in per-pupil spending arise because of differences in the local property tax rate, but more importantly, from differences in property values.

Should We Care? The question then becomes should higher levels of government mandate redistribution across lower levels to offset these differences in spending? In a perfect Tiebout world, communities would have formed for the efficient level of public goods, and redistribution would impede that efficiency.

Should We Care? To the extent that Tiebout does not perfectly describe reality, however, there are two arguments for redistribution. The first is failures of the Tiebout mechanism. For example, even if one desires to be in a high benefit community, a household may be priced out of it by zoning restrictions, etc. The second is externalities. It is possible that local public goods, like education, have spillovers to other communities.

Tools of Redistribution: Grants When higher levels of government redistribute, they do so through grants–cash transfers from one level of government to another. Between 1960 and 2003, grants to lower levels of government grew from 7.6% to 17.9% of federal spending.

Tools of Redistribution: Grants Higher levels of government tend to use three types of grants: Matching grants–which ties the amount of funds transferred to the community to the amount of spending it currently allocates to public goods. Block grants–a fixed amount of money with no mandate on how it is to be spent. Conditional block grants–a fixed amount of money with a mandate that it be spent in a particular way. The consequences of these grants are illustrated in Figure 2.

The city could still choose to consume $750,000 of education. Private spending (in thousands) Such a grant acts as an income effect, but keeps the price ratio at 1 rather than ½. Imagine instead that the city was given an identical amount – $375,000 – in a block grant. $1,375 Initially, the city faces a tradeoff between education and private goods. The price ratio is 1. Such a grant might mandate that the city can spend receive up to $375,000 if it is spent on education. A one-for-one “matching grant” changes the price of education and the price ratio to ½. A final alternative is a conditional block grant, a fixed amount of money that can only be spent on education. As long as the city is already spending more than $375,000 on education, it is equivalent to a block grant and has no effect on behavior. But the block grant also allows other choices, and utility is higher at IC3, which entails less education. With this lower price for education, the income and substitution effects lead to an increase in educational spending. The city pays only half of the $750,000 cost, however. The state pays the remainder, $375,000. Total spending on both education and private goods has increased with the matching grant. $1,000 The city could still choose to consume $750,000 of education. $800 The voters in the city have preferences over public and private goods. They choose $500,000 of education. $625 $500 IC3 IC2 IC1 $0 $375 $500 $575 $750 $1,000 $1,375 $2,000 Education spending (in thousands) Figure 2 The effects of different government grants

The flypaper effect Empirical Evidence As shown in Figure 2, block grants are simply income increases to communities if they are either unconditional or conditional but below the city’s desired spending on the public good. The city should therefore reduce its own spending, a type of crowding out, so that spending on the public good goes up by only a fraction of the total grant amount.

The flypaper effect Empirical Evidence Researchers have compared the spending of states that receive larger and smaller grants from the federal government, to assess whether they largely crowd out state spending, as the theory predicts. Surprisingly, after reviewing the evidence Hines and Thaler (1995) found that crowd out is often close to zero, so total spending rises almost one-for-one.

The flypaper effect Empirical Evidence This finding has been described as the flypaper effect, because “money sticks where it hits.” These older empirical studies suffer from potential bias, however. States that value public goods the most may be the most successful at lobbying for federal grants. Thus, the positive correlation is not because of the flypaper effect, but rather spending preferences differ.

The flypaper effect Empirical Evidence A number of recent studies, that use more convincing quasi-experimental approaches find evidence that is inconsistent with the flypaper effect. These studies suggest that the traditional conclusion of substantial crowd-out from block grants is supported by the evidence.

Redistribution in Action: School Finance Equalization School finance equalization laws mandate redistribution across communities in a state to ensure more equal financing of schools. Local districts receive about 45% of the funding from local sources, primarily from local property taxes. This dependence can lead to vast disparities due to the wide variation in property values across towns. In Texas, for example, per-pupil spending varies by more than a factor of four from the lowest to highest district.

Redistribution in Action: School Finance Equalization Since 1970, every state has made at least one attempt at school finance equalization, some prompted by state courts, others by the voting public.

Redistribution in Action: School Finance Equalization The structure of these equalizations have taken very different forms, some very extreme. California, for example, imposes a 100% tax rate on localities that raise per-pupil spending more than $200 above the lowest district. On the other hand, New Jersey gives matching grants to localities with property values below the 85th percentile.

Redistribution in Action: School Finance Equalization Empirical work suggests that equalization laws have had the intended effect of: Equalizing spending across districts. Equalizing student outcomes like SAT scores.

Redistribution in Action: School Finance Equalization However, equalization schemes have also had perverse effects. Hoxby (2001) computed the tax price of school equalization, the total amount of revenue a local district would have to raise in order to get another $1 of spending. In California, the tax price is infinite. In New Jersey, the tax price is closer to $0.6, because of the matching grants.

Redistribution in Action: School Finance Equalization Hoxby found that extreme equalization schemes with very high tax prices lead to an overall reduction in per-pupil spending. California’s extreme equalization caused a 15% reduction in per-pupil spending. Oklahoma, Utah, and Arizona’s per-pupil spending fell by more than 10%. The equalization came at a cost–a “leveling down” of spending, leading to a deterioration in the quality of public schools and a flight toward private schools.

Redistribution in Action: School Finance Equalization Hoxby also found that equalization schemes with low tax prices raised performance; states like New Jersey, New York, and Pennsylvania were able to “level up” the playing field. The lesson is therefore that school finance equalization can improve outcomes in low-wealth districts, but only if they do not excessively penalize higher-wealth districts.

School finance equalization and property tax limitations in California Application Another interesting consequence of extreme school finance equalizations is examined by Fischel (1989). He asked why California residents passed Proposition 13, limiting property taxes, in 1978 rather than in earlier referenda in 1968 and 1972?

School finance equalization and property tax limitations in California Application The answer may lie in California’s 1974 school finance equalization court case, known as Serrano vs. Priest. This is the case that broke the Tiebout mechanism in California by severing the linkage between taxes paid and benefits received.

School finance equalization and property tax limitations in California Application Wealthy voters in California would have opposed Proposition 13 in the absence of school finance equalization, because their high taxes were paying for schooling they desired for their town without subsidizing anyone else’s school. School finance equalization in California changed this, so the wealthy taxpayers were happy to approve Proposition 13.

Recap of State and Local Government Expenditures Fiscal Federalism in the U.S. and Abroad Optimal Fiscal Federalism Redistribution Across Communities