Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 30 State and Local Government Expenditures F ERNANDO Q UIJANO AND S HELLY T EFFT P R E P A R E D B Y 10.1 Fiscal Federalism in the United States and Abroad 10.2 Optimal Fiscal Federalism 10.3 Redistribution across Communities 10.4 Conclusion

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 2 Redistribution Across Communities There is currently enormous inequality in both the ability of local communities to finance public goods and the extent to which they do so. Should We Care? It depends on the extent to which the Tiebout model describes reality. Tools of Redistribution: Grants If higher levels of government decide to redistribute across lower levels of government, they do so through intergovernmental grants.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 3 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 3 OPTIMAL FISCAL FEDERALISM Public goods provision problem compounded with issues of split levels of government 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 The question of which activities should take place at which level of government.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 4 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 5 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 5 The Tiebout Model A number of activities are run primarily at the state and local levels. Education Public safety Highways Public welfare

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 6 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 6 The Tiebout Model Tiebout (1956) argued that the ability of individuals to move across jurisdictions produces a market-like solution to the local public goods problem. Tiebout 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 7 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 7 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 8 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 8 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

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 9 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 9 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 10 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 11 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 11 Optimal Federalism: what level should provide which services? What is the optimal allocation of economic responsibilities among levels of government in a federal system? Will discuss the advantages and disadvantages of a decentralized system.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 12 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 12 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.”

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 13 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 13 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 14 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 14 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 15 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 15 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.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 16 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.2 Optimal Fiscal Federalism Evidence on the Tiebout Model Resident Similarity across Areas A testable implication of the Tiebout model is that when people have more choice of local community, the tastes for public goods will be more similar among town residents than when people do not have many choices.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 17 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.2 house price capitalization Incorporation into the price of a house the costs (including local property taxes) and benefits (including local public goods) of living in the house. Optimal Fiscal Federalism Evidence on the Tiebout Model Capitalization of Fiscal Differences into House Prices People not only vote with their feet, they also vote with their pocketbook, in the form of house prices.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 18 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 19 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 20 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 21 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 21 Intergovernmental Grants Federal grants important source of revenue to states and localities. Grants from federal and state government are about 34% of total local general revenues.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 22 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 22 Table 1. State and Local Government Finances by Level of Government and by State: (Dollar amounts are in thousands. Coefficients of variation (CV) are expressed as percents. For meaning of abbreviations and symbols, see note below table.) Description Iowa State & local State Local government amount 1 CVamountamount 1 CV Population (July 2004, in thousands)2,953(X)2,953 (X) Revenue 1 22,544, ,363,01510,639, General revenue 1 18,396, ,916,7039,937, Intergovernmental revenue 1 4,304, ,038,2203,723, From Federal Government4,304, ,911,906392, From State government 1 (1)0.0003,331, From local governments 1 (1) ,314(1)0.00 General revenue from own sources14,092, ,878,4836,213, Taxes9,018, ,214,6023,804, Property3,188, ,188,

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 23 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 23 Roles of Intergovernmental Grants Correct for externalities (services or tax costs cross boundaries Redistribution of resources among regions Substituting one tax structure for another Macroeconomic stabilizing tool (fiscal policy)

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 24 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 24 Economic effects of grants Income effects Increasing the resources available for local services Price effects Reducing marginal costs of providing the service

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 25 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.2 Optimal Fiscal Federalism tax-benefit linkages The relationship between the taxes people pay and the government goods and services they get in return.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 26 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Redistribution across Communities Tools of Redistribution: Grants  FIGURE 10-2

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 27 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Matching Grants Redistribution across Communities Tools of Redistribution: Grants matching grant A grant, the amount of which is tied to the amount of spending by the local community.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 28 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Matching Grants Redistribution across Communities Tools of Redistribution: Grants  FIGURE 10-3

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 29 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Block Grant Redistribution across Communities Tools of Redistribution: Grants block grant A grant of some fixed amount with no mandate on how it is to be spent.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 30 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Block Grant Redistribution across Communities Tools of Redistribution: Grants  FIGURE 10-4

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 31 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Conditional Block Grant Redistribution across Communities Tools of Redistribution: Grants conditional block grant A grant of some fixed amount with a mandate that the money be spent in a particular way.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 32 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Conditional Block Grant Redistribution across Communities Tools of Redistribution: Grants  FIGURE 10-5

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 33 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Redistribution across Communities M P I R I C A L E V I D E N C E E THE FLYPAPER EFFECT Hines and Thaler found that the crowd-out of state spending by federal spending is low and often close to zero. Economist Arthur Okun described this as the flypaper effect because “the money sticks where it hits” instead of replacing state spending. As Knight noted, states that get grants are the ones that like spending the most. He also noted that highway grants from the federal government to states are determined by the strength of the state’s political representatives. Knight compared the level of spending in treatment states that see increases in the power of their congressional delegations with the level of spending in control states that see decreases in the power of their congressional delegations. He found that each additional $1 of federal grant money increase due to rising congressional power leads to a $0.90 reduction in the state’s own spending. Additional studies also find evidence inconsistent with the flypaper effect, suggesting that the traditional conclusion of substantial crowd-out from block grants is supported by the evidence.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 34 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Redistribution across Communities Redistribution in Action: School Finance Equalization school finance equalization Laws that mandate redistribution of funds across communities in a state to ensure more equal financing of schools.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 35 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 tax price For school equalization schemes, the amount of revenue a local district would have to raise in order to gain $1 more of spending. Redistribution across Communities The Structure of Equalization Schemes School finance equalization schemes can take very different forms. Some states have systems that attempt to completely or nearly completely equalize spending across school districts. The Effects of Equalization Redistribution in Action: School Finance Equalization

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 36 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.3 Redistribution across Communities School Finance Equalization and Property Tax Limitations in California  APPLICATION  If residents perceived that property taxes were “too high” in California, why did they wait until 1978 to lower them? Proposition 13 was actually a response to a court case that led to school finance equalization in California. The key feature of this decision was that it broke the link between local property taxes and spending on schools. Taxes were no longer a price: they were just taxes. As a result, it was natural for communities to vote to lower taxes, since they did not perceive any benefit from them anymore. Wealthy voters would have opposed Proposition 13 in the absence of the school finance equalization because their high taxes were paying for schooling they desired for their town without subsidizing anyone else’s schooling. Thus, these wealthy taxpayers were happy to approve Proposition 13.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 37 of 30 C H A P T E R 1 0 ■ S T A T E A N D L O C A L G O V E R N M E N T E X P E N D I T U R E S 10.4 Conclusion In every country, the central government collects only part of the total national tax revenues and does only part of the national public spending. When spending is on goods for which local preferences are relatively similar, and where most residents can benefit from those goods, the Tiebout model suggests that the spending should be done locally. When spending is for goods that benefit only a minority of the population, the Tiebout model suggests that it might be difficult to do this spending locally because the majority of people who do not benefit will “vote with their feet” and move elsewhere. Higher levels of government may not believe the conclusions of the idealized Tiebout model, in which case they will want to redistribute across lower levels of government. If the higher-level government decides that it wants to redistribute across lower levels, it can do so through several different types of grants.