Chapter 10: State and Local Public Finance Chapter 10 State and Local Public Finance Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter 10: State and Local Public Finance Optimal Federalism when household incomes are similar Optimal Federalism when household incomes differ The property tax Grants from a higher government to lower governments Introduction

Chapter 10: State and Local Public Finance State and Local Public Finance Figure 10.1 State/local revenues (% of total revenue) Source: Bureau of Economic Analysis NIPA tables: Table Federal Grants, 11% Property Tax, 21% Federal Grants, 20% Other, 21% Income Tax, 15% 2006

Chapter 10: State and Local Public Finance State and Local Public Finance Figure 10.1 State/local spending (% of total spending) Source: Bureau of Economic Analysis NIPA tables: Table Social Services, 9% Public Order and Safety, 10% Social Services, 7%

Chapter 10: State and Local Public Finance The assignment of some government spending programs and taxes to federal, state, and local governments Federalism Optimal Federalism The assignment of spending and taxes that best promotes the well being of the citizenry State and Local Public Finance How do we determine optimal federalism?

Chapter 10: State and Local Public Finance Satisfies the preferences of residents Local governments compete to attract and retain citizens by offering varying packages of goods. This competitive process: Promotes the efficient provision of public services Optimal Federalism when Household Incomes are Similar Promotes innovation and experimentation by local governments The Tiebout process creates capitalization. The Tiebout Process

Chapter 10: State and Local Public Finance Local governments may levy taxes that do not – or at least appear not to – burden local residents. Tax exporting Race to the bottom The Tiebout Process To attract firms and jobs, business taxes may be cut below other local governments Tax competition

Chapter 10: State and Local Public Finance Competition among local governments would not produce optimal outcomes in two cases: Second, when there are economies of scale State Government for Local Externalities or Scale Economies First, when there are externalities State government can improve outcomes through intervening in two ways: Second, by giving a categorical matching grant to local governments First, by providing the service itself

Chapter 10: State and Local Public Finance Residential location when incomes differ: the separation process The non-affluent try to follow Optimal Federalism when Household Incomes Differ The affluent try to move away from the non-affluent The Tiebout process and the separation process operate simultaneously. The affluent use zoning laws to maintain their separation

Chapter 10: State and Local Public Finance Should a city government try to tax suburbanites? Source-based taxation Optimal Federalism when Household Incomes Differ City governments can tax suburbanites, but should they? Should a city tax economic activity that occurs in the city? A progressive tax may be counter-productive Should a city set a high tax rate on affluent residents? Residence-based taxation

Chapter 10: State and Local Public Finance State redistribution to cities that benefits high-income suburbanites Agglomeration economies The Role of State Government when People Separate by Income Suburbanites benefit from the city State redistribution that benefits low-income city residents Adopt policies that promote efficiency then compensate those who lose with redistribution A strategy: efficiency plus redistribution City residents benefit from tax revenue transferred to the city

Chapter 10: State and Local Public Finance …is the most important source of revenue for local governments. The Property Tax Each property has an assessed value, and the property owner pays a flat percentage of the assessed value. The mechanics of the property tax Property value growth compared to income growth The distribution of a residential property tax across households The combination of assessed value and tax rate matters to property owners. Life cycle

Chapter 10: State and Local Public Finance Who Bears the Burden of the Residential Property Tax? A property tax shifts the demand curve down The burden is split between the builders and owners and the home buyers D’ $210,000 The traditional approach P D S Homes $250,000 Figure 10.2A $50,000

Chapter 10: State and Local Public Finance D’ $240,000 The burden of the tax depends on relative elasticities Property taxes are partially capitalized into the price of the home Who Bears the Burden of the Residential Property Tax? P D S Homes Figure 10.2B $250,000 The traditional approach $50,000

Chapter 10: State and Local Public Finance The property owner benefits from the public services that the tax finances Benefits from the property taxes are partially capitalized into the price of the home Who Bears the Burden of the Residential Property Tax? The benefit approach The capital approach A property tax is a tax on wealth accumulation Economists agree that there is merit to all three approaches!

Chapter 10: State and Local Public Finance Do Renters Bear a Burden from the Property Tax? $1,050 S’ A property tax would shift the supply curve up The burden is split between the owners and the renters P D S Apartments Figure 10.3A $1,000 The traditional approach $200

Chapter 10: State and Local Public Finance Do Renters Bear a Burden from the Property Tax? $1,150 $200 The burden of the tax depends on relative elasticities P D S Apartments Figure 10.3B $1,000 The traditional approach S’ The benefit approach would predict that the D curve would shift up

Chapter 10: State and Local Public Finance Land has property value The supply of land is inelastic The Burden of a Property Tax on Land The burden of the tax depends upon the elasticity of demand Consumers, workers, and business owners bear the burden of a property tax on business firms The Burden of a Property Tax on Business Firms

Chapter 10: State and Local Public Finance Burden on retirees The Property Tax Does not discourage economic activity Generates predictable revenue Arguments for the residential property tax Criticisms of the residential property tax Paid only once or twice a year, cash-flow problem Easy to administer Benefits vary directly with the value of the property Property value reflects ability-to-pay Unique tax helps residents keep track Based on a rough estimate of the property’s value

Chapter 10: State and Local Public Finance Grants from a Higher Government to Lower Governments Three main rationales for grants from higher to lower governments: Purpose of grants the existence of a positive externality achieving a goal of the higher government redistribution Open-ended categorical matching grant Different grants for different purposes Unconditional block grant Closed-ended categorical matching grant Incremental matching grant

Chapter 10: State and Local Public Finance Optimal Federalism when household incomes are similar Optimal Federalism when household incomes differ The property tax Grants from a higher government to lower governments Summary

Chapter 10: State and Local Public Finance What schools do Elementary and secondary education Higher education Preview of Chapter 11: Education