1. Public Finance by John E. Anderson Power Point Slides to Accompany:

2. Chapter 18 Multi-level Government Finance

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 Introduction In a federal system of governments, the critical issues are: Assignment of functions to levels of government Assignment of taxes to levels of government

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 Framework for Analysis Wallace Oates defines a federal government as one with: A public sector with both centralized and decentralized levels of decision making in which choices made at each level concerning the provision of public services are determined largely by the demands for those services of the residents of (and perhaps others who carry on activities in) the respective jurisdictions. Oates (1972).

5. Copyright © by Houghton Mifflin Company. All rights reserved.5 Framework for Analysis, [continued] Sub-national, or local, governments have been justified in the U.S. federal system for two primary reasons. First, representative democracy seems to work best the closer the government is to its constituency. The presumption is that a local government will be better at perceiving the desires and demands of constituents for public services better than a distant centralized government.

6. Copyright © by Houghton Mifflin Company. All rights reserved.6 Framework for Analysis, [continued] Second, subsets of people in the country have the right to demand different types and quantities of public goods and services.

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 Framework for Analysis, [continued] George Stigler (a Nobel Prize-winning economist) concludes that these principles imply that. “...decision making should occur at the lowest level of government consistent with the goals of allocational efficiency and distributional equity.”

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 Framework for Analysis, [continued] Stigler’s principle was formalized and became the foundation for thinking about fiscal federalism when Wallace Oates defined the concept of perfect correspondence. He defined the optimal form of a federal system of governments for providing a set of public goods as one in which there is a level of government for each subset of the population over which the consumption of a public good is defined.

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Decentralization Theorem For a public good--the consumption of which is defined over geographical subsets of the total population, and for which the costs of providing each level of output of the good in each jurisdiction are the same for the central or the respective local government--it will always be more efficient (or at least as efficient) for local governments to provide the Pareto-efficient levels of output for their respective jurisdictions than for the central government to provide any specified and uniform level of output across all jurisdictions (Wallace Oates).

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 Figure 18.1: Decentralization Theorem Example

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 Measurement of Decentralization Decentralization ratio: proportion of government revenues or expenditures made by sub-national governments. Figure 2 illustrates World Bank estimates of decentralization for transition countries.

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 Figure 18.2: World Bank Measures of Decentralization for Transition Countries 7 Source: IMF, Government Finance Statistics, 2001. Reprinted by permission of International Monetary Fund.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13 Expenditure and Tax Assignment Expenditure assignment: State and local governments should be given responsibilities to provide public goods/services consistent with the Decentralization Theorem. Tax assignment: State and local governments should tax in ways consistent with the public goods/services roles they have been given. A combination of user charges, benefit taxes, and general taxes can be used.

14. Copyright © by Houghton Mifflin Company. All rights reserved.14 Income Tax Coordination If several units of government in a federal system use the income tax, those tax bases should be coordinated. Each government should tax on the basis of income minus the ability-based taxes of the other unit of government (George Break).

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17. Copyright © by Houghton Mifflin Company. All rights reserved.17 Grants Grants are transfer funding mechanisms used in a federal system of governments. The higher level of government sends money to the lower level of government using a grant mechanism.

18. Copyright © by Houghton Mifflin Company. All rights reserved.18

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 Figure 18.3: Non-Categorical Grant

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 Figure 18.4: Categorical Grant

21. Copyright © by Houghton Mifflin Company. All rights reserved.21 Figure 18.5: Flypaper Effect of a Categorical Grant

22. Copyright © by Houghton Mifflin Company. All rights reserved.22 Figure 18.6: Matching Grant

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Figure 18.7: Closed-Ended Matching Grant

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Mandates A mandate is a public good/service requirement imposed by a higher level of government on a lower level of government in a federal system. The key issue is that the higher level of government imposes a requirement on the lower level of government, without necessarily providing funding.

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Figure 18.8: State Mandate Requires County Elections Board to Increase Elections Services

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27. Copyright © by Houghton Mifflin Company. All rights reserved.27 Fiscal Disparities What are fiscal disparities? Should fiscal disparities be removed? Intergovernmental aid mechanisms. Education aid examples.

28. Copyright © by Houghton Mifflin Company. All rights reserved.28 Two Main Methods of Equalization Foundation aid approach: places emphasis on enabling local governments to provide a foundation level of spending. Power equalization approach: places emphasis on enabling local governments to raise the same revenue from a given tax rate.

29. Copyright © by Houghton Mifflin Company. All rights reserved.29 Foundation Aid A foundation aid program provides grants in aid following the formula: A j = F - t*V j, if t*V j < F. A j = 0, otherwise. Where F is the foundation level of spending, V j is the per-resident property value, and t* is the rate rate applied to each community’s tax base to determine its contribution to financing the foundation spending level for all communities.

30. Copyright © by Houghton Mifflin Company. All rights reserved.30 Power Equalization Aid A power equalization aid formula is given by: A j = t j (V*-V j ), if V j < V*. A j = 0, otherwise. Where V* is the per-resident tax base in the reference jurisdiction (perhaps the jurisdiction with the largest V j ), t j is the actual tax rate in jurisdiction j, V j is the actual property value per resident in district j.

31. Copyright © by Houghton Mifflin Company. All rights reserved.31 Power Equalization Aid, [continued] The tax rate applied in a jurisdiction will depend on its spending level E j. The tax rate will be t j = E j /V j. Substituting this expression into the aid formula gives: A j = E j (1-V j /V*), if V j < V*. A j = 0, otherwise.

32. Copyright © by Houghton Mifflin Company. All rights reserved.32 Power Equalization Aid, [continued] The power equalization aid program works like a matching grant with the matching rate 1-V j /V*. For example, if a school district has a property tax base that is 80% of the reference district amount, it receives a grant with a match rate of 20%. For each dollar it spends on education per pupil, it receives 20 cents in aid from the state.

33. Copyright © by Houghton Mifflin Company. All rights reserved.33 Comparing Aid Programs A fundamental difference between foundation aid and power equalization aid programs: Foundation aid programs provide aid based on a foundation level of expenditure chosen by policy makers at a higher level of government. Equalization aid programs provide aid based on the level of expenditure chosen my the local jurisdiction.

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 Wisconsin District Power Equalization The State of Wisconsin uses a district power equalization method of distributing state aid to public schools. Example: suppose the property tax base in Badgertown is $150,000 per pupil and the district applies a tax rate of 30 mills, or 3%. At this rate of taxation, Badgertown spends $4,500 per pupil per year.

35. Copyright © by Houghton Mifflin Company. All rights reserved.35 Wisconsin District Power Equalization, [continued] Now, the State of Wisconsin introduces a power equalization formula for aid. School districts now have a guaranteed tax base of $300,000 per pupil. If Badgertown keeps the same level of expenditure ($4,500 per pupil) it can reduce its tax rate to 15 mills, or 1.5%. The aid formula acts as a matching grant with a match rate of 0.5.

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Iowa Foundation Aid Formula The State of Iowa uses a foundation aid formula where aid is allocated as : A j = F - 0.0054 V j. where A j is aid to district j, and V j is per pupil property value. The foundation property tax rate is 5.4 mills, or.54%.

37. Copyright © by Houghton Mifflin Company. All rights reserved.37 Iowa Foundation Aid Formula, [continued] The foundation aid program is designed to fill the gap between the revenue yielded at that rate in district j and the foundation level of spending. Suppose that the state sets the foundation level at F = $5,000. A district with property value V j = $200,000 would receive a grant of $3,920 per pupil. A district with V j = $500,000 would receive a grant of $2,300 per pupil.

38. Copyright © by Houghton Mifflin Company. All rights reserved.38 Iowa Foundation Aid Formula, [continued] Districts with more than $926,000 in tax base per pupil ($5,00/0.0054) would receive no grant from the state. These districts are said to be “out of formula.”