CHAPTER 22

PUBLIC FINANCE IN A FEDERAL SYSTEM

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Background

Federal system
Fiscal federalism Centralization

Centralization ratio = Central government expenditures Total government expenditures

22-2

Figure 22.1: Distribution of all US government expenditure by level of government (selected years) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1900 1910 1920 1930 1950 1960 1971 1980 1990 2000 2002
22-3

Local State Federal

Community Formation

Club voluntary association of people who band together to finance and share some benefit
Optimal Club (or community)

22-4

The Tiebout Model

Voting with your feet Tiebouts assumptions

Government activities generate no externalities Individuals are completely mobile People have perfect information with respect to each communitys 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 lawsstatutes that prohibit certain uses of land
22-5

Tiebout and the Real World

Critique of Tiebout
Empirical tests

22-6

Optimal Federalism

Macroeconomic functions
Microeconomic functions

22-7

Disadvantages of a Decentralized System

Efficiency issues

Externalities

local public good

Scale economies in provision of public goods Inefficient tax systems Scale economies in tax collection

Equity issues
22-8

Advantages of a Decentralized System

Tailoring outputs to local taxes

Fostering intergovernmental competition Experimentation and information in locally provided goods and services

22-9

Implications

Purely decentralized systems cannot maximize social welfare

Dealing with community activities that create spillover effects that are not national in scope

Combine communities under a single regional government

Pigouvian taxes and subsidies

Division of responsibility in public good provision Distributional goals and mobility

22-10

Public Education in a Federal System

Local control of schools

Financing education through property taxation Federal role in education

22-11

Property Tax

How the property tax works

Residential Property Tax Rates (selected cities)

City Newark Effective Tax Rate* 2.96%

Assessed value Assessment ratio

Detroit
Atlanta New Orleans Chicago Charlotte New York Los Angeles *Figures are for 2003.

1.82
1.79 1.75 1.69 1.13 1.12 1.08

Source: US Bureau of the Census [2006, p. 301] 22-12

Incidence and Efficiency Effects The Traditional View - Tax on Land

Rent per acre of land SL

LL PsL = P P 00

Price received by landowners falls by amount of the tax

PnL DL DL Acres of land

22-13

Incidence and Efficiency Effects The Traditional View - Tax on Land

Tax capitalized into price of land

Land not fixed in supply

22-14

Incidence and Efficiency Effects The Traditional View - Tax on Structures

Price per structure

PgB

Price paid by tenants increases by full amount of the tax SB

BB PnB = PP 00

PnL DB DB B1 B0 Number of structures 22-15 per year

Summary and Implications of the Traditional View

Progressivity

Land tax Structures tax Measuring income

Empirical evidence

22-16

The New View: Property Tax as a Capital Tax

Partial equilibrium versus general equilibrium

General Tax effect Excise Tax effects

Long-run effects

22-17

Property Tax as a User Fee

The notion of the incidence of the property tax is meaningless

The property tax creates no excess burden

Federal income tax subsidizes consumption of local public services for individuals who itemize Oates [1969]

22-18

Reconciling the Three Views

New view: Eliminating all property taxes and replacing them with a national sales tax
Traditional view: Lowering property tax rate and making up revenue from local sales tax User fee view: Taxes and benefits jointly changed and people are sufficiently mobile

22-19

Why Do People Hate the Property Tax So Much?

Property tax levied on estimated value

Property tax highly visible Property tax perceived as being regressive

Circuit breakers

Property tax easier to attack

22-20

Ideas for Improving the Property Tax

Improve assessment procedures

Personal net worth tax

22-21

Intergovernmental Grants
Relation of federal grants-in-aid to federal and state-local expenditures (selected fiscal years)
Grants as a Percent of Total Federal Outlays 4.61% 9.6% 12.3% 8.9% 13.3% 14.6% Grants as a Percent of State and Local Expenditures 10.0% 17.1% 21.9% 15.2% 19.5% 21.9%

Year 1960 1970 1980 1990 2000 2004

Total Grants (billions of 2004 dollars)* $21 76 146 149 270 348

*Amounts are converted to 2004 dollars using the GDP deflator. Source: Computed from Economic Report of the President [2006, pp. 375, 379]
22-22

Why Have Intergovernmental Grants Grown So Much?

Mismatch theory

22-23

Conditional (Categorical) Grants

Consumption (c) per year

Matching Grants

c2 c1

E2
E1

G1 G2

R Units of public good (G) per year

22-24

Conditional (Categorical) Grants

Consumption (c) per year

Matching Closed-Ended Grants

c3 c1

D E1

E3

G1 G3

R Units of public good (G) per year

22-25

Conditional (Categorical) Grants

Consumption (c) per year

Nonmatching Grants
J A H

c4 c1

E4
E1

G1 G2

R Units of public good (G) per year

22-26

Unconditional Grants

Revenue sharing
Measuring Need

Tax effort

22-27

The Flypaper Effect

Whose indifference curves?

Median voter theorem Flypaper effect

22-28

Intergovernmental Grants for Education

Serrano v Priest [1971]

Foundation aid District power equalization grants

Issues

Educational outcomes Impact of centralized financing on voters support for public education

22-29