PUBLIC FINANCE IN A

FEDERAL SYSTEM
Chapter 22
 Background
• Federal system
• Fiscal federalism
• Centralization
– Centralization ratio =
Central government expenditures
Total government expenditures

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 Distribution of All U.S. Expenditures
by Government Level

Source: Figures for 1900 through 1980 are from Pommerehne [1977]. Figures after 1980 are computed from various editions of the US
Bureau of the Census, Statistical Abstracts of the United States , and from US Bureau of the Census [2012b].

22-3
 Community Formation
• Club – voluntary association of people who
band together to finance and share some
benefit
• Optimal Club (or community)

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 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

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 Tiebout and the Real World
• Critique of Tiebout
• Empirical tests

22-6
 Optimal Federalism
What is the optimal allocation of economic
responsibilities among levels of government?
• Macroeconomic functions
• Microeconomic functions

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 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

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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

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 Public Education in a Federal System
• Local control of schools
• Financing education through property taxation
• Federal role in education

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 Property Tax
Residential Property Tax Rates
• How the property tax (selected cities)
works City Effective Tax Rate (%)
– Assessed value Indianapolis 2.75
– Assessment ratio Detroit 2.11
Jackson 1.70
New Orleans 1.40
Oklahoma City 1.25
Boston 1.06
Seattle 0.79
New York 0.62

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Incidence and Efficiency Effects – The
Traditional View – Tax on Land
Rent per acre

SL
of land

Price received by
landowners falls
by amount of the
PsL = P0L
tax

PnL

DL
DL’

Acres of land
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Incidence and Efficiency Effects – The
Traditional View – Tax on Land
• Tax capitalized into price of land
• Land not fixed in supply

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Incidence and Efficiency Effects – The
Traditional View – Tax on Structures
structure
Price per

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

PnB = P0B SB

PnL

DB
DB’

B1 B0 Number of structures
per year 22-15
 Summary and Implications of the
Traditional View
• Progressivity
– Land tax
– Structures tax
• Empirical evidence
– Measuring income

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 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

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

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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

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Ideas for Improving the Property Tax
• Improve assessment procedures
• Personal net worth tax

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 Intergovernmental Grants
Total Grants Grants as % Grants as %
Billions of Of Total Federal of State & Local
Year 2010 $ Outlays Spending
1970 88 9.6 17.1
1980 168 12.3 21.9
1990 171 8.8 15.2
2000 309 13.2 19.3
2010 532 14.4 25.4
Source: Computed from Economic Report of the President, 2012 [pp. 320, 415].

• Possible explanation for growth: Mismatch Theory

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Conditional (Categorical) Grants
Matching Grants
Consumption (c)
per year

E2
c2
c1 E1

G1 G2 B R
Units of public good (G) per year
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Conditional (Categorical) Grants
Consumption (c)

Matching Closed-Ended Grants

per year

E3
c3 D
c1 E1

G1 G3 B R
Units of public good (G) per year
22-24
Conditional (Categorical) Grants
Consumption (c)

Non-matching Grants
per year

J
A H

E4
c4
c1 E1

G1 G2 B R
Units of public good (G) per year
22-25
 Unconditional Grants
• Revenue sharing
• Flypaper Effect
– Whose indifference curves?
– Median voter theorem
– Flypaper effect

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 Chapter 22 Summary
• In a federal system of government, different governments provide
difference services, although advantages and disadvantages of
centralized government exist
• The club model of community formation indicates that community
size and quantity of public goods depend on tastes
• According to the Tiebout model, a Pareto efficient allocation of
public goods is possible under certain conditions through “voting
with your feet”
• The property tax is an important revenue source for state and local
governments
• Various types of grants from the federal and state government are
other sources of revenue for state and local governments

22-27