Chapter 19 Fiscal Federalism

Intermediate Public Economics

Arguments for multi-level government

Fiscal federalism is the division of revenue collection and expenditure responsibilities between different levels of government.

Arguments for multi-level government Information of local preferences; Provision equally by a national government may

sacrifice efficiency; Tiebout hypothesis: heterogeneous preferences. Distributive arguments: equalization.

The costs of uniformity

Two groups A and B, who have different tastes. And the number of

consumers in the two groups are , ;

A single public good is financed by the use of an income tax rate, ;

The utilit

Assume:

A Bn n

t

y of a typical consumer of group i is :

([1 ] , ), ,

Then

( ) ([1 ] , ).

i i

A A B B

i i iA A B B

u t y G i A B

G n ty n ty

Gu G u y G

n y n y

Figure 19.1 The costs of uniformity

Assume that group have a relatively stronger preference for

the public good than group .

B

A

Conclusion

0 0

0 0

The loss of welfare to society is :

[ ( ) ( )] [ ( ) ( )]

First order condition:

( ) ( )

The value of the loss can be minimized by setting the lo

A A A A B B B B

A A B B

L n u G u G n u G u G

n u G n u G

0

0

0

cation of

so that the marginal benefit for group of having more public

good, ( ) 0, just offsets the marginal loss of group ,

( ) 0; but the essential point is that the loss remains pB B

A A

G B

n u G A

n u G

ositive.

Furthermore, the loss increases the more widely dispersed are

preferences and the more members thre are of each group.

Optimal structure:Efficiency versus Stability Trade off: scale economies against diversity

of preference. A simple model:

Assume a line segment [0,1], with points on the line representing different geographical locations. The public good can be located anywhere along the line and each individuals is characterized by their ideal location for the public good. And individuals are uniformly distributed.

Compare centralized and decentralized.

Figure 19.2: Centralization and decentralization

Compare

The utility function of each individual is under centralization:

1 (1 )

2

and under decentralization

1 (1 ) 2 for [0,1/ 2]

4

3 = (1 ) 2 for [1/

4

ci

di

i

u i C

u i C i

i C i

2,1]

Compare

Under centralized provision, the average distance from 1/2 is 1/4;

Decentralization brings the average distance in either region down

to 1/8.

Therefore decentralizaiton is the optimal solution if and only

if (1/ 4 1/ 8) / 8.

: / 8.Porposition 2

C

Decentralization is optimal if and only if C

Compare: majority voting

There will be a majortity in favour of decentralization in the left-region

if the decisive individual 1/ 4 prefers decentralization, that is if

1 1 1 1 (1 ) (1 ) 2

2 4 4 4

c di i

i

u C u C

/ 4

:

/ 4.

Proposition

C

Decentralization is a majority voting equilibrium if and

only if C

Conclusion

Under majority voting there is decentralization:

voters who are located at the extreme have an incentive to support

decentralized provision to get a public good closer to what they

want,

too much

but the democratic process does not internalize the negative

externalities imposed on voters located in the center.

Accountability

A government is “accountable” if voters can discern whether it is action in their interest and sanction them appropriately if they are not, so that incumbents anticipate that they will have to render accounts for their past action.

Problem: information problem-agency problem.

Political accountability and voter welfare

The payoff matrix: the first number in each cell is the government payoff and the second number is voters welfare. If the government is re-elected it gets the extra value V>r.

Quandary

The government knows the prevailing conditions but all that citizens observe is their current welfare.

Quandary If the voters set the standard for re-election too

high ,say at 3, then the incumbent has the incentive to obtain the rent r and leave office;

If the voters set the standard lower, say at 1, the incumbent will be able to divert rent when conditions happen to be good and be re-elected by giving voters less than what they could obtain.

Decentralization

Brennan and Buchanan (1980) view is that decentralization is an

effective mechanism to control governments' expansive tendencies:

competition among different decentralized governments can exercise

a .

Comparing the performance in office among different incumbents

facing similar circumstances helps in sorting good types from bad types

as well as controlling the quality of their

disciplinary force

decisions. Hence one voters

against an incumbent if his performance is bad relative to others, in order

to induce each incumbent to behave in the public interest.

Political perspective

Federalism

Authoritarianism

A fundamental political dilemma

A fundamental dilemma faces a government attempting to build and protect markets: It must be strong enough to enforce the legal ri

ghts and rules necessary to maintain the economy;

It must be strong enough to commit itself credibly to honoring such rules.

(Montinola et al.,1995)

Market-preserving federalism

F1: A hierarchy of government with a delineated scope of authority exists so that each government is autonomous within its own sphere of authority;

F2: The subnational governments have primary authority over the economy within their jurisdictions;

F3: The national government has the authority to police the common market and to ensure the mobility of goods and factors across subgovernment jurisdictions;

Market-preserving federalism

F4: Revenue sharing among governments is limited and borrowing by governments is constrained so that all governments face hard budget constraints;

F5: The allocation of authority and responsibility has an institutionalized degree of durability so that it cannot be altered by the national government either unilaterally or under the pressures from subnational governments.

(Montinola et al.,1995)

Market- preserving authoritarianism

M1: Subject to changing international and domestic constraints, in particular competitive pressures, senior leaders (or the dominant party) perceive that it is in their interests to preserve the market to facilitate catching-up;

M2: Senior leaders (or the dominant party) are able to make their policy on market-based catching-up more credible by imposing self-constraints through allocating sufficient autonomy (including authority, information, and resources) to a large set of political and, more importantly, economic decision makers in an institutionalized way;

Market- preserving authoritarianism

M3: Senior leaders (or the dominant party) are able to control agency problems of bureaucrats, businessmen, as well as other politicians by imposing constraints on them through designing and fostering institutions such as incentive schemes, checks, coordination and enforcement devices, and to balance autonomy and control.

(Shuhe Li et al.,1999)

Decentralization

Decentralization of information and authority and interjurisdictional competition, can provide a more credible commitment to secure economic rights and preserve markets.

(Yingyi Qian et al.,1997)

Self-enforcing federalism

The twin dilemmas of federalism Dilemma 1: What prevents the national govern

ment from destroying federalism by overawing its constituent units?

Dilemma 2: What prevents the constituent units from undermining federalism by free riding and other forms of failure to cooperate?

(De Figueiredo et al.,2005)

A model of Bottom-Up Federalism

Trade-off: mechanisms to mitigate one dilemma typically exacerbate the other.

Institutional Game Repeated Game

BASIC FEATURES

• Choose constitution

• Set of trigger points for disciplining center

• Definition of “institutional power ” of center

KEY QUESTIONS

• What triggers chosen?

• How strong is center?

BASIC FEATURES

• Federalism ongoing, repeated

• States choose to contribute, shirk or exit

• Center determines how much to provide for public goods and how to enforce penalties

KEY QUESTIONS

• Can federalism be an equilibrium?

•What factors determine set of equilibrium federations?

Conclusion

For a federation to overcome the shirking problem, the center must have sufficient monitoring resources and penalizing capacity to punish shirkers;

To police the center’s tendency to overawe the states, states must coordinate on punishment strategies, perhaps chosen at the constitutional or design stage of a federation. Appropriately designed punishment strategies limit the center’s ability to extract resources from the states, increase the provision of public goods, and result in higher public welfare;

Conclusion

Exit costs shift rents to the center; In choosing the optimal amount of institutional

power granted to the center, designers can effectively resolve the two dilemmas.

(De Figueiredo et al.,2005)

A top-down federation

The threat of separation: the possibility of secession has been a powerful force to limit the ability of the central government to exploit peripheral minorities of voters for the sake of the majority of the population.

The threat of secession of rich regions; Asymmetry fiscal federalism.