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CHAPTER 22
Public Finance in a Federal System
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
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22-2
Background
• Federal system • Fiscal federalism • Centralization
– Centralization ratio = Central government expenditures Total government expenditures
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22-3
Distribution of All U.S. Expenditures by Government Level
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22-4
Community Formation
• Club – voluntary association of people who band together to finance and share some benefit
• Optimal Club (or community)
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22-5
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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22-6
Tiebout and the Real World
• Critique of Tiebout • Empirical tests
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22-7
Optimal Federalism
• Macroeconomic functions • Microeconomic functions
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22-8
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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22-9
Advantages of a Decentralized System
• Tailoring outputs to local taxes • Fostering intergovernmental competition • Experimentation and information in locally
provided goods and services
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22-10
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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22-11
Public Education in a Federal System
• Local control of schools • Financing education through property taxation • Federal role in education
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22-12
Property Tax
• How the property tax works – Assessed value – Assessment ratio
City Effective Tax
Rate*
Newark 2.03%
Detroit 2.01
Atlanta 1.75
New Orleans 1.75
Chicago 1.58
Charlotte 1.20
Los Angeles 1.10
New York .66 *Figures are for 2006.
Source: US Bureau of the Census [2009, p. 276]
Residential Property Tax Rates (selected cities)
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22-13
Incidence and Efficiency Effects – The Traditional View - Tax on Land
Acres of land
Ren
t per
acr
e o
f lan
d SL
DL
P0L
DL’
PnL
PsL = P0
L Price received by landowners falls by amount of the
tax
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22-14
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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22-15
Incidence and Efficiency Effects – The Traditional View - Tax on Structures
Number of structures per year
Pric
e pe
r s
truct
ure
SB
DB
P0B
DB’
PnL
PnB = P0
B
B0 B1
PgB
Price paid by tenants increases by full amount of
the tax
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22-16
Summary and Implications of the Traditional View
• Progressivity – Land tax – Structures tax
• Empirical evidence – Measuring income
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22-17
The New View: Property Tax as a Capital Tax
• Partial equilibrium versus general equilibrium • General Tax effect • Excise Tax effects • Long-run effects
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22-18
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]
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22-19
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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22-20
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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22-21
Ideas for Improving the Property Tax
• Improve assessment procedures • Personal net worth tax
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22-22
Intergovernmental Grants Relation of federal grants-in-aid to federal and state-local
expenditures (selected fiscal years)
*Amounts are converted to 2007 dollars using the GDP deflator. Source: Computed from Economic Report of the President, 2009 [pp. 377, 381].
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22-23
Why Have Intergovernmental Grants Grown So Much?
• Mismatch theory
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22-24
Conditional (Categorical) Grants
G1
c1 E1
Units of public good (G) per year
Con
sum
ptio
n (c
) pe
r yea
r
A
B
Matching Grants
R G2
c2 E2
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22-25
Conditional (Categorical) Grants
G1
c1 E1
Units of public good (G) per year
Con
sum
ptio
n (c
) pe
r yea
r
A
B
Matching Closed-Ended Grants
R G3
c3 E3 D
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22-26
Conditional (Categorical) Grants
G1
c1 E1
Units of public good (G) per year
Con
sum
ptio
n (c
) pe
r yea
r
A
B
Non-matching Grants
R G2
c4 E4
H
J
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22-27
Unconditional Grants
• Revenue sharing • Measuring Need
– Tax effort
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22-28
The Flypaper Effect
• Whose indifference curves? • Median voter theorem • Flypaper effect
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22-29
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