state and local public finance spring 2014, professor yinger lecture 17 introduction to...

State and Local Public FinanceSpring 2014, Professor Yinger

Lecture 17

Introduction to Intergovernmental Relations

State and Local Public FinanceLecture 17: Intergovernmental Relations

Class Outline

Key Features of the U.S. Federal System

Principles for Allocating Responsibilities in a Federal System

Intergovernmental Grants

Fiscal Disparities


U.S. Constitutional Structure

The federal government and the states have equal standing as constitutional units, with separate rights and responsibilities.

Counties, townships, cities, villages, school districts, and special districts are creatures of the states.


Rough Distribution of Responsibilities

The federal government provides national defense, social insurance, and social welfare

The states provide higher education, social services, and highways.

Local governments provide elementary and secondary education, police and fire protection.


The Role of Intergovernmental Grants

Higher levels of government provide extensive financial assistance to lower levels of government in the form of intergovernmental aid.

The federal government gives grants to states and to local governments

State governments give grants to local governments.


Federal Grants to State and Local Governments

Federal grants peaked in 1978 at over ¼ of state and local general revenue.

Federal grants declined rapidly in the Reagan years, but have usually increased since, mainly due to Medicaid—to about the 1978 level.

Federal grants now (2011) provide 24.7% of state and local revenue and 12.3% of local school revenue (up from 8.1% in 2008).


State Grants to Local Governments

States provide 32.9% of local general revenue (2011).

This share rose slowly for a long time but has now stalled.

The state share is higher for education (44.4%, down from 48.3% in 2008).


Mandates and Rules

Higher levels of government also affect lower levels of government in other ways.

The federal government can give financial incentives for state or local governments to do certain things (e.g. NCLB).

The federal government cannot impose requirements on states, however.


Mandates and Rules, 2

State governments can impose unfunded spending mandates on local governments.

State governments can alter the assignment of spending responsibilities or taxing rules.

E.g., some cities must provide ports, airports, hospitals, or higher education.

E.g., some cities have access to a commuter tax.


Principles to Guide the Assignment of

Responsibilities

A famous framework developed by an economist named Richard Musgrave, divides the responsibilities of government into three “branches”:

Stabilization Allocation Distribution


Stabilization

Everyone agrees that the main responsibility for stabilization policy (i.e. monetary and fiscal policy) should fall on the federal government.

Nevertheless, states can alter the impact of economic fluctuations on their citizens through rainy day funds or similar policies.


Allocation

All levels of government address issues involving the allocation of resources.

Allocation questions involve both of the types of efficiency discussed in this class:

Productive or technical efficiency.

Allocative efficiency.


Productive Efficiency, Economies of Population Scale

The per-capita cost of a public service may depend on the number of people being served.

Economies of population scale, also called publicness, arise when the per-capita cost declines with population.

Diseconomies of population scale, also called congestion, arise when the per-capita cost increases with population.


Productive Efficiency, Economies of Population Scale

Elementary and secondary education has U-shaped cost functions.

The minimum-cost size is 3,000 pupils in New York and 58,000 in California.

This difference reflects different measures of school performance emphasized in each state and perhaps other factors.

Defense is a pure public good; there are diseconomies of scale for police.


Economies of Population Scale in Public Education

Number of Pupils in District

CostPerPupil (for given output)

3,000

Split Up? (NY)Consolidate

58,000

New York

California


Productive Efficiency, Economies of Population Scale, Cont.

All else equal, the responsibility for a public service should be assigned to the unit of government with the scale closest to the minimum-cost scale.

Suburban school districts meet this test. Rural districts are too small, and, on cost

grounds, at least, they should consolidate. Urban districts are too large and, on cost

grounds, they should be split up. Different public services have

different optimal scales—a reason for layers of government.

Cost considerations may, of course, be offset by other concerns.


Allocative Efficiency, 1

Recall the normative argument by Tiebout: A federal system is efficient if there are many local governments and people are able to choose their preferred service-tax package.

This argument calls for assigning service responsibilities to small local governments, all else equal.

State and Local Public FinanceLecture 17: Intergovernmental RelationsAllocative Efficiency 2, Spillovers Spillovers from public services are an

externality. Example: Benefits from a state highway

system to people in surrounding states.

One way to address spillovers is to assign service responsibility to a level of government high enough to internalize the externality.

Example: An air- or water-pollution district that encompasses an entire air- or water-shed.

Another way to address spillovers is with intergovernmental grants

Examples: Federal matching grants for highways, state aid for education.


Distribution

Most analysts call for the assignment of distribution to higher levels of government:

Truly equal opportunity requires a higher level of government.

E.g., national programs for social insurance or civil rights.

Redistribution may involve spillovers:

People in State A who believe in equality benefit from equality in State B.

Redistribution at lower levels of government may be undermined by mobility.

Wealthy individuals can escape progressive state and local taxes

Needy individuals may move to generous cities or states.

Evidence says these effects are small.


Behavioral Responses to Grants

Intergovernmental grants are intended to influence the choices made by lower levels of government.

The impacts of grants on the behavior of recipient governments has been widely studied.

Policy makers who design grants should know about this research!


Fisher’s Intergovernmental Grant Table

Conditions on Use

Categorical Grants General Grants

Allocation Method

Formula Project Formula

Matching? Lump-Sum

Lump-Sum

Matching Lump-Sum

Revenue Sharing

(Matching)

Limits? Closed-Ended

Open-Ended

1 2 3 4 5 6


Lump-Sum Grants as Income

In theory: In a median-voter model, $1 of grants is equivalent to an increase in voter income that equals $1 after being multiplied by tax-price (= what the voter saves).

In practice: Grants have consistently been found to have a larger-than-predicted impact on public spending.

This is called the flypaper effect.


The Flypaper Effect

Estimates of the flypaper effect vary widely.

A typical estimate finds that $1 of aid has the same impact as $3 of income.

Bill Duncombe and I find that in some cases $1 of school aid has the same impact as $10 of income.

There is no consensus about the cause of the flypaper effect.

Some scholars think it represents a kind of illusion on the part of voters.

Others think it represents mis-measurement of some kind.


Impact of Grants on Efficiency An issue at the frontier of

knowledge is whether grants affect governmental efficiency.

This issue has 2 parts: A grant to promote service A (math

and English scores) may also boost service B (music education).

A grant may lead to bureaucratic waste.

Duncombe and I find indirect evidence of both effects.

So grants funds are transferred in a leaky bucket!


Categorical vs. General Grants

The decision as to which type of grant to use is analogous to that of cash versus food stamps.

There is no evidence that the flypaper effect (or the efficiency impacts) are different for general and categorical grants, so the standard graph applies.

Making a grant “categorical” often does not alter its impact.


Categorical Versus General Grant

Everything Else

Y+G

0 Subsidized Category

Budget line with

categorical grant

Budget line with general grant

Original

budget line

Y

I 1

I 2I

3

I 1*

I 2*

City 1

City 2


Matching vs. Lump-Sum Grants

In deciding which of these grants to use, the standard figure for income and price subsidies is often used.

This figure implies that a matching grants has a larger impact on local performance than does a lump-sum grant with the same cost to the granting government.

This effect reflects the fact that a matching grant, unlike a lump-sum grant, has both an income effect and a price effect.


Education

EverythingElse

E1 E3 E2

Budget Line with Lump-Sum Grant

Cost of Both Programs

Tangency Pointwith Matching Grant

I3

I2

I1

Budget Line with Matching Grant

Tangency Pointwith Lump-Sum Grant

Matching Versus Lump-Sum Grant


Matching vs. Lump-Sum Grants

But this theorem ignores (a) the flypaper effect, which only applies to lump-sum grants and (b) the impact of grants on efficiency.

In a recent paper, Bill Duncombe and I show that when these two things are considered, lump-sum grants might be more simultative, particularly when given to disadvantaged districts.

In addition, matching grants are unpopular with elected officials because their cost is not known at budget time.


Fiscal Health

Fiscal health is the extent to which a jurisdiction’s ability to provide reasonable services at a reasonable tax rate is constrained by factors outside its control.

Fiscal health is relevant for policy: It provides perspective on

spending/performance differences. It helps in designing aid to local

governments, particularly schools.

The key philosophical issue here is whether a state should accept some responsibility for the fiscal disparities its actions help to create.


Fiscal Health, 2

Fiscal health equals the difference between a jurisdiction’s expenditure need and its revenue-raising capacity, both based on factors outside the jurisdiction’s control.

A deficit is a poor measure of fiscal health because forecasting methods and assumptions are not outside a jurisdiction’s control.


Expenditure Need

Expenditure need depends on expected service quality (constant across jurisdictions), assigned responsibilities, and public service costs.

In symbols:

( )( )( )j j jEN E R C


Revenue-Raising Capacity RRC = the ability of a jurisdiction

to raise revenue based on factors outside its control.

The Income-Plus-Exporting approach holds tax burden constant across jurisdictions.

How much could a jurisdiction raise if it placed the same tax burden on its residents as the average jurisdiction?

The Representative Tax System approach holds tax rates constant.

How much could a jurisdiction raise if it levied the same tax rates as the average jurisdiction?


Income-Plus-Exporting Approach

Define for jurisdiction j and tax i: b = tax burden Y = income per capita e = taxes raised from nonresidents

for every dollar raised from residents = export ratio

s = expected revenue share for given tax

Then

1j j i iji

RRC bY s e


Representative Tax System Approach

Define for jurisdiction j and tax i: t = tax rate B = tax base per capita

Then

j i iji

RRC t B


Fiscal Health, 3

In short:

States influence fiscal health by setting service responsibilities, access to taxes, and tax rules.

Fiscal health is also influenced by a city’s economy.

Fiscal health varies widely across large cities and across school districts.

j j jFH RRC EN

state and local public finance spring 2014, professor yinger lecture 17 introduction to...

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