Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin - PowerPoint PPT Presentation

Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 10: Federalism and Intergovernmental Grants ECON 551: Lecture 10 1 of 40

Agenda 1. Overview 2. Models of Federalism: Breton + Oates. 3. Intergovernmental Grants 4. Equalization Grants ECON 551: Lecture 10 2 of 40

Overview of Federalism What should be the relationship between national and subnational jurisdictions?  Should there even be subnational jurisdictions?  How many? Three big ones? Many little ones? How would a non-economist motivate subnational jurisdictions?  Allows political liberty and cultural autonomy. Schools, church, language. Think of Switzerland, Canada, Germany.  Fosters political participation ECON 551: Lecture 10 3 of 40

Economic Motivations for Federalism Local Public Goods: the MES for public goods might be small. Spillovers: The extent and nature of spillovers among regions Laboratory: Justice Brandeis in New State Ice Co. V. Liebman 285 US 262, 311 (1932). “ It is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country. ” ECON 551: Lecture 10 4 of 40

In 1926, the shares were: 37.8 fed, 20.2 prov, 42.0 local. (Source: Musgrave, Musgrave, and Bird) ECON 551: Lecture 10 5 of 40

ECON 551: Lecture 10 6 of 40

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Agenda 1. Overview 2. Models of Federalism: Breton + Oates. 3. Intergovernmental Grants 4. Equalization Grants ECON 551: Lecture 10 8 of 40

Breton (1965) : “A Theory of Government Grants” Theory hinges on the provision of public goods.  Which level of government should provide them? Breton describes public goods with various degrees of ‘localness’. There are  International goods (Clean atmosphere, oceans, defence alliances)  National goods (legal system, defence)  Provincial goods (some resource management)  Local goods (parks)  Private goods (my lunch) ECON 551: Lecture 10 9 of 40

Breton (1965): “A Theory of Government Grants” In a world l ike this, Breton describes the ‘optimum constitution.’  All objective benefits of the local good are exhausted within the border of the jurisdiction.  Provides a ‘perfect mapping’ between the scope of local public goods and the political jurisdiction.  This generalizes the Tiebout idea to vertical levels of goods.  With lump-sum or benefit taxes, we get Pareto optimal allocations.  OR, with a supra level of government, they could make conditional grants to ensure that each level can pay for its optimal level of goods. ECON 551: Lecture 10 10 of 40

Solutions to inter-jurisdictional externality problem How can we solve this externality problem? Try central government.  Could be direct provision by feds.  Could be quantity control through regulations or conditional grants.  Could be price control through subsidies / matching grants. Could we just let Coasian bargaining solve the inter-jurisdictional problem?  Translink presumably accounts for city-to-city spillovers. Garbage collection and fire stations, however, are done locally. If there are spillovers, then they made a deal to account for them in that area alone but not for all goods.  But, bargaining problems: uncertain property rights, uncertainty about others’ threat points, free -riding by jurisdictions, enforceability of agreements — governments might renege. ECON 551: Lecture 10 11 of 40

Oates and ‘fiscal federalism’ The seminal work in this area is a book by Wallace Oates called Fiscal Federalism (1972).  The model laid out in the book studies the costs and benefits of decentralization. Local Governments:  Can respond to local tastes and preferences.  Cannot produce public goods efficiently if MES is large, or spillovers exist. Central Governments:  Can deal with externalities and scale.  But cannot respond to local tastes — assumption of “ policy uniformity. ” ECON 551: Lecture 10 12 of 40

The Oates ‘Decentralization Theorem.’ “For a public good— the consumption of which is defined over geographical subsets of the total population, and for which the costs of providing each level of output of the good in each jurisdiction are the same for the central of the respective local government — it will always be more efficient (or at least as efficient) for local governments to provide the Pareto-efficient levels of output for their respective jurisdictions than for the central government to provide any specified and uniform level of output across all jurisdictions” Here is my restatement of it: (1) if a public good costs the same if provided by either level of government, (2) And the good must be provided uniformly if provided centrally, (3) And jurisdictions are formed according to a Bretonian ‘optimum constitution’ Then, local government provision is weakly more efficient than central government provision. ECON 551: Lecture 10 13 of 40

The Oates ‘Decentralization Theorem.’ The central tension is between policy uniformity and externalities.  If no externalities, then local provision is weakly preferred.  If all had same tastes, then central provision is weakly preferred.  Optimal division is found at the point where the cost of policy uniformity equals the gain from internalizing the externalities. Think of this in a two-by-two box: Same tastes Different tastes Spillovers Centralization Tension No spillovers Either / or Decentralization ECON 551: Lecture 10 14 of 40

Agenda 1. Overview 2. Models of Federalism: Breton + Oates. 3. Intergovernmental Grants 4. Equalization Grants ECON 551: Lecture 10 15 of 40

Government grants A good reference is the Boadway and Wildasin text book listed on the syllabus. Also, Handbook of Public Economics Chapter 11 by Rubinfeld. Imagine that we are living in Breton’s world of an ‘optimum constitution.’  Spending on public goods is contained within jurisdictional borders. Now imagine that the tax revenue to pay for the goods cannot be efficiently raised within each jurisdiction.  Perhaps raising revenue on mobile factors more efficiently done nationally.  In this case, we would have a vertical fiscal gap between the spending responsibilities and the revenue raising responsibilities of some order of government. This generates the need for grants between levels of governments. What does this look like in Canada? ECON 551: Lecture 10 16 of 40

ECON 551: Lecture 10 17 of 40

Who should raise revenue? Why centrally?  Economies of scale: Fixed costs can be spread over more bodies. However, in Canada 9 out of 10 provinces set their own rates but contract the CRA to collect it on their behalf.  Fiscal externalities: With mobility, attempts at redistribution will be frustrated. As you move up to higher-tier jurisdictions, mobility becomes less easy, meaning that the efficiency cost of taxation is lower. Why locally?  Accountability: easier for citizens to follow the dollars.  Preferences: some places may want different patterns of taxation.  Efficiency: income distributions may differ across provinces. ECON 551: Lecture 10 18 of 40

Conditional vs. Unconditional, matching vs. block There are many different ways one could imagine the transfers taking place between levels of government.  At one extreme, you could imagine sending a ‘blank cheque’ along to the other level of government.  At the other extreme, you could imagine a grant that ‘must’ be spent on one type of government program. In addition, there could be a ‘match’ rate; for every $1 of lower level spending, the higher level government will match with a $1. We will look at different kinds of structures for grants  Conditional vs. unconditional block grants.  Matching grants. ECON 551: Lecture 10 19 of 40

Unconditional Block Grant Let’s start with looking at the most simple case: a non -matching block grant. In Canada, this is the relevant case for the Canada Health and Social Transfer (since 1996) and the Equalization program. After tax income B A U 0 U 1 Public Good ECON 551: Lecture 10 20 of 40

Unconditional Block Grant The graph shows:  After tax income of the province on the vertical axis. (This could equivalently be thought of as amount of the private good.)  Spending on the public good on the horizontal axis.  ‘Community Indifference Curves’ representing the ‘province manager’ or the median voter.  The effect of the block grant is to move the budget constraint out in a parallel way.  The equilibrium moves from A to B.  Point B could be to the left or to the right of point A, so that the block grant could lead to higher or lower public good spending. It depends if the public good is normal or inferior. Bradford and Oates (1971) show that grants should almost completely crowd out local government spending, because the median voter takes the grant as an increase of income. The MPC on local public goods is likel y only around 5%, so we shouldn’t expect a large increase in spending. ECON 551: Lecture 10 21 of 40