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Chapter 6
State and Local
Government
Expenditures
Public Finance and Public Policy


Introduction
 Optimal fiscal federalism is the question of

which activities should take place at which
level of government.
 For example, welfare programs were
historically financed at the federal and state
level, while education is largely financed at the
state and local level.


FISCAL FEDERALISM IN THE U.S.
AND ABROAD
 Early in the history of the United States, the

federal government played a relatively limited
role.
 The last amendment of the Bill of Rights of the
United States Constitution states:

“The powers not delegated to the United
States by the Constitution, nor prohibited
by it to the states, are reserved to the
states respectively, or to the people.”

 Figure 1 shows the spending patterns over time.


Figure 1
Federal
State
In 1902,
and
government
the
local
federal
governments
was
government
responsible
The were
role
The
ofshare
the federal
of state
government
financing coming
responsible
accounted
for national
fordefense,
only
education,

34%foreign
of
grew
police,
totalwith
fromthe
theintroduction
federal government
of the
has
relations,
roads,
government
sanitation,
judicialspending;
functions,
welfare,
federal
local
health,
and grown
income
the
because
tax and of
thejoint
Newprogram
Deal like
governments
hospitals,

postal
accounted
service.
and so on.
programs
for 58%. of
cash
the welfare
Great Depression.
and Medicaid.


FISCAL FEDERALISM IN THE U.S.
AND ABROAD
 The largest element of state and local

spending is education, followed by health care
and public safety.
 For federal spending, the largest elements are
health care, Social Security, and national
defense.


Spending and Revenue of State and
Local Governments
 The major source of revenue at the state and

local level is the property tax, the tax on land
and any building on it.
 Property taxes raised $253 billion in revenue in

2001, and accounted for almost one-half of the
non-grant revenues of local governments.


Fiscal Federalism Abroad
 The U.S. sub-national governments collect a

much larger share of total government
revenue than in other countries, and spend a
somewhat larger share of total government
spending.
 Table 1 shows this.


Table 1

Subnational government spending/revenue
as a share of total government
spending/revenue
Spending %
Greece
Portugal

Revenue %

5.0

3.7

12.8

8.3

France

18.6
On the spending
Theside,
average
the state/local
government
collectsless
22% of total 38.8
government
Norway differences are slightly
dramatic.
revenue, while those40.0
in the U.S.
United States
collect 40%.
Denmark
57.8
OECD Average

32.2

13.1
20.3
40.4
34.6

21.9


Fiscal Federalism Abroad
 The higher level of centralization in other

nations exists because state/local
governments have almost no legal power to
tax citizens.
 Many countries practice fiscal equalization,
whereby the national government distributes
grants to sub-national government in an effort
to equalize differences in wealth.


Fiscal Federalism Abroad
 There has been a move toward

decentralization around the world.
 In the U.S., there have been increased efforts
to shift control and financing of public
programs to the states, such as with welfare
reform in 1996.


OPTIMAL FISCAL FEDERALISM
 What is the optimal division of responsibilities

across different levels of government?
 A theory of how the efficiency of public goods

provision may differ at different levels of
government helps answer this questions.


OPTIMAL FISCAL FEDERALISM
 Two of the major problems in public goods

provision are:

Preference revelation: Difficult to design
democratic institutions to cause
individuals to reveal their preferences
honestly.
 Preference aggregation: Difficult to
aggregate individual preferences into a
social decision.



The Tiebout Model
 Tiebout (1956) showed that the inefficiency in

public goods provision came from two missing
factors: shopping and competition.
 Shopping induces efficiency in private
markets.
 Competition induces the right prices and
quantities in private markets.

The Tiebout Model
 With public goods provided at the local level,

competition naturally arises because individuals
can vote with their feet by moving to another
town without much disruption.
 This induces fiscal discipline for local
governments and creates a new preference
revelation device: mobility.
 Tiebout argued that the threat of exit can
induce efficiency in local public goods
production.
 Under certain (unrealistic) conditions public
goods provision will be fully efficient at the local
level.


The Tiebout Model
 Tiebout’s formal model assumes the following:

Large number of individuals, who divide
themselves up across towns that provide
different levels of public goods.
 Town i has Ni residents who all demand
Gi of the public good.




Uniform tax of Gi/Ni.

The Tiebout Model
 Tiebout’s model solves two problems:

Preference revelation: There is no
incentive to lie. With a uniform tax on
all residents, the consumer saves 1/Ni in
tax but receives 1/Ni less of the public
good.
 Preference aggregation is solved
because everyone in the town wants the
same level of public goods, Gi.



Problems with the Tiebout
Model
 There are a number of problems with the

model, however, related to:

Tiebout competition
 Tiebout financing
 Spillovers



Problems with the Tiebout
Model

 Tiebout competition may not hold because:

It requires perfect mobility.
 It requires perfect information on the
benefits individuals receive and the
taxes they pay.
 It requires enough choice of towns so
that individuals can find the right levels
of public goods.



Problems with the Tiebout
Model
 Tiebout financing is problematic because:

It requires lump-sum taxes that are
independent of a person’s income. This
is viewed as highly inequitable.
 It is more common for towns to finance
public goods through proportional taxes
on homes, leading to the problem of the
poor chasing the rich.
 The use of zoning can ameliorate this
problem.



Problems with the Tiebout
Model

 Zoning regulations protect the tax base of

wealthy towns by pricing lower income
individuals out of the housing market.
 For example, a town that prohibits multifamily
dwelling such as apartments lowers the
available amount of housing, and thus inflates
the value of existing housing, keeping the poor
out.


Problems with the Tiebout
Model
 Tiebout model is also problematic because of

the assumption of no externalities or
spillovers:

Model assumes public goods only have
effects in a given town, and that they do
not spill over to neighboring towns.
 Some public goods, like a public park,
probably violate this assumption.



Evidence on the Tiebout Model
 Even given the problems of the Tiebout model

the basic intuition that individuals vote with

their feet is still a strong one. Two types of
tests reveal this:

Resident similarity
 Capitalization



Evidence on the Tiebout Model
 A clear prediction of the Tiebout model is that

residents in a local community will have
similar preferences for local public goods.
 The more local communities and choices, the
more residents can sort themselves into
similar groupings.
 Gramlich and Rubenfeld (1982) found greater
sorting in larger metropolitan areas (where
mobility costs would be smaller), and greater
satisfaction with public goods provision.


Evidence on the Tiebout Model
 Very little actual mobility is required for the

Tiebout mechanism to operate because people
not only vote with their feet.
 They also vote with their pocketbook.
 Tiebout model predicts that any differences in
fiscal attractiveness will be capitalized into

house prices.


Evidence on the Tiebout Model
 That is, the price of any house reflects the

costs (including local property taxes) and
benefits (including local public goods) of living
there.
 Holding taxes constant, higher levels of public
goods raise housing prices.
 Hold public good levels constant, raising taxes
lowers housing prices.
 Housing prices are a reflection of people voting
with their pocketbook.