Topic 3: Local Public Goods and Fiscal Federalism

Decentralisation - definition

Transferring authority, responsibility and decision-making power from central government to lower levels (regional, municipal, local), so decisions respond to local needs.

Principle of subsidiarity

Central government should only handle matters that cannot be handled effectively at a lower level.

Four types of decentralisation

1) Political (citizens or elected reps decide). 2) Administrative (local planning, financing, service management). 3) Fiscal (local taxing and spending powers). 4) Economic or market (shift to private sector or communities, e.g. privatisation, PPPs).

Deconcentration vs delegation vs devolution

Deconcentration: central ministries place staff in regional offices. Delegation: semi-autonomous agencies take over functions. Devolution: full transfer of power to local government.

Decentralisation - benefits

More efficient and responsive services, more participation and accountability, local innovation, less bureaucratic delay.

Decentralisation - challenges

Unequal local capacity, risk of local corruption or mismanagement, coordination problems with central government, wider regional inequality.

Optimal fiscal federalism

The question of which activities should take place at which level of government.

Fiscal decentralisation vs centralisation

Decentralisation: spending and tax powers delegated to lower levels. Centralisation: delegated to upper levels.

Vertical fiscal imbalance (VFI)

Mismatch between revenues and spending across levels of government: spending responsibilities are local but revenue raising stays centralised.

Fiscal equalisation

National government gives grants to subnational governments to even out differences in wealth.

Money is fungible (local level)

Only total resources matter for the local choice between private and public goods, whatever the label on the money.

Matching grant

Grant tied to the community's own public good spending (e.g. 1 for every 1 spent). Lowers the price of the public good.

Block grant

Fixed amount with no conditions on how it is spent. Pure income effect.

Conditional block grant

Fixed amount that must be spent on a particular good.

Block grant - effect

Shifts the budget line out in parallel (income effect only). Community spends some on the public good and some on private goods.

Matching grant - effect

Rotates the budget line (cheaper public good): income and substitution effects both raise public good spending. Gives the largest increase in public good spending per pound.

Conditional block grant - effect

Often no different from a block grant if the community already spends more than the grant on that good (it reallocates its own money: crowd-out). Only binds if the grant exceeds what it would have spent.

Which grant for which goal?

Maximise local welfare: block grant. Maximise spending on the public good (e.g. education): matching grant.

Crowd-out (grants)

A grant leads to a less than proportionate rise in spending on the good because the community cuts its own spending.

Flypaper effect

Money 'sticks where it lands': grants raise public spending by more than an equal rise in local income would. Hines and Thaler (1995): crowd-out often close to zero.

Flypaper effect - caveats

Early studies biased: places that value the good most lobby hardest for grants. Recent evidence: flypaper in the short run but substantial crowd-out of block grants in the long run.

UK local government structure

343 English authorities. Two-tier areas (county councils + district councils) and single-tier areas (London boroughs, metropolitan districts, unitary authorities).

UK local government funding sources

Central government grants, council tax (residential property tax) and business rates (tax on business premises). Council tax is the largest single source in England.

Club good

Non-rival or partly rival good where exclusion is possible (e.g. a gym or swimming club).

Local public good

Public good available only to people in a restricted area, non-rival or partly non-rival there (e.g. street lighting, library, local pool).

Local public goods - key features

Benefits restricted to an area. Exclusion by residence (and taxes). Localities compete for residents through public good and tax levels. People pick the locality giving the highest utility.

Tiebout hypothesis

If public goods are local, people 'vote with their feet' by moving to the community with their preferred tax and public good mix, creating a market-like solution to public good provision.

Tiebout model - setup

2N families with equal income, 2 towns with N homes each. N families with kids value C and schools G. N elderly families value only C. G chosen by the median voter and financed equally (C = Y - G/N).

Tiebout equilibrium - conditions

1) In each town G is set by the median voter and shared equally. 2) No two families want to swap towns.

Tiebout Theorem Part I

Families sort by taste for the public good: one all-elderly town (G = 0) and one all-kids town (G = G*). Any mix would give a kids family and an elderly family who both gain from swapping.

Tiebout Theorem Part II

Each town provides the efficient level: G = 0 where nobody values G, and in the kids town the median voter's choice satisfies the Samuelson rule (sum of MRS = MC = 1).

Tiebout - implications

No local redistribution (benefit principle: you get what you pay for), people choose their tax/public good mix, and competition forces efficient provision.

Tiebout - assumptions / limitations

Many communities, no spillovers across communities, zero moving costs, exogenous income, perfect information, and tools (e.g. zoning) to control community size.

Hoxby (2000)

US school districts: cities with many small districts (Boston) vs few large ones (Miami). More districts means more sorting (well established) and higher average test scores (controversial, Rothstein 2007).

Evidence on community size and sorting

More municipalities in a metro area means each is more homogeneous in demand for public services (Gramlich and Rubinfeld 1982). Heterogeneous demand goes with more, smaller municipalities (Fisher and Wassmer 1998).

Schonholzer (2026)

Compares house prices on opposite sides of the same local-government boundary (1.5m homes). Households pay a premium to access particular local governments, reflecting both service quality and who they share services with.

Tiebout - consequence for redistribution

Local redistribution breaks down: poor move in, rich move out. Redistribution works better at higher levels (state or national) where moving is costly. Locally, keep a tax-benefit link.