econ 334 - lecture 9

Optimal fiscal federalism

strives to resolve how

government functions should be allocated across levels.

The U.S. has layers of government: federal, state and local (cities, towns, school districts). Fiscal federalism asks:

which level should provide which services?

Fiscal equalization

refers to policies that are intended to

redistribute revenues across different levels of

government to offset regional disparities in the tax base

(e.g. value of property; income, etc.).

Where state and local money comes from has changed:

in 1960, property taxes were the biggest source (36%). By 2023, federal grants were the biggest (26%), with property taxes down to about 20%.

three problems with government providing public goods

1. reference revelation: people understate what they’d pay, to avoid higher taxes

2. Preference knowledge: people don’t know what they’d pay

3. Preference aggregation: combining everyone’s preferences is hard

Preference revelation:

people understate what they’d pay, to avoid higher taxes

Preference knowledge:

people don’t know what they’d pay

Preference aggregation:

combining everyone’s preferences is hard

Voting with your feet/Tiebout Competition

ppl can move to the town with the combination of tax and public services they like the most, they will sort themselves into towns they enjoy the most

Tiebout Comp fixes what? 2 things

1. Fixes Preference revelation aka free rider problem

2. Fixes Preference aggretaion

How does Tiebout fix free rider?

in a town where evyone wants the same things- everyone pays the same tax, there’s no need to understate the value when it wont lower your own bill

How does tiebout fix preference aggregation?

if everyone wants the same amount of public goods combing preferences is easy

Tiebouts assumptions aka pitfalls

Moving is free (perfect mobility), People know all the taxes and services in every town (perfect information), There are enough towns to match every preference, Towns can still be big enough for economies of scale, Everyone pays the same (lump-sum) tax, No spillovers between towns — all these assumptions must work for tiebout to work

1. Moving is free (perfect mobility)

Moving is expensive: selling a house, changing jobs, leaving family and friends

People know all the taxes and services in every town (perfect information)

Most people don’t know other towns’ tax rates or public good quality in detail

There are enough towns to match every preference

You may not find a town with exactly the mix you want, especially in rural areas with few towns nearby

Towns can still be big enough for economies of scale

Some services are cheaper per person when provided at a large scale (like a water system), so lots of tiny towns can be inefficient

Everyone pays the same (lump-sum) tax

Real local taxes are based on property value or income, so richer people pay more. That brings back free riding: lower-income residents get the same services while paying less

No spillovers between towns

Many local goods affect neighbors (parks, roads, police), so a low-tax town can free ride on its neighbor’s services

Big Problems with Tiebout

Taxes aren’t lump-sum, Zoning

Taxes aren’t lump-sum.

A lump-sum tax (everyone pays the same dollar amount) is efficient, since it doesn’t change anyone’s behavior. But it’s seen as unfair, because a poor family pays as much as a rich one. Real property taxes make richer people pay more, which is fairer, but it brings back the free-rider problem.

Zoning.

Rules like minimum lot sizes or height limits make it hard to build cheaper housing in rich towns. That can keep lower-income families out, so not everyone can “vote with their feet.” Zoning might be justified to prevent negative externalities (like overcrowding), but it can also just protect home values.

Optimal fiscal federalism: three factors

The Tiebout model says three things decide whether a service should be local:

Tax-benefit linkage, Spillovers between towns, Economies of scale.

Tax-benefit linkage.

f the people who pay for a service are the same people who benefit, it should be local. Example: trash pickup. You pay local taxes, your trash gets picked up.

Spillovers between towns.

If a service benefits neighboring towns too, a single town will underprovide it (the same free-rider problem as public goods). Those should be handled at a higher level. Example: a big regional highway that people from many towns use.

Economies of scale.

If a service is much cheaper at a big scale, lots of small towns doing it separately is wasteful. Example: national defense. You wouldn’t want every town buying its own fighter jets.

So local governments should NOT handle services that are:

• (a) highly redistributive (rich people would just move to towns that don’t redistribute)

• (b) full of spillovers

• (c) cheaper at a large scale

Local governments SHOULD handle

services with strong tax-benefit links, few spillovers and no big economies of scale: trash, local parks, police patrols.

Fiscal equalization

policies that move money from high-revenue areas to low-revenue areas. In the U.S., this happens through federal grants (Medicaid, SNAP, WIC) and the progressive federal tax code.

The tax price

how much a town has to raise in taxes to get $1 more of school spending for itself.

$$\text{Tax price} = \frac{1}{1 - \text{share redistributed away}}$$

Why it matters: the property tax revolt

When the tax price gets very high, voters lose any reason to support local school taxes, since the money mostly goes elsewhere. Evidence suggests extreme equalization can lower total school spending.

Effect of very high tax prices

Can reduce total per-pupil spending, most of each dollar raised locally goes to other districts, so voters have little reason to support local school taxes.

Proposition 13 (1978)

California property tax revolt that strictly limited property tax growth; widely seen as a result of school finance equalization

Why did equalization lead to tax revolts?

If voters can’t choose to pay more for their own schools, they vote to cap property taxes instead