Federalism
The Optimum Size and Shape of Governments
Alexander
Tabarrok
Department of Economics
George Mason University
Tabarrok@gmu.edu
Why Federalism?
Before we answer that question, we need to
ask why have government at all?
or
How should the production of goods be
divided between market and government?
Public Goods
• A “public good” is a nonexcludable and non–
rivalrous good.
• Non-excludability means
that people who don’t pay
can still consume – free
riders.
• Non-rivalry means that your
consumption of the good
does not reduce my
consumption.
– Non-rivalry implies that even if it
were possible to exclude it would
not be efficient to do so.
Two Problems with Producing Public Goods:
1) Free Riders
Photo: REUTERS/ Beawiharta
Two Problems with Producing Public Goods:
2) Forced Riders
Photo: GEOGroup.com
Maximizing the Value of Public Goods
To maximize the value of
public goods minimize
free riders and forced riders.
The Geographic Range of Public Goods
Why Federalism?
1. The Pure Economic Theory
– Federalism helps to maximize the value of
public goods by matching the range of the
public good to the range of the government
or organization producing the public good.
Transaction Costs
• If “transaction costs” were zero then in theory any type of
public good could be produced optimally by any structure
of government.
• E.g. In theory, national defense could be provided by a
combination of states that bargained with one another to
reach an optimal plan.
• At the other extreme, local parks could be provided by a
national government which carefully gathered
information on the demand for parks by location and
allocated taxes to coincide with benefits.
Bargaining and Information Transmission
Problems
• In practice, bargaining is expensive, information
is not free and information is difficult to transmit
from the periphery to the center.
• As a result, when range of public good does not
match the range of government we can have
failures of decentralization and failures of
centralization.
Failure of Decentralization
Defense, for example, is unlikely to
be optimally provided by bargaining
among a series of small units.
Failure of Centralization
• Consider a city with three neighborhoods.
1. The central urban area is
densely populated, few homes
have yards.
2. The near suburbs have
homes with small yards.
3. The far suburbs have homes
with large yards.
• What will happen if there are city wide taxes and
a city wide vote on parks?
The Matching Rule for Public Good Production
• Match the range of the public good to the range of the government
producing the public good.
– European Subsidiary Principle: Assign finance and control to the
smallest unit of government that matches the range of the public good.
• Local public goods should be produced and paid for locally. (e.g. 3
park districts for the city.)
• National defense should be provided by the national government.
Support for basic research should be provided nationally, or even
more appropriately internationally.
–
The WHO, for example, helps to finance and coordinate the production
of influenza vaccines. Without world finance we are likely to get free
riders and too little vaccine production (Similarly for basic research,
asteroid detection and destruction, world defense?!).
Heterogeneous and Homogenous Preferences
Many activities that may be quite rationally
collectivized in Sweden, a country with a
relatively homogeneous population, should
be privately organized in India, Switzerland,
or the United States.
Buchanan and Tullock, The Calculus of Consent.
Photo: Associated Press
The Matching Rule is About the Optimal Size
and Shape of Governments
What is the key public good/resource in this picture?
What area should the relevant government cover?
What area(s) does it cover?
Special Districts
Special districts are often created for activities that
have natural boundaries that do not coincide with
political boundaries (as in the Detroit-Windsor river
example). As a result, most special districts do not
coincide with county boundaries, either crossing
over or residing only partially within them.
Special Districts
Special Districts
• Special districts do not have to follow the one-person,
one-vote rule.
– Limiting the right to vote to landowners and weighing votes by
land value does not violate the equal protection clause of the
14th Amendment because of a water storage district's limited
purpose and the disproportionate effect of its activities on
landowners.
– Salyer Land Company v. Tulare Lake Basin Water Storage District (1973)
• Homeowner Associations, including condominiums, also
often weight votes (and taxes!) according to property
value.
• Similar to matching principle – match those who pay with
those who receive benefits in order to maximize value of
public good by minimizing free riders and forced riders.
Special Districts
• A virtue of special districts is that they can
grow or shrink over time.
– Special districts have tripled in number since
1952.
– Why? Suggests that spillover effects requiring
better matching have become more important
or that the cost of having multiple governments
has fallen.
The Case for More States
• In 1789 the United States had 13 states and four
million people.
– Not that much different from contemporary
Switzerland which has 26 cantons and approximately
7 million people.
• If the number of states had grown as fast as the
number of people we would today have about
1000 states.
• If that sounds extreme why is 50 the magic
number? And why is 50 the magic number
when the population is 150 million as when it is
300 million?
Principal-Agent Problems
• Bundle nature of political goods makes it more
difficult to articulate demands for individual
goods.
• Larger populations makes voting individually
less effective and rational ignorance more
rational.
• Slack allows politicians more opportunities for
self-aggrandizement and rent seeking.
• Decentralize to more tightly monitor and
constrain politicians.
• Decentralization allows more choice-people can
move around to find optimum bundle.
Tiebout Competition
Aside: The ideal conditions for Tiebout
competition are best approximated in the
real world by virtual communities!
Tiebout Competition and the Rise of Private
Governments
• Private governments such as homeowners associations
and condominium cooperatives provide all manner of
public goods, from road maintenance, trash collection,
and snow removal to transportation, policing, and
medical care.
• Practically unheard of in 1960, in 2012 some 63.4 million
people in the United States live in various neighborhood
associations.
• A majority of new housing units in rapidly growing urban
areas are privately governed.
Leisure World
• “Leisure World of
Maryland is a private,
age-restricted
community located in
Montgomery County,
Maryland.
• Community amenities,
which are held in Trust for benefit of the residents,
include an 18-hole golf course, two clubhouses, indoor
and outdoor swimming pools, tennis courts, dining
facilities, bus transportation (within the Community and to
outside shopping centers), a medical center with
pharmacy, and full maintenance services.”
Federalism, Innovation and Yardstick
Competition
“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 country.”
Justice Brandeis, New State Ice Co. v. Liebmann,
285 U.S. 262, 311 (1932) (dissenting
Louis Brandeis, 1856-1941
Yardstick Competition
The existence of other governments provides a yardstick to
measure the quality of your government which is useful
even if you never move.
– Corporate law advances at a quicker pace in the US in response
to technological change than in Europe.
– Improved policing strategies in New York were adopted by other
cities when crime fell in New York.
– The East Germans knew what life was like in the West and this
knowledge helped to ferment the revolutions of 1989-1991.
– Governors who raise taxes are more likely to be reelected if
neighboring states also raise taxes.
Minimal Federalism
• A minimal definition of federalism (Riker 1964):
1. At least two hierarchical governments over the same land and
people.
2. Each government with institutionalized autonomy in its own
sphere. (Autonomy protected by more than legislation.)
•
Minimal federalism is not sufficient to generate
important benefits.
–
Tiebout competition (and yardstick competition) doesn’t do
much if the field of competition is unimportant.
Market Preserving Federalism
• Market preserving federalism (Weingast 1995) is defined
as minimal federalism plus:
1. Subnational governments have primary regulatory
responsibility over the economy.
2. Subnational governments cannot erect trade barriers against
one another – national free-trade is ensured.
3. Subnational governments face hard budget constraints.
• MPF means that Tiebout/yardstick competition will be
over something important, economic policies set by
subnational governments.
• Competition encourages the subnational governments to
adopt good policies while bad policies are limited by
hard budget constraints.
Market Preserving Federalism (cont)
• MPF helps to depolitize economics.
– The governments with the right to bail out inefficient firms are
limited by competition and hard budget constraints.
– The central government does not face competition and has a soft
budget constraint but it does not have the right to bail out firms.
• MPF requires real autonomy of the subnationals. If the
subnationals are greatly subsidized they are insulated
from competition.
0
5
10
15
20
25
Federal Grants as a Share of State and Local Revenues
1900
1920
1940
1960
Year
Source: Gruber 2005
1980
2000
Market Preserving Federalism (cont)
• MPF is inspired by the original Federalism of the United
States:
The powers delegated by the proposed Constitution to the
Federal Government are few and defined. Those which are to
remain in the State Governments are numerous and indefinite.
The former will be exercised principally on external objects, as
war, peace, negotiation and foreign commerce;... the powers
reserved to the several States will extend to all the objects,
which, in the ordinary course of affairs, concern the lives,
liberties and prosperities of the people.
The Federalist, #45
Argentina as an Example of What Not To Do
• On paper, Argentina has a very
decentralized government. The
provinces have the primary
responsibility for education, health
services, poverty programs, housing,
economic infrastructure and so forth
and they also have the primary rights
to collect taxes.
• On paper, Argentina could be an
example of MPF in action.
Argentina as an Example of What Not To Do
• But in practice, Argentina’s fiscal
structure is bizarrely inverted. Spending
is decentralized but the provinces have
ceded taxing authority so that taxes are
centralized. Taxes flow to a single large
bucket in the center before being
redistributed back to the provinces.
– About half of the total spending is done by the
provinces (two-thirds excluding pensions) but
a majority of the spending is financed by
transfers from the center.
– In fact, most of the provinces finance less
than 20 percent of their own spending!
• What incentives does this create?
Argentina as an Example of What Not To Do
• The provincial governments spend someone else’s money
and tax their own citizens for the benefit of other people!
Thus expenditures are high but provincial taxes are low.
– Why tax the people who elect you in order to benefit the people
in another province?
• The Federal government has repeatedly bailed out the
provincials.
– This is both a sign of the problem (undisciplined provincial
expenditures) and a cause of the problem (moral hazard).
• Add to this that each province has its own central bank and
the provinces borrow extensively in both the national and
international markets.
• The provinces do not have hard budget constraints.
Argentina as an Example of What Not To Do
• At the national level some taxes are required by law to
be shared with the provinces (and vice-versa) but tax
revenue from other sources is non-shared. This leads to
an inefficient focus on the non-shared taxes which are
too high at the same time as the shared taxes are too
low.
• Spending is based not on demand/need but on archaic
rules and regulations and/or who is in power on that day.
• Thus in practice Argentina violates most of the principles
of MPF.
Minimal Federalism is Not Enough
Market Preserving Federalism requires the
discipline of competition - the subnational
governments responsible for economic policy must
bear the costs and benefits of their political
choices both economically and politically.
The Spillover Problem
Wiping up the Spillovers:
Intergovernmental Relations
• Coordination: If interests are common sometimes
coordination is enough to solve problems.
• Coordination of tax systems.
• Joint agreements over pollution, public good production etc.
• Regulation of air travel.
• When bargaining is not enough Federalization, i.e.
relinquishment of control to the central government, may
be justified.
• The federal government “internalizes” the spillovers and so
doesn’t have an incentive to underinvest or overinvest as would
the sub-nationals but lack of incentive to do wrong is not the
same as a positive incentive to do right!
Redistribution and the Problem (?)
of Welfare Magnets
• British 19th century poor laws tried to limit mobility by
restricting the poor to their home parishes.
• Articles of Confederation excluded “paupers” from right
to free travel across the states.
• 1996 welfare legislation said benefits to newly-arrived
residents could be limited to the amount they would have
received in the state of exit. But this was ruled
unconstitutional in the 1999 Supreme Court case Saenz
v. Roe.
Wiping up the Spillovers:
Intergovernmental Relations
• Federalization is one solution but there are others
requiring less central control.
• Intergovernment grants.
– Matching grants versus block grants.
– Welfare reform of 1996 moved from matching grants to block
grants – block grants give the states greater room and
incentive for innovation (perhaps leading to diffusion via
yardstick competition) at price of reduced cost-sharing and
thus a higher price on the margin for increasing welfare.
• Note also, however, that the “decentralization” to the
states was also accompanied by strings.
• There is a very real danger that central finance becomes
central control.
Federalism and Crime
Applying the Tools
Prior to the twentieth century the states
defined and prosecuted nearly all criminal
conduct – with exceptions
for treason, bribery
of federal officials,
theft of government
property and a
few other clearly
federal issues.
Federalism and Crime
• Theory suggests decentralized approach to crime was
efficient.
– Crime is mostly a state and especially a local matter,
preferences and circumstances differ, experimentation can
spread innovations, Tiebout competition can create a
competitive market in crime fighting.
• The expansion of interstate commerce and with it
interstate crime certainly suggests, however, that
increasing federalization of crime may be justified.
• But how much federalization is necessary and of what
crimes?
Federalism Theory and the Federalization of
Crime
A federal role in crime control can be justified in
two circumstances.
1. Positive Spillover: The states underinvest in crimefighting because the costs of fighting crime are theirs
alone but some of the gains spillover to other states.
2. Negative Spillover: The states overinvest in crime
fighting because the benefits of fighting crime are
theirs alone but some of the costs spillover to other
states.
Positive Spillovers
A. Who should/will prosecute a hacker who lives in Georgia
but who hacks into computers in New York City?
B. Who should prosecute a kidnapper who crosses state
lines. (Lindbergh Act)
C. Crime fighting in border cities to detect and capture
imports of contraband and exports of stolen property.
• Federalization of crime may be best way to
handle examples but subsidies and mutual
enforcement agreements may also be sufficient.
Negative Spillovers 1
How should these spillovers be handled?
Negative Spillovers 2
How should these spillovers be handled?
Negative Spillovers 3
How should these spillovers be handled?
Federalization of Crime Has Grown Even
Where Not Necessary
• There are now at least 3,500 federal crimes and
probably well over 4,000.
• A large fraction, about half, of these have been added
since 1970.
• Many federal crimes do deal with positive spillovers
and/or federal questions.
• But many federal crimes followed the wake of news
flurries about especially brutal crimes and seem to have
been passed so that Federal officials could be seen to
be “doing something,” rather than because the states
lacked any competence or incentive to fully prosecute.
The Crime Fighting Congress
• In 1998 House Majority Leader Dick Armey argued:
– ‘‘[The] Republican-led crackdown on violent criminals . . . is the
real reason for recent gains in public safety.’’
• To support his argument, he cited a long list of
‘‘legislative victories,’’ including
– The Juvenile Crime Control Act
– The Church Arson Prevention Act
– The Sex Crimes against Children Prevention Act
• Armey’s argument might leave the naïve to wonder why
juvenile crime, church arson and sex crimes against
children were not illegal until 1998.
Federalism and Medical Marijuana
The Federal government continues
to prosecute marijuana users under
Federal criminal law even when legal
under state law.
Yet the theory of federalism is strongly in favor of decentralization on this
question.
Laboratories of democracy, Tiebout competition, yardstick competition,
heterogeneity of preferences, few spillovers – all these suggest that on
issues like medical marijuana the states should have full authority.
Federalism and
Physician-Assisted
Suicide
• Oregon voters approved Measure 16 the
Death With Dignity Act in 1994. The act
was challenged but was in essence
passed again with strong support (60-40)
and took effect in October of 1997.
• The act allows terminally ill patients,
under proper safeguards, to obtain a
physician's prescription to end life.
• Federalist principles support the right of
Oregon voters to pass a doctor-assisted
suicide law.
• Laboratories of democracy, heterogeneity
of preferences, few spillovers – all these
suggest that on issues like doctorassisted suicide the states should have
full authority.
• Ruled constitutional in Gonzales v.
Oregon, 546 U.S. 243 (2006).
Other Problems With the Federalization
of Crime
• Overloading of the Federal Courts
• De-facto Double Jeopardy
• Selective Prosecution. Aristotle said justice
means treating equal persons equally. What
then to make of Rudolph Giuliani’s Federal Day?
Conclusions
• Federalism has many advantages but it has
no natural constituency.
• Federalism is about a balance of power.
• Balances are hard to maintain.
Federalism
The Optimum Size and Shape of Governments
Alexander
Tabarrok
Department of Economics
George Mason University
Tabarrok@gmu.edu
Federalism Around the World
A Brief Detour
• The US is one of the most decentralized
(federalist) countries in the world but has been
slowly centralizing over the past century.
• Around the world most countries are becoming
less centralized.
Central Government Share of Spending is High
but Slowly Declining
• The central government
share of spending also
shows trends towards more
decentralization.
• Note, however, that political
measures of decentralization
show more decentralization
than the central government
share of spending, i.e. more
decentralization on paper
than in practice.
• Latin America is considerably
less decentralized than the
developed countries on this
score.
0
5
10
15
20
25
Federal Grants as a Share of State and Local Revenues
1900
1920
1940
1960
Year
Source: Gruber 2005
1980
2000
Who is on the Margin of Mobility?
• Not all citizens are equally mobile.
• Tiebout competition assumes that the mobile citizens are
similar to the immobile citizens so that Tiebout
competition will benefit everyone.
• In the same way that careful shopping by consumers who are
informed benefits all computer buyers.
• But what if the mobile citizens differ systematically from
the immobile citizens?
• Tiebout competition will then benefit the mobile with no
necessary gain to the immobile and perhaps at the
expense of the immobile.
• The wealthy elderly.
• Mobile corporations (subsidy seekers).
Is Voice Superior To Exit?
• If exit is costly then citizens may
exert more “voice.” Opening the
exits can diminish voice to the
detriment of third parties.
– School choice leading to exit of the
types of parents who monitor schools.
• But voice and exit can be
complements as well as substitutes.
• Voice is not always good – it
depends on who is speaking!