Chapter 18
Fiscal Federalism and State and
Local Government Finance
1
Levels of Government





Federal
State
County (called a Parish in Louisiana)
School, Water, Fire, Sanitation District
City, Town, Village
2
Grants-in-Aid

The federal government sends 15% of its
tax revenue to state and local governments.

Most of this money goes to fund Medicaid
and TANF programs that states are required
to provide.
3
Fiscal Federalism

Fiscal Federalism is the structure of the
levels of governments in which each level
has sources of revenues and economic or
fiscal responsibilities.
4
Local Public Goods
Local public goods are goods that create no
rivalry to the good within a certain
geographic area.
Examples:
 local streets
 sewers and sanitation systems
 parks
 police protection
 fire protection
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Providing Local Public Goods Locally

The benefit of providing local public goods with
local tax dollars is that the preferences of the
population using the services can be matched
with their willingness to pay taxes to receive
them.

The problem with providing local public goods
with local tax dollars is that differences in the
ability to pay between local jurisdictions can
cause differences in the provision of public
goods: This is sometimes seen as inequitable.
6
Centralized vs Decentralized Decisions

An important problem for a society: which goods
and services should be provided at which level of
government?

Are equity concerns more or less important than
the concerns of matching preferences to service
levels? For instance, should primary and
secondary education be provided nationally or
locally?
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Mobility between Jurisdictions: Voting
with Your Feet

When local public goods are provided in differing
amounts in different communities, citizens can move from
one jurisdiction to another to match their preferences for
local public goods.

This concept is called the Tiebout model, in which people
choose jurisdictions as they choose any good. Each
jurisdiction provides services that come at a price (the tax
rate) and people can choose how much government to
consume by choosing where they want to live.
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The Global Economy and Federalism


The European Union (EU):
 pushed federalism beyond national borders by
agreeing to establish uniform regulations and tax
systems to establish more integrated economies.
 eliminated border and customs controls between
member nations.
 replaced individual currencies with the Euro
The U.S.
 Infrastructure and education have increasingly
become the responsibility of state and local
government.
 Tax competition among states often limits their ability
to raise revenue
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Interjurisdictional Externalities

Costs or benefits accrue to citizens in one
jurisdiction that result from the public
goods choices of another jurisdiction.

A suburb with higher taxes to provide better
parks may provide recreation to more than
just its own citizens.
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The Theory of Taxation with a
Decentralized System
The Tax Base

People being taxed can move to another jurisdiction as a
result of a tax placed upon them. The elasticity of the tax
base represents this as the percentage change in the tax
base divided by the percentage change in the tax rate.

A new tax can therefore increase overall revenues or
decrease overall revenues, depending upon whether the
new tax raises more revenue from a new base being taxed
than is lost from existing taxes because people leave the
jurisdiction.
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Tax Base Elasticity, Tax Rates and Revenues
Values of ET
Changes in Tax
Rates t
Changes in
Revenues (tB)
ET > –1
(inelastic)
ET = –1
(Unit elastic)
An increase in t
A decrease in t
Either an increase
or a
decrease in t
An increase in t
A decrease in t
Revenues increase
Revenues decrease
No change in
Revenues
ET < –1
(elastic)
Revenues decrease
Revenues increase
12
Tax Competition and Tax Exporting


Jurisdictions attempt to lure residents and
business to an area by offering them lower tax
rates or tax abatements. This is called tax
competition. For example, governments issue tax
abatements to industries if they agree to move to
their community.
When jurisdictions place a tax on a good that is
consumed by people who do not live in the
jurisdiction this is called tax exporting. For
example, cities place a hotel tax on visitors to
their communities.
13
Fiscal Capacity
Fiscal capacity is a measure of a
jurisdiction’s ability to raise revenue.
Possible Measures
 Per capita income
 Per capita retail sales
 Per capita assessed valuation
14
Revenue Effort

Revenue effort is a measure of how much
revenue a jurisdiction is collecting relative
to how much it could collect.

It is typically measured as the ratio of the
tax collections from all sources in a
jurisdiction to its per capita income.
15
Interstate Tax Exportation

Many state governments do succeed in exporting their tax
burden to residents of other states.

Tax exportation arises in a variety of ways:




Tax out-of-state input owners who employ their inputs in the
state
Tax goods and services purchased by out-of-state individual
Tax hotels and entertainment activities
The federal deductibility of state and local income and
property taxes from taxable income under the income tax
amounts to tax exportation.
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Governmental Grants




Categorical Grants are grants by one level of government to
another to support a specific program.
Matching Grants are grants by one level of government to
another that must be matched by the receiving government
in support of a program.
Unconditional Grants are grants by one level of government
to another that may be used for any broad purpose.
Sometimes called Block Grants or Revenue Sharing.
Because money not spent in one area when a grant is
received can be spent in another, a restricted grant may
serve unintended purposes. This is called fungibility.
17
Federal Grants in Aid
Year
Grants as a Percent of
State and
Local
Outlays
Federal
Outlays
GDP
1970
19.0
12.3
2.4
1980
26.3
15.5
3.5
1990
18.7
10.8
2.5
2002
26.3
17.5
3.4
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The Theory of Grants
If you are in the role of the Federal
Government you can



provide the good;
provide local governments with an incentive
to provide the good themselves with
matching grants, or
provide local governments with the means to
provide the good with categorical grants or
with block grants.
19
Expenditures on Private
Goods per Year
Figure 18.1 Political Equilibrium: A Matching Grant
Versus a Nonmatching Grant of Equal Value
G
A'
A
M
T1
G
Slope = – ti(1 – m)
E
M'
E'
{
QP1
QP2
Slope = – ti
B
B'
C
Public Goods per Year
20
Impact of a Nonmatching Grant on the
Political Equilibrium


A nonmatching grant would likely (depending on
the preferences of the median voter) increase both
the level of public goods produced as well as
allow for lower taxes so that more private goods
could be consumed.
Less of the grant is devoted to public goods with
a nonmatching grant than with a matching grant.
21
Cost of Removal per
Pound (Dollars)
Figure 18.2 Matching Grant
A
Net Gain in Well-Being
E
10
8
Grant per Unit
of Abatement
Local Cost
per Unit of
Abatement
E*
MSC
SMBN = MSB
SMBL
100 150
Pollution Abated per Year (Thousands of Pounds)
22
Education Finance

What is the proper role of the federal
government in school finance? The
question is one of equity vs local control.
Because some school districts are poor
relative to others, a completely local
system could be seen as inequitable. On the
other hand, local control of the curriculum
is seen as important as well.
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