Public Sector Econ Lecture 3 - State and Local

Public Sector Economics: Lecture 3
Prof. Alexander Gelber
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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10
C H AP T E R 1 0 S T AT E AN D LO C AL G O V E R N M E N T E X P E N D I T U R E S
Fiscal Federalism
The United States has a federal system,

dividing activity between a national
government and state and local
governments.
Education, for example, is often provided by
state and local governments.
Optimal fiscal federalism: The question
of which activities should take place at
which level of government.
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10.1
Fiscal Federalism in the United States and Abroad
Much state and local spending is supported

by intergovernmental grants.
o Intergovernmental grants: Payments
from one level of government to another.
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Application:EffectofFiscalStimulus
ARRA (stimulus bill) increased the percentage of Medicaid
expenditures that the federal government pays for all states by 6.2
percentage points and increased the match rate by more for states
that experienced especially large increases in unemployment.
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Application:EffectofFiscalStimulus
Overall conclusion: $100,000 in stimulus was associated
with 3.8 additional job-years (3.2 job-years outside the
government, health, and education sectors).
The big picture: was stimulus in the form of transfers to
states worth it? Should there be further stimulus now?
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10.2
The Tiebout Model
What determines how much and how

efficiently public goods local governments
provide?
The market provides the optimal amount of
private goods.
Why does the market do so well for private
goods but not public goods?
Tiebouts insight: shopping and
competition.
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10.2
The Tiebout Model: Shopping and Competition
There is little shopping or competition for a

national government.
But when public goods are provided at the
local level by cities and towns, competition
arises.
o Individuals can vote with their feet.
This threat of exit can induce efficiency in
local public goods production.
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10.2
The Formal Model
Competition across towns can lead to the

optimal provision of public goods.
Towns determine public good levels and tax
rates.
People move freely across towns, picking
their preferred locality.
People with similar tastes end up together,
paying the same amount in taxes and
receiving the same public goods.
There is no free riding because everyone
pays the same amount in each town.
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ProblemswithTieboutmodel?
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10.2
Problems with Tiebout Model
The Tiebout model requires a number of

assumptions that may not hold in reality,
including:
People are actually be able to move.
People have full information on taxes and
benefits.
People must be able to choose among a
range of towns that might match their
taste for public goods.
No externalities from one jurisdictions
policy to another.
Means that one jurisdictions policy has
no effect on well-being of other
jurisdictions.
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10.2
Capitalization of Fiscal Differences into House

Prices
Fiscal differences across jurisdictions are also
reflected in house prices.
House price capitalization: Incorporation
into the price of a house the costs
(including local property taxes) and benefits
(including local public goods) of living in the
house.
Areas with relatively generous public goods
(given taxes) should have higher house
prices.
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10.2
EVIDENCE: Evidence for Capitalization from

Californias Proposition 13
Californias Proposition 13 became law in
1978.
o Set the maximum amount of any tax on
property at 1% of the full cash value.
o Note: actual property tax rate can be
higher due to voter-approved debt,
Mello-Roos taxes, and other taxes
o Full cash value: Value as of 1976, with
annual increases of 2% at most.
Reduced property taxes immensely in some
areas (with high property taxes before Prop
13), little change in others (with low property
taxes before Prop 13).
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10.2
EVIDENCE: Evidence for Capitalization from

Californias Proposition 13
Each $1 of property tax reduction increased
house values by about $7, about equal to
the PDV of a permanent $1 tax cut.
In principle, the fall in property taxes would
result in a future reduction in public goods
and services, which would lower home
values.
The fact that house prices rose by almost
the present discounted value of the taxes
suggests that Californians did not think that
they would lose many valuable public
goods and services when taxes fell.
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10.2
Optimal Fiscal Federalism

Tiebout model implies that the extent to which public
goods should be chosen locally depends on three
factors:
1. Tax-benefit linkages: The relationship between the
taxes people pay and the government goods and
services they get in return. Goods with strong taxbenefit linkages should (all else equal) tend to be
provided locally.
If residents can directly enjoy benefits of
property taxes, they are willing to pay local
taxes. If not, they leave.
Example: local welfare policy.
2. Cross-municipality spillovers in public goods.
3. Economy of scale (if any) in public good provision.
If taxes and benefits are linked, and there are no
Public
Finance and Public
Jonathan Gruber of
Fourth
Edition Copyright
2012 Worth
Publishers good14 of 35
spillovers
orPolicy
economies
scale,
then local
public
Application:StateandLocalIncentivesforBusiness
Location
http://www.nytimes.com/2012/12/02/us/how-local-taxpayers-bankrollcorporations.html
States, counties and cities giving over $80b/year to companies. Is this socially
efficient? What, if anything, should the federal government do?
Example: $22 million + payroll tax break to Twitter and other companies
(e.g. Yammer) for locating in San Francisco (rather than the Peninsula).
Other companies (e.g. Uber, Square) now in that general area
Exempts companies that move to or remain in theMarket and Tenderloin
districts from paying the payroll tax on new employees for six years.
San Francisco companies with payrolls higher than $250,000 are
charged a 1.5 percent business tax on employee compensation.
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10.3
Redistribution across Communities

Enormous inequality in revenue across
municipalities.
Berkeley raises $12,802/student while
Bolinas-Stinson raises $28,928.
Should we care?
o If Tiebout is right, then this reflects optimal
sorting and financing.
o But if not, redistribution might be called for.
o Note: may prefer to redistribute by
income, not location.
o The main tool of redistribution is
intergovernmental grants, cash transfers
from one level of government to another.
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10.3
Matching Grants
Grants come in multiple forms, with different

implications.
Block grant: A grant of some amount with
no mandate as to how it is spent.
Conditional block grant: A grant of
some amount with a mandate as to how it
is spent.
Matching grant: A grant, the amount of
which is tied to the amount of spending by
the local community.
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10.3
Tools of Redistribution: Grants
Other
spending
(thousands
)
$1,000
500
500
IC1
B
$1,000
Education
spending
(thousands)
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10.3
Matching Grants
Education spending matched one-for-one
with grants from a higher level of
government
Other
spending
(thousands
)
$1,000
625
500
IC2
IC1
B
500 750 1,000
C
$2,000
Education
spending
(thousands)
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10.3
Block Grant
Other
spending
(thousands
) D
$1,375
1,000
A
Z
800
625
500
Y
X
IC3
IC1
500575750 1,000
1,375
Income effect
Substitution effect
C
$2,000
Education
spending
(thousands)
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10.3
Conditional Block Grant
Other
spending
(thousands
) D
$1,375
1,000
F
Z
800
625
500
Y
X
IC3
IC1
B
0
375500575750 1,000
Income effect
Substitution effect
E
1,375
C
$2,000
Education
spending
(thousands)
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10.3
Implications of Different Grant Types

Different grant types affect incentives in
different ways.
Matching grants rotate out the budget
constraint, acting like a subsidy.
o Help with externalities, since they are
targeted.
Block grants shift out the entire budget
constraint, raising spending on all goods.
o Good if redistribution is the goal.
Conditional block grants may differ from
block grants if the amount of the grant is
greater than the initial educational
spending.
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Application:IncentivesforMedicaidExpansion
Affordable Care Act authorizes states to expand
Medicaid to adults under age 65 with income up to 138
percent of federal poverty level (FPL).
Federal government pays 100 percent of the cost of
newly eligible adult Medicaid beneficiaries through
2016.
Phases down to a 90 percent matching rate by 2020
and remains at 90 percent permanently.
As originally written, ACA compelled states to include
in Medicaid expansion all non-disabled adults up to
138% of FPL or risk losing all Medicaid funding
John Roberts decision in NFIB vs. Sebelius: this was
a gun to the head and unconstitutional coercion of
states
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StatesexpandingMedicaidunderACA
https://www.you
tube.com/watch
?
v=SvwN6oJiuTY
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10.3
Redistribution in Action: School Finance Equalization
A very important local redistribution is

school finance equalization.
School finance equalization laws: Laws
that mandate redistribution of funds across
communities in a state to ensure more
equal financing of schools.
o Example: New Jersey redistributes most
revenue from towns with per capita
revenue above the 85th percentile.
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10.3
Redistribution in Action: School Finance Equalization
Different structures result in different tax

prices.
Tax price: For school equalization schemes,
the amount of revenue a local district would
have to raise in order to gain $1 more of
spending.
If half of revenue is redistributed, tax price
is $2.
If all revenue is redistributed, tax price is
infinite.
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10.3
APPLICATION: School Finance Equalization and

Property Tax Limitations in California
School finance equalization in California
meant tax price became very high
Note that spending differences across
localities remain.
Taxes no longer financed local school
spending; largely just taxes, rather than
prices.
Proposition 13 sometimes said to have been
a response to school finance equalization in
California.
i.e. voters were happy to limit property
taxes once those taxes brought them
little benefit.
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10.3
EVIDENCE: The Flypaper Effect
The simple model implies that conditional

grants largely crowd out local spending.
In our example, conditional block grant
of $375 raised local spending on
education by only $75 (from $500 to
$575).
Implied crowdout of local spending
on education: $300 (=$375-$75).
Looking at how states spend grant money,
some empirical literature has found that the
flypaper effect matters: The money sticks
where it hits.
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10.4
Conclusion
Central governments collect only part of

total tax revenues and spend only part of
total public spending.
The Tiebout model suggests that the
spending should be done locally when:
o Strong tax-benefit linkages.
o Little cross-municipality spillovers.
o No economies of scale in public good
provision.
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10.4
Conclusion
Higher levels of government may still want

to redistribute across lower levels of
government.
o If the higher-level government decides
that it wants to redistribute across lower
levels, it can do so through several
different types of grants.
o Appropriate choice of grants depends on
goal of government financing.
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Public Sector Economics: Lecture 3

Prof. Alexander Gelber

The United States has a federal system,

Fiscal Federalism in the United States and Abroad

Much state and local spending is supported

The Tiebout Model

What determines how much and how

The Tiebout Model: Shopping and Competition

There is little shopping or competition for a

The Formal Model

Competition across towns can lead to the

Problems with Tiebout Model

The Tiebout model requires a number of

Capitalization of Fiscal Differences into House

EVIDENCE: Evidence for Capitalization from

EVIDENCE: Evidence for Capitalization from

Optimal Fiscal Federalism

Redistribution across Communities

Grants come in multiple forms, with different

Tools of Redistribution: Grants

Conditional Block Grant

Implications of Different Grant Types

Redistribution in Action: School Finance Equalization

A very important local redistribution is

Redistribution in Action: School Finance Equalization

Different structures result in different tax

APPLICATION: School Finance Equalization and

EVIDENCE: The Flypaper Effect

The simple model implies that conditional

Central governments collect only part of

Higher levels of government may still want

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