Local Government Expenditures: A Social Welfare Analysis

Author(s): James M. Henderson

Source: The Review of Economics and Statistics , May, 1968, Vol. 50, No. 2 (May, 1968),
pp. 156-163
Published by: The MIT Press

Stable URL: https://www.jstor.org/stable/1926191

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 LOCAL GOVERNMENT EXPENDITURES:
A SOCIAL WELFARE ANALYSIS
James M. Henderson*
I Introduction
ANUMBER of economists have endeavored
to "explain" one or more types of local
government expenditures. Hawley [6], Brazer
[3], Hirsch [7], and Hansen [5] have been
prominent among these. Each has employed a
one-equation multiple-regression model to ex-
press per capita local expenditures as a function
of selected independent variables using cross-
section data. This paper also contains a mul-
tiple-regression analysis of per capita cross-
section data. However, two equations derived
from explicit optimizing behavior are used.
The theory of collective choice through the
medium of a social-welfare function was in-
troduced by Bergson [2], and extended by
Samuelson [8], Arrow [1], and Graaff [4].
Theil [9], has developed an elaborate empiri-
cally oriented analysis in which quadratic
social-welfare functions play a major role.
Beyond this, social-welfare functions have sel-
dom served as a basis for empirical work.
This paper attempts another move in the em-
pirical direction. Some of the concepts of
social-welfare analysis are applied to the ex-
penditure and tax decisions of local govern-
ments. The collective consumer is the popu-
lace of a local area. Collective decisions are
made by elected representatives following the
rules of a democratic society. It is postulated
here that the resultant public expenditure and
tax decisions can be explained as if they were
the result of maximizing a social welfare func-
tion subject to a social budget constraint, both
defined in expenditure space.
Particular forms for social, or in the current
context community, welfare functions and
budget constraints are assumed and the conse-
quences of community welfare maximization
examined in the next section of this paper. The
third section contains descriptions of data, pro-
cedures and results for empirical analyses of
United States counties on a cross-section basis
*The author is grateful to John C. Hause and Anne
0. Krueger for their helpful suggestions.
[ 156 ]
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using the concepts of the preceding section.
The behavior implications of estimates for
metropolitan and nonmetropolitan counties are
examined in the following two sections. A
final section contains some concluding remarks.
II Community Welfare Maximization
Community Welfare Functions
The elected representatives of local govern-
mental units make many decisions on behalf
of the residents of their communities. Atten-
tion is here centered upon their selection of
local public expenditure and tax levels. The
major exogenous variables which influence their
decisions, but are not influenced by them in-
clude personal income levels and revenues from
other governments, and population size.
The analysis of expenditure and tax decisions
is focused upon two goods -or more accu-
rately, two types of expenditures - from which
the members of a community derive satisfac-
tion: (1) public expenditures and (2) private
expenditures. In this context public expendi-
tures are limited to expenditures made by the
local government or governments being investi-
gated. Private expenditures are defined as per-
sonal income less local taxes and thus include
taxes paid to state and federal governments
as well as consumption and savings.
A community's ordinal collective welfare, de-
noted by W, is expressed as a function of its
per capita public and private expenditure levels,
denoted by G and X respectively:
Wz= (ao+alY+a2R + a3P) logeG + X (1)
where Y is the community's per capita personal
income, R is its per capita revenue from federal
and state governments, P is its population, and
e = 2.71828 . . . is the base of the system of
natural logarithms. The functional form (1)
is termed "logex" since the variable G is raised
to the power given by the expression in paren-
thesis and X enters as an exponent of e.1 The
'The ordinal function (1) also can be written as
U = G(ao + ai Y + a2R + a3P)ex
after the transformation U = eW.
 LOCAL GOVERNMENT EXPENDITURES 157
general form of the welfare function covers all
communities. The values of Y, R, and P may
vary from community to community. Since
they are exogenous for the decision makers in
each community, the term in parenthesis in
(1) is a parameter.
Community Budget Constraints
A consumer's expenditures are limited by
the finance provided by his income, assets and
ability to borrow. Community expenditures are
similarly limited. They are financed by local
taxes, intergovernmental revenues and new
debt. The canons of local finance are sum-
marized by the equation:
T= /(G-R) (2)
in which per capita local taxes, T, are assumed
to be a fixed proportion of the difference be-
tween local expenditures and intergovernmental
revenues. New per capita debt, denoted by D,
is the difference between local expenditures and
local taxes plus intergovernmental revenues:
D =G - T - R = (1 - ,) (G - R).
If j8 = 1, local taxes would just cover expendi-
tures not financed by intergovernmental rev-
enues and the community would incur no new
debt. This is not the usual observed case, how-
ever. Most local governments have increased
debt rapidly in recent years to partially finance
capital expenditures. Hence, values for ,8 of
less than unity appear normal.
Substituting T = Y - X in (2) and re-
arranging terms, the community budget con-
straint can be expressed in terms of the same
variables as the community-welfare function:
X +P8G = Y +PAR. (3)
The left-hand side of (3) relates expenditures
to income sacrifice. Each dollar of private ex-
penditure utilizes one dollar of income. Each
dollar of local expenditures, however, requires
a sacrifice of only ,B dollars for local taxes with
the remaining (1 - ,) dollars financed by new
debt. Intergovernmental revenues are con-
verted to an income equivalent in a similar
fashion on the right-hand side of (3).
Maximum Welfare
Local representatives are assumed to select
values for G and X that maximize their com-
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munity's welfare (1) subject to its budget con-
straint (3). Form the Lagrange function.
L = (ao + alY + a2R + a3P) logeG
+X-x(X+,BG-Y-/3R) (4)
and set its partial derivates equal to zero,
DL (ao+al+a2R+a3P) _ =
DG G
DL
DX - 1-k = 0
aL - X +#G - Y -,BR = 0.
Eliminating X = 1 the first-order conditions for
community welfare maximization are
G =A+ y + a2R + :3P
X=Y-/3(G-R) (5)
together with the definitions
T= Y-X
D=G-T-R. (6)
The second-order condition for constrained-
welfare maximization requires that the com-
munity indifference curve be convex. Differen-
tiating (1) totally and substituting from (5),
the first and second-order conditions imply
that
d2X (ao + al Y+ a2R + a3P) ,B
dG2 G2 G
Since both j8 and optimal values of G must be
positive for the system to be meaningful, the
fulfillment of the first-order conditions will en-
sure fulfillment of the second-order condition.
III Empirical Estimates
The Data
Estimates for the parameters of the first-
order conditions, (5) and (6), have been de-
rived from cross-section data for United States
counties. Per capita values for G, T, and R
are from the 1957 Census of Governments.2
These figures cover all of the local govern-
ments, i.e., cities, school boards, special dis-
tricts and commissions, etc., within each
2 See Local Government Finances and Employment in
Relation of Population: 1957, State and Local Government
Special Studies: Number 45 (Washington, 1961). The spe-
cific categories used are "total general expenditure" for G,
"total taxes" plus "charges and miscellaneous general rev-
enue" for T, and "total intergovernmental revenue" for R.
 158 THE REVIEW OF ECONOMICS AND STATISTICS
county. Corresponding county per capita per-
sonal income data cover 1959 and are drawn
from the 1960 Census of Population.3 Personal
income generally increased between 1957 and
1959. However, the Census income data ap-
pear to be underestimates on the basis of in-
dependent data for the United States as a
whole. Therefore, the Census per capita income
data for 1959 were taken as true data for
1957. County population levels for 1957 were
derived from Census of Population data for
1950 and 1960 by assuming constant annual
rates of change over the ten-year period.
The Regression Equations
Rewriting the local expenditure and tax
equations of (5) and (6) in stochastic form,
ao +ali a a3
Gi = + p Y, + Rj + -3Pi + U*
T, = (G, - Rj) + v, (7)
where the subscript i denotes observations, and
ui and vi are disturbances. Simple least squares
is appropriate for the expenditure equation.
The tax equation has the dependent variable G
on its right-hand side and simple least-squares
usually would provide inconsistent estimators
of /.4 Therefore, two-stage least squares are
used for the tax equation.5 The tax equation
is also unusual in that its constant term is
forced to zero.
The regression equations were fitted sep-
arately for metropolitan and nonmetropolitan
counties. The 100 counties with the largest
1957 populations are defined as metropolitan.
The remaining 2,980 counties for which the
requisite data are available comprise the non-
metropolitan group.
The metropolitan equations are
G = 9.9982 + .0439Y + 1.4231R + .0102P
(16.9620) (.0077) (.1376) (.0037)
-2 = .651,
3 See Bureau of the Census, County and City Data
Book: 1962 (Washington, 19.62). Table 2 provides 1959
aggregate income and 1960 population on a county basis.
The 1960 population data were adjusted to 1959 by assum-
ing constant annual rates of change between 1950 and
1960.
'Simple least squares would yield a consistent esti-
mator if us and v4 were independent. See Wold [10]. Un-
fortunately, this assumption does not hold in the present
case.
' See Theil [9], 225-231.
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and
T = .9046(G - R) R2 = .389
(.1183)
were P is measured in thousands of persons and
the remaining variables in 1957 dollars per
capita. The corresponding nonmetropolitan
equations are
G- -20.8280 + .0819Y + 1.0371R - .2734P
(2.7829) (.0020) (.0259) (.0203)
R2 = .552,
and
T=.9651 (G-R) R2 - .377.
(.0229)
Each coefficient, except the constant in the
metropolitan expenditure equation, is signifi-
cantly different from zero at a one per cent
confidence level with a t-test.
IV Local Behavior
The coefficient estimates presented in the last
section are used to draw inferences about the
behavior of local governmental bodies in metro-
politan and nonmetropolitan counties and be-
havioral differences between the two groups
of counties. These inferences are prefaced by
a brief comparison of the two groups of coun-
ties.
County Characteristics
The mean metropolitan and nonmetropoli-
tan counties are quite different. Foremost, the
mean metropolitan county has a much larger
population and a much higher personal in-
come than its nonmetropolitan counterpart-
692,580 people contrasted with 21,241 and 2172
dollars per capita contrasted with 1334. The
mean metropolitan county pays higher local
taxes ($117.91 to $78.79), has larger local ex-
penditures ($170.11 to $130.85), and has
smaller intergovernmental revenues ($40.52 to
$49.11). The mean nonmetropolitan county
carries a heavier local tax burden - 5.95 per
cent of personal income contrasted with 5.39
per cent.
Expenditures, Taxes and Debt
The coefficient ,8 gives the proportion of local
expenditures not financed by intergovernmental
revenue that are financed by local taxes. The
remaining proportion (1 - 8) is financed by
 LOCAL GOVERNMENT EXPENDITURES 159

new local debt. The estimated j3 coefficients TABLE 1. -RESPONSE OF ENDOGENOUS VARIABLES TO
PERSONAL INCOME INCREMENTS
are less than unity for both groups of counties
(dollars per dollar)
indicating that both use debt as a means of
finance. The coefficients, 0.9046 for the metro- Metropolitan Nonmetropolitan
Counties Counties
politan counties and 0.9651 for the nonmetro-
Local expenditures .0439 .0819
politan, suggest a greater reliance upon debt Private expenditures .9603 .9210
for the metropolitan. This differential is in Local taxes .0397 .0790
Local debt .0042 .0029
accord with expectations in that the metro-
politan counties are growing faster, have a
higher proportion of total expenditures for capi- ties. The income response differential of the
tal purposes which are traditionally financed two groups of counties is discussed further in
in part by debt, have better credit ratings than section V where income elasticities of demand
smaller units and can borrow at lower cost. for local and private expenditures are derived.
However, the metropolitan coefficient has a
relatively high standard error and a t-test at a Intergovernment Revenue Response
confidence level of 5 per cent does not reject It is clear from the local budget constraint
the null hypothesis that the sample data were that intergovernmental revenues are an income
drawn from distributions with the same mean equivalent.
,B. If they were a perfect income
equivalent, one would expect the same distribu-
Income Response tion of such revenues between local and private
The responsiveness of the endogenous va-i- expenditures as would be achieved from a per-
ables to changes in the exogenous are deter- sonal income increment of the same amount.
mined given the assumption that the first-order Most intergovernmental grants require that
conditions are always satisfied. Differentiat- their proceeds be used directly to finance local
ing (5) and (6) totally and solving for the expenditures. Federal grants, in particular, are
endogenous variables in terms of the exoge- often made on a basis whereby the recipient
nous: must provide matching funds for a particular
purpose, e.g., highways or urban renewal. Such
dG = -dY + a2dR + 3 dP rules limit the use of intergovernmental rev-
dX = (1-aL)dY- (a2-,8)dR-- a3dP enues for the expansion -of private expendi-
dT = al dY + (a2-/3)dR + a3dP tures. Nonetheless, it may be possible to in-
directly allocate intergovernmental revenues to
dD= LdY + 'Y-dR+!adP private expenditures by simply providing less
(8) for tax-financed expenditures. This process
where yl = a(l -8), 72 = (a2-,/) (1-/3) cannot be observed directly. However, the re-
and Y3 = a3(1 - 8). gression coefficients provide some indirect evi-
The coefficients a, and (1 -a,) give the dence.
distribution of a marginal dollar of personal Response coefficients based upon the regres-
income for local taxes and private expenditures sion equation estimates are presented in table
respectively assuming that dR -dP= 0. Es- 2. A marginal dollar of intergovernmental rev-
timates of these coefficients derived from the enue leads to more than one dollar of new local
regression equations are listed in table 1. They expenditures for both groups of counties.
indicate that a marginal income dollar gen- Hence, these revenues are less than perfect in-
erates a tax increase for the nonmetropolitan come substitutes for both. An intergovernmen-
counties twice as large as a similar increase tal revenue increase also leads to increases of
for the metropolitan - $0.0790 contrasted with local taxes and debt, and a reduction of pri-
$0.0397. Private expenditures are increased vate expenditures for both groups of counties.
less in nonmetropolitan counties. The expendi- The relative response rates for the two groups
tures differential is somewhat smaller than the of counties contrast with their personal income
tax differential because of the greater expan- response rates. The metropolitan counties show
sion of local debt by the metropolitan coun- a much larger response than the nonmetropoli-

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160 THE REVIEW OF ECONOMICS AND STATISTICS

tan - $1.4231 of new local expenditures per
marginal grant dollar contrasted with $1.03 71
for the nonmetropolitan. The metropolitan
counties also increase local taxes and debt more
and decrease private expenditures more.
support to a value substantially in excess of
unity. Brazer's sample covered 462 cities with
populations over 25,000 for 1950-1951. His
other independent variables were population
density and past population growth.

TABLE 2. -RESPONSE OF ENDOGENOUS VARIABLES TO Population Response

INTERGOVERNMENT REVENUE INCREMENTS Population increments, with per capita per-
(dollars per dollar)
sonal income and grants fixed, have opposite
Metropolitan Nonmetropolitan
effects upon the two sets of counties. The
Counties Counties
metropolitan counties increase per capita local
Local expenditures 1.4231 1.0371 expenditures, taxes and debt, and reduce pri-
Private expenditures -.3827 -.0358
Local taxes .3827 .0358
vate expenditures as population increases. The
Local debt .0404 .0013 nonmetropolitan reduce local expenditures,
taxes and debt, and increase private expendi-
tures.
Unity provides a departure point for evalu-
The reduction of per capita local expendi-
ating local expenditure response to intergov-
tures with population increase is very marked
ernmental revenues. A value less than unity
for the nonmetropolitan counties, $0.2734 per
would be prima-facie evidence of the ability
thousand of population. This may be the re-
of communities to divert intergovernmental
sult of decreasing costs in the provision of pub-
revenues indirectly to private expenditures. If
lic services. A small community must provide
a grant requires y dollars of locally financed
many public services at relatively high per
local expenditures per dollar of grant, a coeffi-
capita costs which decline as its population in-
cient greater than unity but less than (1 + y)
creases. Education, hospitals, police and sew-
would also indicate a form of diversion. It is
age removal normally are examples. In each
not possible to estimate y directly. However,
case marginal cost is below average cost as
matching requirements are widespread and it
total service level increases.
appears reasonable to presume a value greater
than zero. TABLE 3. - RESPONSE OF ENDOGENOUS VARIABLES TO
The values of the local-expenditure response POPULATION INCREMENTS
coefficients given in table 2 are suggestive with (dollars per capita per thousand people)
respect to the problem of intergovernmental
Metropolitan Nonmetropolitan
revenue diversion. The coefficient for the non- Counties Counties

metropolitan counties, $1.03 71, is close to unity Local expenditures .0102 -.2734

and may well be less than (1 + y). If so, there Private expenditures -.0093 .2638
Local taxes .0093 -.2638
is diversion for the nonmetropolitan. Local debt .0009 -.0096
The metropolitan response coefficient,
$1.4231, appears to be much larger than any
The average per capita cost for many pub-
reasonable value for (1 + y). Rather than
lic services may eventually increase. The
diversion, the metropolitan response suggests
metropolitan local expenditure response coeffi-
an element of "bandwagonism" in that the re-
cient is positive but much smaller in absolute
ceipt of grants may induce metropolitan coun-
value than the nonmetropolitan - $0.0102 in-
ties to commit local funds beyond matching re-
crease of per capita local expenditures per
quirements to projects that would not otherwise
thousand population increase. The largest
have been undertaken.
metropolitan county had a 1957 population in
Harvey Brazer obtained an intergovernmen-
excess of five million. The population coeffi-
tal revenue coefficient of 1.740 dollars with
cient suggests that its per capita local expendi-
total operating expenditures per capita as the
tures would exceed that of the smallest by
dependent variable.6 His results thus add some
more than fifty dollars given identical per-
'See [31,25. sonal income and grant levels. The costs of

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 LOCAL GOVERNMENT EXPENDITURES 161
very large size and congestion may be substan-
tial.
There is a reinforcing, or perhaps alternative,
explanation of increasing per capital local ex-
penditures with size for the metropolitan coun-
ties. The larger communities provide a broader
range of services than the smaller ones. There
are many services that a small community
cannot or need not provide. Therefore, the resi-
dents of the larger communities may receive
more per capita services for their larger per
capita expenditures as well as paying more for
the same services provided in smaller metro-
politan areas.
Brazer [3] concluded that city population
size was not a significant variable in the de-
termination of per capita expenditures. He
found a simple relationship between expendi-
tures and population, but his population vari-
able lost significance once other variables such
as population density and past population
growth rate were included in his regression
equations. Hirsch [7] found that population
was not a significant variable for communities
within the St. Louis metropolitan area. Ex-
periments with density and growth variables
such as those used by Brazier instead of popu-
lation were unsuccessful.
The conclusions of this study stand in con-
trast to those of Brazer and Hirsch. Popula-
tion size is a significant variable. The impor-
tance of the population variable appears to be
a result of the stratification of counties into
metropolitan and nonmetropolitan groups. A
regression equation was fitted for the 462 coun-
ties with the largest 1957 populations to allow
comparison with Brazer's results. The popu-
lation variable was not significant at a 5 per
cent confidence level.
V Income Elasticities for Local Services
Partial Elasticities
Elasticities for local and private expendi-
tures with respect to personal income are de-
rived from (8) with dR -dP = 0:
aG Y a1Y
aY G (ao+a3P)+alY+a2R
(9)
ax V
'Exy ay DX
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(a1-al) Y
-(ao+a3P) + (1-al) Y- (a2-,(&)R
Elasticities for the expenditures with respect to
intergovernment revenue are derived from (8)
with dY= dP 0:
DG R a2R
DR G (ao+a3P) +alY+a2R
(10)
aX R
EX? R X
(a,2-/3) R
-(ao+a3P)+(1-al)Y- (a2-/3)R
Unity is not an appropriate standard for thes
elasticities. In general, an expenditure elas-
ticity is a ratio of marginal and average ex-
penditure rates. Thus, it is above unity if the
marginal rate exceeds the average and below
unity if the average exceeds the marginal. The
marginal rates for the above elasticities are
each defined in terms of only one of two income
components -Y for (9) and R for (10). In
both cases the average rate reflects expendi-
tures from both income components. Hence,
(9) and (10) give partial elasticities.
Total Income Elasticities
Total income, denoted by Y*, is defined as
the sum of the two income components:
Y* = Y + ,3R. Total income elasticities are
derived by assuming that Y and R change in
proportion to their average ratio, i.e., R = uY,
dR = udY and dY* = dY + /dR where u is
a constant:
=EGY alY+a2R EGy + EGt
(ao+a3P) +alY+ca2R
(11)
(1 -al) Y-(a2-13)R
EX =^ - (ao+a3P) + (1-al) Y- (a2-/3)R
- EXY + EXR
The total elasticities thus are sums of the par-
tial elasticities.
The average of the G and X total elasticities,
using the respective expenditure weights ,G/Y*
and X/Y*, is unity. Hence, unity is a mean-
ingful standard for evaluation of the total elas-
ticities. If the term (ao + a3P) is positive,
zero or negative, EGY* will be less than, equal
to or greater than unity respectively, and cor-
respondingly Exy* will be greater than, equal
to or less than unity. The observed expenditure
 162 THE REVIEW OF ECONOMICS AND STATISTICS
weights for private expenditures are about ten
times as great as those for local expenditure.
Hence, deviations of EGy* from unity will be
about ten times as large as deviations of EXy*
from unity.
Empirical Elasticities
Partial and total income elasticities were
computed by inserting regression coefficients
and mean values of the variables in the elas-
ticity equations. These are presented in table
4*7 The wide differential between the personal
TABLE 4. -PARTIAL AND TOTAL INCOME ELASTICITIES
FOR MEAN METROPOLITAN AND NONMETROPOLITAN
COUNTIES
Metropolitan Nonmetropolitan
COy .561 .835
eol .339 .389
eGy* .900 1.224
eXY 1.015 .979
exR -.008 -.001
exy* 1.007 .978
income partial elasticities is a result of the wide
difference in the regression coefficients (ac/f8)
noted in the last section. The differential ratios
of personal income to local expenditures works
in the opposite direction. A partial elasticity
computed from the metropolitan coefficient and
the nonmetropolitan personal income-local ex-
penditure ratio is 0.448 which is even lower
than that obtained from the metropolitan ratio.
The situation is somewhat different for the
intergovernmental revenue partial elasticities.
The regression coefficient (a2/,8) is much
higher for the metropolitan counties, but the
corresponding partial elasticity is much higher
for the nonmetropolitan. This follows from a
large difference in the intergovernmental rev-
enue - local expenditure ratio - 4.198 for the
metropolitan counties contrasted with 2.664 for
the nonmetropolitan. The metropolitan coef-
Since the tax equations have zero constant terms, they
are not necessarily satisfied by the means of their variables.
Therefore, in lieu of means, values of X were calculated by
inserting the mean values of Y and G in the tax equations
and subtracting these calculated T values from the mean
personal income levels. The differences between these calcu-
lated values and the means for T and X are small - $0.13
for the metropolitan counties and $0.10 for the nonmetro-
politan.
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ficient together with the nonmetropolitan means
yields a partial elasticity of 0.534; the non-
metropolitan coefficient together with the met-
ropolitan means yields 0.247.
The total elasticities reflect relative prefer-
ences, i.e., are greater than unity, for private
expenditures for the mean metropolitan county
and for local expenditures in the mean non-
metropolitan county. This may suggest that
the poorer metropolitan counties have greater
unfilled needs for local services as witnessed
by their willingness to sacrifice marginally more
private expenditures than the metropolitan.
VI Concluding Remarks
This paper began with the assumption that
local expenditure and tax decisions could be ex-
plained as if local representatives maximized
logex local welfare functions subject to local
budget constraints. The consequences of such
constrained maximization have been derived
and coefficients for first-order conditions esti-
mated by the application of two-stage least
squares to county data for metropolitan and
nonmetropolitan areas. None of the coefficients
violated expectations as to sign and order of
magnitude, and all but one constant are signifi-
cantly different from zero at a one per cent
confidence level. The logex is only one of many
possible forms for a local welfare function.
Some other function may provide a better and
perhaps substantially different analysis.
Comparisons based upon the regression equa-
tion coefficients show four major differences
between the metropolitan and nonmetropolitan
counties: (1) the nonmetropolitan are more
responsive to per capita personal income incre-
ments with intergovernmental revenues and
population constant, (2) the nonmetropolitan
have a relative marginal income preference for
local over private expenditures and the metro-
politan have a relative income preference for
private, (3) the metropolitan are more respon-
sive to per capita intergovernmental revenue
increments with personal income and popula-
tion constant, and (4) nonmetropolitan per
capita local expenditures decrease with popula-
tion increments with personal income and
grants constant and metropolitan per capita
expenditures increase with population. In con-
 LOCAL GOVERNMENT EXPENDITURES 163

trast with other recent studies population is a
significant variable.
A final word of caution is in order. All of
the conclusions of this paper are based upon
cross-sectional county data for a single year.
A time-series analysis might yield different
conclusions.
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