Public Finance In Economics

(Econ 3122)
Chapter 9
Fiscal Federalism

Addis Ababa University

Department of Economics
Course instructor: Kefyalew Endale (Ph.D.)
May 2021
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 Major Contents
• Definition of fiscal federalism
• Gains from decentralization
• The Tiebout model (voting by feet)
• Advantages and disadvantages of decentralization

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 Fiscal Federalism
• Federal Government: is a public sector with both
centralized and decentralized level of decision making.
– Choices concerning the provision of public services are determined
largely by the demands for those services by the residents in their
respective jurisdiction.

• Fiscal federalism: reflects the complicated relationships

between local and high level authorities.

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 The Welfare Gains from Decentralization: the
Decentralization Theorem
• Assumptions:
1. The population of a particular nation/state is divided into two
distinct localities
2. A local public good is to be provided in each locality and the
cost is to be shared equally by each resident
The next figure illustrates the demand for the local public good by
the two representative individuals, one from each locality

B
E A C MC
P
D
DA
DB
O
QB Q* QA
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 The Welfare gains cont’d
• DA and DB are demands of the representative individuals in
localities A and B, respectively.
• MC-marginal cost of providing the public good (assume it is
constant)
• P- the price paid by each representative individual.
Centralized regime:
– Supply OQ* level (which is a compromise level between demands
in the two localities
– This level is lower than the amount demanded in locality A and
larger than the demand in locality B
– Both localities experience welfare losses at OQ*. The losses are
represented by the areas of triangles ABC and AED.
– Triangle ABC indicates the welfare losses that arise because
individual A doesn’t consume as much as he/she would choose if
there were no need to compromise. She would be glad to pay
5/25/2021QACQA to made the extra output (QA-Q*) available. 5
 The Welfare gains cont’d
• Triangle ADE indicates the welfare losses that are experienced by
individual B because she is consuming more than she would choose.
She paid QBEAQ* for the extra output (Q*-QB) but she valued the
additional output only at QBEDQ*
• Thus, if each locality could provide itself with just the quantity of
the good that it requires, these dead weight losses could be
avoided.
• Decentralization permits each locality to provide itself with the
quantity of the good it prefers.
• The above efficient gains from decentralization arise as
government deals with its allocative function
• By contrast macro stabilization and income distribution have to
be addressed by central government owing to
– Openness of local governments (mobility of people between localities)
– Lack of macroeconomic policy instrument at the disposal of local
governments 6
 The Tiebout Model: Vooting by feet
• The theory of local public goods has been used as a partial explanation
for the distribution of nation’s population among different fiscal
jurisdictions (i.e., local governments)
• Individuals are assumed to select communities which best fits their
private preference.
• The advantage of openness of the local economy is that decentralized
public finance offers the benefits of improved allocative efficiency.
• Individuals can migrate from one local jurisdiction to another in
response to local taxes and expenditure between jurisdictions.
Assumptions of the model
i. Free mobility of consumers (i.e migration is costless)
ii. Local taxes are not variable (there is a lump sum tax)
iii. Many communities to choose from
iv. No spillover effect from the local public goods
v. The outcome of the voting with one’s feet may not be considered as desirable
on the ground of distributive justice.
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 The Tiebout Model Cont’d
• Given the assumptions (in the previous slide), Tiebout suggested
that if there were sufficiently large number of local communities,
and if each community is offered a different menu of public goods
(expenditure), then each individual could be thought to select the
local community to live which provides a level of public goods and
output corresponding to his preference.
• By voting with their feet, individuals simultaneously reveal their
preferences and promote an efficient allocation of resources in the
public sector.
• Furthermore, since all of those who choose to live in the same
community will have similar tastes, there is no voting problem.
Thus, the allocation of resources is pareto efficient.
• In sum, assuming that migration is costless and local governments
produce output at minimum average costs, and that local taxes are
lump sum ad non-distortionary, then
– The Tiebout hypothesis demonstrates that the provision of public goods by a
system of competitive local governments will be no less efficient than the
allocation of private goods by market economy.
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 Advantages of decentralization
1. Tailoring output to local tastes: local governments proximity to the people
makes it more responsive to citizens preference than central governments.
– Local governments are likely to provide the goods and services demanded by
the residents efficiently.
– Central government, on the other hand, tend to provide the same level of
goods and services throughout the country regardless of the people’s
preference or taste.
2. Fostering intergovernmental Competition: local/sub-national provision
may lead to people becoming more aware of the costs and benefits of public
goods, and hence making better choices about public goods. Citizens can
choose among communities as they are free to move and this kind of threat may
lead to public managers to provide goods and service efficiently.
3. Experimentation and innovation in locally provided goods/services: a
system of diverse governments enhance the chance of new solutions to
problems to be sought. This is made possible by experimentation through
letting each community choose its own way and then compare the results.
This is important because for many policy questions, no one is certain about
the right answer, or even whether there is a single solution that is best in all
situations. 9
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 Limitations of decentralization
The limitations can be broadly classified into efficiency and equity related
1. Efficiency related limitations arise due to the following factors
i. Externalities: decentralized local authorities / communities impose externalities
(negative or positive) to each other. Since each community care more for its
members, the inter-jursdictionary externalities/spillovers may be overlooked.
This causes an inefficient allocation of resources and may require the
interventions of the central governments to control or regulate. Example
pollution (Addis Vs Tafo), public education , health (eg. Diredawa-nearby
region people occupy the heath centers and schools).
ii. Scale economies in the provision of public goods: for certain public
goods/services the cost-per person may fall as the number of users increases.
This implies that the small communities may not be able to enjoy this unless
they come together.
iii. Inefficient tax system: efficient tax systems require that inelastically demanded
or supplied goods and services has to be taxed at relatively higher rates and
vice versa. However, taxes levied on decentralized system are not efficient
from the national point of view. Taxes are levied based on whether a
commodity is exportable or importable. Exportable goods are taxed at higher
rate while importable goods are at low rate so as to induce production of such
goods in the locality. Tax collection efforts of the local governments could
also decrease as they get grants from the federal government 10
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 Limitations of decentralization
iv. Scale economies in tax collection: individual communities/authorities
may not be able to take advantage of scale economies in the collection
of taxes. Each authority of the community will devote to tax
administration. Resources could be saved if there is a joint taxing
authority.
2. Equity Issues
• Maximization of the social welfare may require income transfer to the
poor. Since people’s decision to relocate in a given community may be
influenced by the available tax-welfare package, a community with
expenditure –tax pattern favorable to its low income members may be
attractive to the poor from the rest of the country (unless there are
barriers to movement between communities). As the population
increases, so does the cost of redistribution of fiscal policy.
• At the same time, in the communities the upper income people may
decide to exit on the ground that they cannot pay high taxes for the poor
when they can move to any other community where expenditure-tax
pattern is to their own advantage.
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 Group assignment
• Assess Ethiopia’s fiscal constitutional
assignments of
i. Financial expenditures (Article 94)
ii. Tax collections (Articles 96, 97, 98, and 99).

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