Chapter 10

State and Local Government

Expenditures

Jonathan Gruber
Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

 Introduction

 Optimal fiscal federalism is the question of which

activities should take place at which level of
government.
 For example, welfare programs were historically
financed at the federal and state level, while
education is largely financed at the state and local
level.
 FISCAL FEDERALISM IN THE U.S.
AND ABROAD
 Early in the history of the United States, the federal
government played a relatively limited role.
 The last amendment of the Bill of Rights of the
United States Constitution states:
“The powers not delegated to the United States by the
Constitution, nor prohibited by it to the states, are
reserved to the states respectively, or to the people.”
 Figure 1 shows the spending patterns over time.
 Figure 1

Federal
State
In 1902,
and
government
the
local
federal
governments
was
government
responsible
The were
role
The ofshare
the federal
of state
government
financing coming
responsible
accounted
for national
fordefense,
only
education,
34%foreign
of
grew
police,
totalwith
fromthetheintroduction
federal government
of the has
relations,
roads,
government
sanitation,
judicialspending;
functions,
welfare,
federal
local
health,
and grown
income
the because
tax and ofthejoint
Newprogram
Deal like
Breakdown
governments
hospitals,
postal of so
accountedTotal
service.
and forGovernment
on.
programs
58%. of cash
theSpending
welfare
Great Depression.
and Medicaid.

100%
Share of Total Government Spending

80%

60%

40%

20%

0%
1902

1927

1952

1977

2002
Federal State Local
 FISCAL FEDERALISM IN THE U.S.
AND ABROAD
 The largest element of state and local spending is
education, followed by health care and public safety.
 For federal spending, the largest elements are health
care, Social Security, and national defense.
 Spending and Revenue of State and Local
Governments
 The major source of revenue at the state and local
level is the property tax, the tax on land and any
building on it.
 Property taxes raised $253 billion in revenue in
2001, and accounted for almost one-half of the
non-grant revenues of local governments.
 Fiscal Federalism Abroad

 The U.S. sub-national governments collect a much

larger share of total government revenue than in
other countries, and spend a somewhat larger share
of total government spending.
 Table 1 shows this.
 Table 1

Subnational government spending/revenue as a

share of total government spending/revenue
Spending % Revenue %
Greece 5.0 3.7
Portugal 12.8 8.3
France 18.6 13.1
Norway On the spending
Theside, the state/local38.8
average government 20.3
differences are slightly
United States collectsless
22% of total 40.0
government 40.4
dramatic.revenue, while those in the U.S.
Denmark 57.8
collect 40%. 34.6
OECD Average 32.2 21.9
 Fiscal Federalism Abroad

 The higher level of centralization in other nations

exists because state/local governments have almost
no legal power to tax citizens.
 Many countries practice fiscal equalization,
whereby the national government distributes grants
to sub-national government in an effort to equalize
differences in wealth.
 Fiscal Federalism Abroad

 There has been a move toward decentralization

around the world.
 In the U.S., there have been increased efforts to shift
control and financing of public programs to the
states, such as with welfare reform in 1996.
 OPTIMAL FISCAL FEDERALISM

 What is the optimal division of responsibilities

across different levels of government?
 A theory of how the efficiency of public goods
provision may differ at different levels of
government helps answer this questions.
 OPTIMAL FISCAL FEDERALISM

 Two of the major problems in public goods

provision are:
 Preference revelation: Difficult to design democratic
institutions to cause individuals to reveal their
preferences honestly.
 Preference aggregation: Difficult to aggregate individual
preferences into a social decision.
 The Tiebout Model

 Tiebout (1956) showed that the inefficiency in

public goods provision came from two missing
factors: shopping and competition.
 Shopping induces efficiency in private markets.
 Competition induces the right prices and quantities
in private markets.
 The Tiebout Model
 With public goods provided at the local level,
competition naturally arises because individuals can
vote with their feet by moving to another town without
much disruption.
 This induces fiscal discipline for local governments
and creates a new preference revelation device: mobility.
 Tiebout argued that the threat of exit can induce
efficiency in local public goods production.
 Under certain (unrealistic) conditions public goods
provision will be fully efficient at the local level.
 The Tiebout Model

 Tiebout’s formal model assumes the following:

 Large number of individuals, who divide themselves
up across towns that provide different levels of
public goods.
 Town i has Ni residents who all demand Gi of the
public good.
 Uniform tax of Gi/Ni.
 The Tiebout Model

 Tiebout’s model solves two problems:

 Preference revelation: There is no incentive to lie.
With a uniform tax on all residents, the consumer
saves 1/Ni in tax but receives 1/Ni less of the public
good.
 Preference aggregation is solved because everyone in
the town wants the same level of public goods, Gi.
 Problems with the Tiebout Model

 There are a number of problems with the model,

however, related to:
 Tiebout competition
 Tiebout financing
 Spillovers
 Problems with the Tiebout Model

 Tiebout competition may not hold because:

 It requires perfect mobility.
 It requires perfect information on the benefits
individuals receive and the taxes they pay.
 It requires enough choice of towns so that
individuals can find the right levels of public goods.
 Problems with the Tiebout Model

 Tiebout financing is problematic because:

 It requires lump-sum taxes that are independent of
a person’s income. This is viewed as highly
inequitable.
 It is more common for towns to finance public
goods through proportional taxes on homes, leading
to the problem of the poor chasing the rich.
 The use of zoning can ameliorate this problem.
 Problems with the Tiebout Model

 Zoning regulations protect the tax base of wealthy

towns by pricing lower income individuals out of
the housing market.
 For example, a town that prohibits multifamily
dwelling such as apartments lowers the available
amount of housing, and thus inflates the value of
existing housing, keeping the poor out.
 Problems with the Tiebout Model

 Tiebout model is also problematic because of the

assumption of no externalities or spillovers:
 Model assumes public goods only have effects in a
given town, and that they do not spill over to
neighboring towns.
 Some public goods, like a public park, probably
violate this assumption.
 Evidence on the Tiebout Model

 Even given the problems of the Tiebout model the

basic intuition that individuals vote with their feet is
still a strong one. Two types of tests reveal this:
 Resident similarity
 Capitalization
 Evidence on the Tiebout Model

 A clear prediction of the Tiebout model is that

residents in a local community will have similar
preferences for local public goods.
 The more local communities and choices, the more
residents can sort themselves into similar groupings.
 Gramlich and Rubenfeld (1982) found greater
sorting in larger metropolitan areas (where mobility
costs would be smaller), and greater satisfaction with
public goods provision.
 Evidence on the Tiebout Model

 Very little actual mobility is required for the Tiebout

mechanism to operate because people not only vote
with their feet.
 They also vote with their pocketbook.
 Tiebout model predicts that any differences in fiscal
attractiveness will be capitalized into house
prices.
 Evidence on the Tiebout Model

 That is, the price of any house reflects the costs

(including local property taxes) and benefits
(including local public goods) of living there.
 Holding taxes constant, higher levels of public
goods raise housing prices.
 Hold public good levels constant, raising taxes
lowers housing prices.
 Housing prices are a reflection of people voting
with their pocketbook.
 Evidence for capitalization from
California’s Proposition 13
 Proposition 13 was a voter initiative passed in 1978
that limited the ability of localities to levy property
taxes.
 It limited the tax rate to 1% of a home’s assessed
value.
 More importantly, it limited the tax base–the house’s
value. The base could increase by only 2% per year,
unless the home was sold.
 A typical Los Angeles home saw its property tax
increase 80% in the four years prior to Proposition 13.
 Evidence for capitalization from
California’s Proposition 13
 Rosen (1982) studied 60 municipalities in the San Francisco
area, before and after Proposition 13.
 The treatment group were the towns with high property tax
rates prior to Proposition 13.
 The control group were the towns with low property tax rates.
 Using this approach, Rosen found that for every $1 of
property tax reduction house values increased by about $7,
which implies close to full capitalization.
 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.
 Evidence for capitalization from
California’s Proposition 13
 In reality, many localities were forced to drastically
cut services.
 San Jose, California laid off art and music teachers
in elementary schools, cut bus transportation, fired
school nurses and guidance counselors, and
shortened the school day from 6 to 5 periods.
 Even so, in 1983, the school district became the first
American public school system in 40 years to
declare bankruptcy.
 Optimal Fiscal Federalism
 What are the normative implications of the Tiebout
model?
 That is, what should be the principles that guide the
provision of public goods at different levels of
government?
 The extent to which public goods should be
provided at the local level is determined by:
 Tax-benefit linkages
 Positive externalities or spillovers
 Economies of scale
 Optimal Fiscal Federalism
 First, the model implies that the extent to which public
goods should be provided at the local level is determined by
tax-benefit linkages.
 Strong linkages (such as local roads) means most residents
benefit, and the good should be provided locally.
 Weak linkages (such as welfare payments) means that most
residents do not benefit, and the good should be provided at
a higher level.
 If residents can see directly the benefits they are buying with
their property tax dollars, they will be willing to pay local
taxes. Otherwise, they may “vote with their feet.”
 Optimal Fiscal Federalism

 The second factor that determines the optimal level

of decentralization is the extent of positive
externalities.
 If the local public good has spillovers to other
communities, they will be underprovided. In this
case, higher levels of government have a role in
promoting the provision of these public goods.
 Optimal Fiscal Federalism

 The third factor that determines the optimal level of

decentralization is the economies of scale in
production.
 Public goods with large economies of scale, like
national defense, are not efficiently provided by
many competing local jurisdictions.
 Public goods without large economies of scale, like
police protection, may be provided more efficiently
in Tiebout competition.
 Optimal Fiscal Federalism

 The Tiebout model therefore predicts that local

spending should focus on broad-based programs
with few externalities and relatively low economies
of scale.
 Examples include road repair, education, garbage
collection, and street cleaning.
 REDISTRIBUTION ACROSS
COMMUNITIES
 The Tiebout model allows us to consider one of the
most important problems in fiscal federalism:
Should there be redistribution of public funds
across communities?
 There is currently enormous inequality in the ability
and perhaps desire for communities to finance
public goods.
 Gaps in per-pupil spending arise because of
differences in the local property tax rate, but more
importantly, from differences in property values.
 Should We Care?

 The question then becomes should higher levels of

government mandate redistribution across lower
levels to offset these differences in spending?
 In a perfect Tiebout world, communities would have
formed for the efficient level of public goods, and
redistribution would impede that efficiency.
 Should We Care?

 To the extent that Tiebout does not perfectly

describe reality, however, there are two arguments
for redistribution.
 The first is failures of the Tiebout mechanism. For
example, even if one desires to be in a high benefit
community, a household may be priced out of it by
zoning restrictions, etc.
 The second is externalities. It is possible that local
public goods, like education, have spillovers to other
communities.
 Tools of Redistribution: Grants

 When higher levels of government redistribute, they

do so through grants–cash transfers from one level
of government to another.
 Between 1960 and 2003, grants to lower levels of
government grew from 7.6% to 17.9% of federal
spending.
 Tools of Redistribution: Grants
 Higher levels of government tend to use three types of
grants:
 Matching grants–which ties the amount of funds transferred
to the community to the amount of spending it currently
allocates to public goods.
 Block grants–a fixed amount of money with no mandate on
how it is to be spent.
 Conditional block grants–a fixed amount of money with a
mandate that it be spent in a particular way.
 The consequences of these grants are illustrated in Figure 2.
Private Imagine
Such a grant
instead actsthat
asthean city
incomewas
spending effect,
given
butan keeps identical
the price
amount ratio– at 1
(in thousands) $375,000 rather – inthan
a block
½. grant.
$1,375 Such
AInitially,
Afinal
one-for-one
a grant
alternative
themightcity“matching
faces
mandate grant”
is a conditional
a tradeoff
that the
block
changes
between
city
grant,
can
theeducation
aspend
price
fixed of amount
receive
As education
and
longprivate
up
of money
as to
theand city is already
that
$375,000
can
goods.
the
only isBut
if itprice
The
be the on
spent
spent
price
ratio
spending block
ratio
on
to ½. isgrant
education.
education.
more 1. thanalso$375,000
allows otheron
The
With
Total city
this
spending
choices, pays
lower
and only
price
on half
both
for
isofhigher
education
education,
the $750,000
ICand
the
education, it isutility
equivalent to at 3,
a block
$1,000 income
private
cost, however.
and
goods
which substitution
entailshasThe increased
state
effects
payswith
lead
the
theto
grant andThe has citynoless
effect
couldeducation.
on
stillbehavior.
choose to
$800 The anvoters
increase
remainder,
inmatching
in educational
the $375,000.
city havegrant. spending.
preferences
consume $750,000 of education.
over public and private goods. They
$625 choose $500,000 of education.
$500
IC3
IC2
IC1

$0 $375
$500
$575 $750
$1,000 $1,375 $2,000 Education
spending
(in thousands)
Figure 2 The effects of different government grants
 The flypaper effect
 As shown in Figure 2, block grants are simply
income increases to communities if they are either
unconditional or conditional but below the city’s
desired spending on the public good.
 The city should therefore reduce its own spending, a
type of crowding out, so that spending on the public
good goes up by only a fraction of the total grant
amount.
 The flypaper effect
 Researchers have compared the spending of states
that receive larger and smaller grants from the
federal government, to assess whether they largely
crowd out state spending, as the theory predicts.
 Surprisingly, after reviewing the evidence Hines and
Thaler (1995) found that crowd out is often close to
zero, so total spending rises almost one-for-one.
 The flypaper effect
 This finding has been described as the flypaper
effect, because “money sticks where it hits.”
 These older empirical studies suffer from potential
bias, however. States that value public goods the
most may be the most successful at lobbying for
federal grants.
 Thus, the positive correlation is not because of the
flypaper effect, but rather spending preferences
differ.
 The flypaper effect
 A number of recent studies, that use more
convincing quasi-experimental approaches find
evidence that is inconsistent with the flypaper effect.
 These studies suggest that the traditional conclusion
of substantial crowd-out from block grants is
supported by the evidence.
 Redistribution in Action: School Finance
Equalization
 School finance equalization laws mandate
redistribution across communities in a state to
ensure more equal financing of schools.
 Local districts receive about 45% of the funding
from local sources, primarily from local property
taxes. This dependence can lead to vast disparities
due to the wide variation in property values across
towns.
 In Texas, for example, per-pupil spending varies
by more than a factor of four from the lowest to
highest district.
 Redistribution in Action: School Finance
Equalization
 Since 1970, every state has made at least one
attempt at school finance equalization, some
prompted by state courts, others by the voting
public.
 Redistribution in Action: School Finance
Equalization
 The structure of these equalizations have taken very
different forms, some very extreme.
 California, for example, imposes a 100% tax rate on
localities that raise per-pupil spending more than
$200 above the lowest district.
 On the other hand, New Jersey gives matching
grants to localities with property values below the
85th percentile.
 Redistribution in Action: School Finance
Equalization
 Empirical work suggests that equalization laws have
had the intended effect of:
 Equalizing spending across districts.
 Equalizing student outcomes like SAT scores.
 Redistribution in Action: School Finance
Equalization
 However, equalization schemes have also had
perverse effects.
 Hoxby (2001) computed the tax price of school
equalization, the total amount of revenue a local
district would have to raise in order to get another
$1 of spending.
 In California, the tax price is infinite.
 In New Jersey, the tax price is closer to $0.6, because
of the matching grants.
 Redistribution in Action: School Finance
Equalization
 Hoxby found that extreme equalization schemes with very
high tax prices lead to an overall reduction in per-pupil
spending.
 California’s extreme equalization caused a 15% reduction
in per-pupil spending.
 Oklahoma, Utah, and Arizona’s per-pupil spending fell by
more than 10%.
 The equalization came at a cost–a “leveling down” of
spending, leading to a deterioration in the quality of public
schools and a flight toward private schools.
 Redistribution in Action: School Finance
Equalization
 Hoxby also found that equalization schemes with
low tax prices raised performance; states like New
Jersey, New York, and Pennsylvania were able to
“level up” the playing field.
 The lesson is therefore that school finance
equalization can improve outcomes in low-wealth
districts, but only if they do not excessively penalize
higher-wealth districts.
 School finance equalization and
property tax limitations in California
 Another interesting consequence of extreme school
finance equalizations is examined by Fischel (1989).
 He asked why California residents passed
Proposition 13, limiting property taxes, in 1978
rather than in earlier referenda in 1968 and 1972?
 School finance equalization and
property tax limitations in California
 The answer may lie in California’s 1974 school
finance equalization court case, known as Serrano
vs. Priest.
 This is the case that broke the Tiebout mechanism in
California by severing the linkage between taxes paid
and benefits received.
 School finance equalization and
property tax limitations in California
 Wealthy voters in California would have opposed
Proposition 13 in the absence of school finance
equalization, because their high taxes were paying
for schooling they desired for their town without
subsidizing anyone else’s school.
 School finance equalization in California changed
this, so the wealthy taxpayers were happy to approve
Proposition 13.
 Recap of State and Local Government
Expenditures
 Fiscal Federalism in the U.S. and Abroad
 Optimal Fiscal Federalism
 Redistribution Across Communities