State and Local Government Expenditures

Public Finance Dr. Katie Sauer

Figure 10-1: Changing Fiscal Federalism

The Tiebout Model Charles Tiebout asked: What is it about the private market that guarantees optimal provision of private goods that is missing in the case of public goods? His answer: - shopping - competition

While people are unlikely to move to a different nation on the basis of public goods, people do move at the state and local level. People can ³vote with their feet´ to find the level of state / local services that they prefer. The threat of exit can induce efficiency in local public goods provision.

Model: Each town i has Ni residents. Public goods spending is Gi . It is financed with a uniform tax on all residents Gi / Ni . People will sort themselves into towns such that each resident has the same taste for public goods, demanding the same level of government spending.

This model solves the problem of preference revelation: no incentive to lie because the tax is uniform

Ex: Jack and Ava are consuming a public good, fireworks. The cost of fireworks are $0.75 each. Suppose Jack moves to a town that has 99 other individuals with preferences just like his.

Lindahl Pricing: With MC = 0.75, Jack¶s optimal level of fireworks is 75.
MC

He is willing to pay 0.75 for the 75th firework. The total cost of firework provision is: 0.75 x 75 = 56.25 The tax per resident is: 56.25 / 100 = 0.5625 = 0.56

MC

Suppose, however, Jack lies and says he is willing to pay 0.75 only for the 25th firework. To be credible, he¶d have to move to a town where people have those same preferences. - Ava¶s town - 99 people

MC

In Ava¶s town, the total cost of firework provision is: 0.75 x 25 = 18.75
MC

Tax per resident would be: 18.75 / 100 = 0.1875 = 0.19 Jack would pay less in taxes, but would get less fireworks.

MC

The model rests on a number of assumptions: 1. perfect mobility 2. perfect information on the public good benefits 3. free choice over a range of towns with varying levels of public goods and there are enough towns 4. efficiencies of scale 5. no externalities / spillovers 6. lump-sum tax

Redistribution Across Communities Rationale: - Tiebout mechanism can fail (reasons people can¶t effectively sort) - externalities

Suppose the city of Lexington provides one public good: education. It finances education through property taxes. Any money that individuals do not pay in taxes will go to spending on private goods. Residents collectively have $1 million in income to allocate to taxes and private goods. Suppose residents have preferences that lead to $500,000 being spent on education and $500,000 on private goods.

Private Good spending (thousands $)

$1,000

$500

IC

BC $500 $1,000 Education spending (thousands $)

Now suppose the local government receives a Matching Grant from the state. - match rate can vary from 0.01 to more than 1 ex: a match rate of 0.50 - when a local government allocates $1, the state government will add 0.50 - from the local government¶s point of view, $1.50 worth of education is gotten for $1

- in order to provide $1 of education, the local government must spend: X + 0.5X = 1 1.5X = 1 X = 0.67

Suppose a one-for-one match. For every one dollar allocated at the local level, there is actually 1 + 1 = 2 to spend. In order to spend $1 on education, the local government needs to come up with X + (1)X = 1 2X = 1 X = 0.50

Private Good spending (thousands $)

Since the price of education is now $0.50, the budget constraint shifts out along the education axis.

$1,000

$500

IC BC2 Education spending (thousands $) $2,000

BC $500 $1,000

Private Good spending (thousands $)

Lexington can increase education spending and private goods spending. Spend $625 on private goods. Spend $1000 - $625 = $375 on education and get (1)(375) = 375 extra from the state government « $750
IC2 IC BC2 Education spending (thousands $) $2,000

$1,000

$625 $500

BC $500 $750 $1,000

Private Good spending (thousands $)

Income Effect: -new BC is ³higher´ so spend more on education Substitution Effect: - new slope on BC (flatter « edu is cheaper) so spend more on education
IC2 IC BC2 Education spending (thousands $) $2,000

$1,000

$625 $500

BC $500 $750 $1,000

A Block Grant is a fixed amount with no mandates on how it must be spent. Suppose instead of $375,000 in matching funds, the state government gives Lexington a $375,000 block grant.

Private Good spending (thousands $)

Lexington now has an extra $375,000. Spend $800 on private goods and $575 on education.

$1,375 $1,000 $800 $625 $500

IC3

IC BC2 $1,375 Education spending (thousands $) $2,000

BC $500 $750 $1,000

$575

Private Good spending (thousands $)

Income Effect: - BC is higher so spend more on education Substitution Effect: - BC has same slope, so no effect
IC3

$1,375 $1,000 $800 $625 $500

IC BC2 $1,375 Education spending (thousands $) $2,000

BC $500 $750 $1,000

$575

Because matching grants put both the income effect and substitution effect in play, they encourage spending on public goods.

A Conditional Block Grant is a fixed amount of money, that must be spent on a mandated purpose. Suppose Lexington receives a $375,000 conditional block grant for education.

Private Good spending (thousands $)

The money can¶t be spent on the private good. - can spend $1,000 on private good and spend $375 on education - can spend $0 on private good and $1,375 on education
IC3

$1,375 $1,000 $800 $625 $500

IC BC2 $1,375 Education spending (thousands $) $2,000

BC $375 $500 $750 $1,000

$575

Private Good spending (thousands $)

$1,375 $1,000 $800 $625 $500

If the town was already spending more than the grant amount on education, the grant will not change the level of spending. - effectively, the grant is not conditional - crowd out
IC3

IC BC2 $1,375 Education spending (thousands $) $2,000

BC $375 $500 $750 $1,000

$575

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