Chapter 18

Fiscal Federalism and State and

Local Government Finance

1
 Levels of Government

 Federal
 State
 County (called a Parish in Louisiana)
 School, Water, Fire, Sanitation District
 City, Town, Village

2
 Grants-in-Aid

 The federal government sends 15% of its tax

revenue to state and local governments.

 Most of this money goes to fund Medicaid and

TANF programs that states are required to
provide.

3
 Fiscal Federalism

 Fiscal Federalism is the structure of the

levels of governments in which each level
has sources of revenues and economic or
fiscal responsibilities.

4
 Local Public Goods
Local public goods are goods that create
no rivalry to the good within a certain
geographic area.
Examples:
 local streets
 sewers and sanitation systems
 parks
 police protection
 fire protection
5
 Providing Local Public Goods Locally
 The benefit of providing local public goods with
local tax dollars is that the preferences of the
population using the services can be matched
with their willingness to pay taxes to receive
them.

 The problem with providing local public goods

with local tax dollars is that differences in the
ability to pay between local jurisdictions can
cause differences in the provision of public
goods: This is sometimes seen as inequitable.

6
Centralized vs Decentralized Decisions
 An important problem for a society: which goods
and services should be provided at which level of
government?

 Are equity concerns more or less important than

the concerns of matching preferences to service
levels? For instance, should primary and
secondary education be provided nationally or
locally?

7
 Mobility between Jurisdictions: Voting
with Your Feet
 When local public goods are provided in differing amounts
in different communities, citizens can move from one
jurisdiction to another to match their preferences for local
public goods.

 This concept is called the Tiebout model, in which people

choose jurisdictions as they choose any good. Each
jurisdiction provides services that come at a price (the tax
rate) and people can choose how much government to
consume by choosing where they want to live.

8
 The Global Economy and Federalism
 The European Union (EU):
 pushed federalism beyond national borders by
agreeing to establish uniform regulations and tax
systems to establish more integrated economies.
 eliminated border and customs controls between
member nations.
 replaced individual currencies with the Euro
 The U.S.
 Infrastructure and education have increasingly become
the responsibility of state and local government.
 Tax competition among states often limits their ability
to raise revenue

9
 Interjurisdictional Externalities

 Costs or benefits accrue to citizens in one

jurisdiction that result from the public
goods choices of another jurisdiction.

 A suburb with higher taxes to provide better

parks may provide recreation to more than
just its own citizens.

10
 The Theory of Taxation with a
Decentralized System
The Tax Base

 People being taxed can move to another jurisdiction as a result of

a tax placed upon them. The elasticity of the tax base represents
this as the percentage change in the tax base divided by the
percentage change in the tax rate.

 A new tax can therefore increase overall revenues or decrease

overall revenues, depending upon whether the new tax raises
more revenue from a new base being taxed than is lost from
existing taxes because people leave the jurisdiction.

11
Tax Base Elasticity, Tax Rates and Revenues
Values of ET Changes in Tax Changes in Revenues
Rates t (tB)
ET > –1 An increase in t Revenues increase
(inelastic) A decrease in t Revenues decrease
ET = –1 Either an increase No change in
(Unit elastic) or a Revenues
decrease in t
ET < –1 An increase in t Revenues decrease
(elastic) A decrease in t Revenues increase

12
 Tax Competition and Tax Exporting
 Jurisdictions attempt to lure residents and
business to an area by offering them lower tax
rates or tax abatements. This is called tax
competition. For example, governments issue tax
abatements to industries if they agree to move to
their community.
 When jurisdictions place a tax on a good that is
consumed by people who do not live in the
jurisdiction this is called tax exporting. For
example, cities place a hotel tax on visitors to
their communities.

13
 Fiscal Capacity

Fiscal capacity is a measure of a

jurisdiction’s ability to raise revenue.
Possible Measures
 Per capita income
 Per capita retail sales
 Per capita assessed valuation

14
 Revenue Effort

 Revenue effort is a measure of how much

revenue a jurisdiction is collecting relative
to how much it could collect.

 It is typically measured as the ratio of the

tax collections from all sources in a
jurisdiction to its per capita income.

15
 Interstate Tax Exportation
 Many state governments do succeed in exporting their tax
burden to residents of other states.

 Tax exportation arises in a variety of ways:

 Tax out-of-state input owners who employ their inputs in the
state
 Tax goods and services purchased by out-of-state individual
 Tax hotels and entertainment activities

 The federal deductibility of state and local income and

property taxes from taxable income under the income tax
amounts to tax exportation.

16
 Governmental Grants
 Categorical Grants are grants by one level of government to
another to support a specific program.
 Matching Grants are grants by one level of government to
another that must be matched by the receiving government
in support of a program.
 Unconditional Grants are grants by one level of government
to another that may be used for any broad purpose.
Sometimes called Block Grants or Revenue Sharing.
 Because money not spent in one area when a grant is
received can be spent in another, a restricted grant may
serve unintended purposes. This is called fungibility.

17
 Federal Grants in Aid
Year Grants as a Percent of

State and Federal GDP

Local Outlays
Outlays
1970 19.0 12.3 2.4

1980 26.3 15.5 3.5

1990 18.7 10.8 2.5

2002 26.3 17.5 3.4

18
 The Theory of Grants

If you are in the role of the Federal Government

you can
 provide the good;
 provide local governments with an incentive to
provide the good themselves with matching
grants, or
 provide local governments with the means to
provide the good with categorical grants or with
block grants.

19
 Figure 18.1 Political Equilibrium: A Matching Grant
Versus a Nonmatching Grant of Equal Value
Expenditures on Private

G
Goods per Year

A'
A
Slope = – ti(1 – m)
M E
T1 E'
M' {
G Slope = – ti

QP1 QP2 B B' C

Public Goods per Year
20
 Impact of a Nonmatching Grant on the
Political Equilibrium
 A nonmatching grant would likely (depending on
the preferences of the median voter) increase both
the level of public goods produced as well as
allow for lower taxes so that more private goods
could be consumed.
 Less of the grant is devoted to public goods with
a nonmatching grant than with a matching grant.

21
 Figure 18.2 Matching Grant

A
Cost of Removal per

Net Gain in Well-Being

Pound (Dollars)

E E*
10 Grant per Unit
MSC
of Abatement Σ MBN = MSB
8
Σ MBL
Local Cost
per Unit of
Abatement

100 150
Pollution Abated per Year (Thousands of Pounds)
22
 Education Finance
 What is the proper role of the federal
government in school finance? The
question is one of equity vs local control.
Because some school districts are poor
relative to others, a completely local
system could be seen as inequitable. On the
other hand, local control of the curriculum
is seen as important as well.

23