Fiscal Federalism

1. Fiscal Federalism Jonathan Rodden Stanford University August 8, 2011

2. Part 1:Broad Overview • Intellectual history • From welfare economics and public choice to political economy • Stylized facts and trends • Partial decentralization • Incomplete contracts • An example: The study of intergovernmental grants

3. Part 2: Macroeconomic management • State/local budgets and the business cycle • Pro-cyclical fiscal flows and borrowing • Fiscal discipline in multi-layered systems • The end of market discipline?

4. Intellectual history From “First Generation” to “Second Generation” fiscal federalism

5. Welfare economics • Coherent logic connecting Montesquieu, Rousseau, Tocqueville, Madison, Musgrave, Oates: • To achieve simultaneously the advantages of large and small governmental units by solving the “assignment problem.” • Oates: “The provision of public services should be located at the lowest level of government encompassing, in a spatial sense, the relevant benefits and costs.”

6. Welfare economics, cont. • Assume that political leaders are benevolent despots who maximize the welfare of their constituents. • Presumption in favor of decentralization because of: • stronger incentives • better information about preferences • above all, greater homogeneity of preferences at lower levels of government

7. Competition and sorting • Tiebout (1956): Key advantage of decentralization is the market analogy. • Citizen land-owners sort into communities that offer desired levels of taxes and bundles of goods. • Provides a powerful preference-revelation mechanism beyond voting and lobbying.

8. Competition as a restraint on government • Leviathan (Hayek 1939, Brennan and Buchanan 1980) • Tax competition prevents revenue-hungry politicians and bureaucrats from consuming too much. • Persson and Tabellini (2000), Weingast (1995) • Decentralization with capital mobility allows government to commit not to over-tax capital or over-regulate the economy.

9. Broad consensus circa 1990: • Based on theory literature, virtual consensus about potential benefits of decentralization, especially in developing countries in late 1980s

10. What went wrong? • The obvious things: • Corruption, clientelism, elite capture • Accountability problems • Challenges for safety nets and poverty reduction • Macroeconomic management: • Specifically, soft budget constraints and bailouts

11. What was the theory literature missing? • Decentralization in practice rarely resembles the type of decentralization imagined in the theory literature. • “Partial Decentralization” • Grants and shared taxes rather than autonomous local taxation • Muddy division of authority • Politicized resource distribution

12. What do we know? Trends and stylized facts

13. local regional

14. Source: GFS

15. Correlates of expenditure decentralization • Panizza 1999, Garrett and Rodden 2005: • Country size • GDP per capita • Democracy • Federal constitution • Ethno-linguistic heterogeneity?

16. But what about the revenue side?

17. Kernel density of expenditure and tax decentralization in 40 countries, 1990s

18. Histogram, Subnational tax autonomy in OECD countries (full rate and base autonomy), 1990s Switzer-land Canada USA Source: OECD

19. Federalism vs. decentralization • Federalism has roots in a bargain or contract • Coming together vs. holding together • To be credible, the contract usually requires institutional protections: • Unit-based rather than population-based representation • Supermajority requirements • Courts with judicial review • Explicit delimitation of powers & responsibilities, residual powers

20. The division of expenditure responsibilities

21. Source: Henderson (2000)

22. Source: Henderson (2000)

23. Pathologies of partial fiscal decentralization • Limited accountability • Local governments direct resources to clients and blame higher-level governments for poor service provision. • Offloading and unfunded mandates • Stringent conditions for grants • Incentives for local governments to hide information and dissemble • Politicized transfers

24. Rethinking fiscal federalism in the last decade • Motivations of politicians • Electoral and other political motivations replace benevolent despots and Leviathans. • Focus on institutions of representation • E.g., the nature of legislative bargaining: Persson and Tabellini (1996), Inman and Rubinfeld (1997), Dixit and Londregan (1998), Besley and Coate (2003), Lockwood (2002).

25. Rethinking federalism, cont. • Sharper focus on “fiscal interests” • Taxes and fees vs. grants • Types of grants, formulas • Incomplete contracts • The ultimate locus of authority is often unclear and contested. • Principal-agent relationship • Focus on crafting better incentives for subnational governments

26. Re-centralization? • Central governments are seeking out new ways of structuring the principal-agent relationship • Replacing discretion with rules • Audits • Enhanced central monitoring and data collection • But challenges remain: • Example: difficulty of data collection in decentralized environments

27. Who gets what? Empirical studies of intergovernmental transfers

28. Motivation • The trend toward fiscal decentralization is funded primarily by a combination of formulaic and discretionary transfers. • Grants and fiscal flows shape incentives of regional governments and central legislators. • By what logic are they distributed?

29. Studies of intergovernmental grants • First generation: Welfare economics and fiscal flows • Second generation: Political economy of fiscal flows • Partisan dictators • Legislative bargaining • Fiscal flows and inter-regional redistribution: When and where are grants progressive? • Representation and redistribution

30. Welfare economics • Central government is a benevolent dictator • Uses inter-regional fiscal flows to: • Capitalize on economies of scale in taxation • Internalize externalities • Facilitate inter-governmental competition • Stabilize asymmetric shocks

31. Partisan dictators • Cox and McCubbins (1986): • Core support • Key assumptions: Risk-averse incumbent • Dixit and Londregan (1996): • “Swing voters” • These theories are not necessarily about geography or districts, but the application is natural • Partisan alignment

32. Empirical literature • Scattered evidence for all these propositions • Usually an empirical focus on one relatively small, discretionary part of the budget (e.g. environmental grants in Sweden, infrastructure grants in Spain). • “Core vs. swing” debate unresolved: Basic story is that incumbents favor some combination of marginal and core districts, direct resources away from the opponent’s core support districts. • Strong support for the partisan alignment hypothesis • Formulaic transfers are not immune • Challenges: • Measuring ideological indifference • Endogeneity: Do fiscal flows actually buy votes?

33. Big questions left unanswered: • What happens when we drop fixed effects and examine long-term cross-section variation? • Are fiscal flows progressive? • When and where? • Implications for European idea of a “transfer union.”

34. Empirical analysis of fiscal flows • MacDougall Report (1977) • Renewed interest due to optimal currency area literature, e.g. Sala-i-Martín and Sachs (1992); Bayoumi and Masson (1995) • Broadest comparative work builds on Bayoumi and Masson (1995): Espasa (2001); Barberán, Bosch, Castells, Espasa (2000); Bosch, Espasa, Sorribas (2002)

35. Income elasticity of fiscal flows

36. Income elasticity of grants in 9 federations, 1990-2005

37. Average income and transfers (1990-2005)

38. To sum up: • Considerable redistribution through intergovernmental grants in Canada, Spain, Germany, and Australia • Very little redistribution in Argentina, Brazil, Mexico, Switzerland, the United States, and the EU. • Why?

39. The representation of regions • Some state receive far more representation per capita than others. • There are good reasons to believe that over-represented states will do well in the game of legislative bargaining

40. Legislative representation and transfers (1990-2005)

41. Average income and transfers (1990-2005) Size of marker reflects relative per-capita representation

42. Another possible explanation: • Classic political economy theory about the income distribution: • Does the skew in the inter-regional income distribution predict redistribution? • If the policy is set by the median state, we should expect to see large redistribution when median state is poor relative to the mean.

44. Note: NT dropped Note: city-states dropped

45. But what is the politically relevant income distribution? • Perhaps in the parliamentary federations without much inter-provincial bargaining, the relevant distribution is the (highly skewed) inter-personal one, and high levels of inter-personal and inter-regional redistribution go hand in hand. • But an interesting thing happens when the geography is divided into winner-take-all districts or states…

46. Distribution of Median Income in U.S. Congressional Districts and U.S. States Median/Mean Ratios: Individuals: .74 Cong. Dist.: .95 States: .98

47. A different perspective on unit-based vs. population-based representation • Perhaps this helps explain why federations, and countries with single-member districts, demonstrate lower levels of redistribution • The politically relevant median voter (the median income in the median state) is not very poor relative to the mean

48. A related observation: • All of the redistributive federations are parliamentary systems with strong and disciplined political parties. • The non-redistributive federations are presidential systems with weaker parties and region-based coalition building in the legislature, especially the upper chamber. • A similar story emerges from Persson and Tabellini (1996), who show that inter-regional bargaining leads to lower levels of risk-sharing than majority rule

49. Summing up: • The “first generation” literature taught lessons about the optimal distribution of authority that are still relevant • But it ignored questions related to institutional design and political economy • After addressing these questions, we now know more about the incentives generated by fiscal and political institutions for voters, creditors, elected officials, and bureaucrats. • This helps provide a clearer sense of the conditions under which decentralization might facilitate or undermine service delivery and macroeconomic management.

50. Summing up (cont.): • Much literature now focuses on strategies to minimize the “dangers” of decentralization • Not much focus on the impact of decentralization per se • Instead, focus on incentives created by the intergovernmental framework • Transition from observational to experimental empirical research