Fiscal Federalism Jonathan Rodden Stanford University August 8, 2011
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
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?
Intellectual history From “First Generation” to “Second Generation” fiscal federalism
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.”
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
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.
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.
Broad consensus circa 1990: • Based on theory literature, virtual consensus about potential benefits of decentralization, especially in developing countries in late 1980s
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
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
What do we know? Trends and stylized facts
Correlates of expenditure decentralization • Panizza 1999, Garrett and Rodden 2005: • Country size • GDP per capita • Democracy • Federal constitution • Ethno-linguistic heterogeneity?
Kernel density of expenditure and tax decentralization in 40 countries, 1990s
Histogram, Subnational tax autonomy in OECD countries (full rate and base autonomy), 1990s Switzer-land Canada USA Source: OECD
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
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
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).
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
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
Who gets what? Empirical studies of intergovernmental transfers
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?
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
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
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
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?
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.”
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)
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?
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
Average income and transfers (1990-2005) Size of marker reflects relative per-capita representation
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.
Note: NT dropped Note: city-states dropped
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…
Distribution of Median Income in U.S. Congressional Districts and U.S. States Median/Mean Ratios: Individuals: .74 Cong. Dist.: .95 States: .98
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
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
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.
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