State and Local Public Finance Spring 2014, Professor Yinger

1. State and Local Public FinanceSpring 2014, Professor Yinger Lecture 17 Introduction to Intergovernmental Relations

2. State and Local Public FinanceLecture 17: Intergovernmental Relations Class Outline • Key Features of the U.S. Federal System • Principles for Allocating Responsibilities in a Federal System • Intergovernmental Grants • Fiscal Disparities

3. State and Local Public FinanceLecture 17: Intergovernmental Relations U.S. Constitutional Structure • The federal government and the states have equal standing as constitutional units, with separate rights and responsibilities. • Counties, townships, cities, villages, school districts, and special districts are creatures of the states.

4. State and Local Public FinanceLecture 17: Intergovernmental Relations Rough Distribution of Responsibilities • The federal government provides national defense, social insurance, and social welfare • The states provide higher education, social services, and highways. • Local governments provide elementary and secondary education, police and fire protection.

5. State and Local Public FinanceLecture 17: Intergovernmental Relations The Role of Intergovernmental Grants • Higher levels of government provide extensive financial assistance to lower levels of government in the form of intergovernmental aid. • The federal government gives grants to states and to local governments • State governments give grants to local governments.

6. State and Local Public FinanceLecture 17: Intergovernmental Relations Federal Grants to State and Local Governments • Federal grants peaked in 1978 at over ¼ of state and local general revenue. • Federal grants declined rapidly in the Reagan years, but have usually increased since, mainly due to Medicaid—to about the 1978 level. • Federal grants now (2011) provide 24.7% of state and local revenue and 12.3% of local school revenue (up from 8.1% in 2008).

7. State and Local Public FinanceLecture 17: Intergovernmental Relations State Grants to Local Governments • States provide 32.9% of local general revenue (2011). • This share rose slowly for a long time but has now stalled. • The state share is higher for education (44.4%, down from 48.3% in 2008).

8. State and Local Public FinanceLecture 17: Intergovernmental Relations Mandates and Rules • Higher levels of government also affect lower levels of government in other ways. • The federal government can give financial incentives for state or local governments to do certain things (e.g. NCLB). • The federal government cannot impose requirements on states, however.

9. State and Local Public FinanceLecture 17: Intergovernmental Relations Mandates and Rules, 2 • State governments can impose unfunded spending mandates on local governments. • State governments can alter the assignment of spending responsibilities or taxing rules. • E.g., some cities must provide ports, airports, hospitals, or higher education. • E.g., some cities have access to a commuter tax.

10. State and Local Public FinanceLecture 17: Intergovernmental Relations Principles to Guide the Assignment of Responsibilities • A famous framework developed by an economist named Richard Musgrave, divides the responsibilities of government into three “branches”: • Stabilization • Allocation • Distribution

11. State and Local Public FinanceLecture 17: Intergovernmental Relations Stabilization • Everyone agrees that the main responsibility for stabilization policy (i.e. monetary and fiscal policy) should fall on the federal government. • Nevertheless, states can alter the impact of economic fluctuations on their citizens through rainy day funds or similar policies.

12. State and Local Public FinanceLecture 17: Intergovernmental Relations Allocation • All levels of government address issues involving the allocation of resources. • Allocation questions involve both of the types of efficiency discussed in this class: • Productive or technical efficiency. • Allocative efficiency.

13. State and Local Public FinanceLecture 17: Intergovernmental Relations Productive Efficiency, Economies of Population Scale • The per-capita cost of a public service may depend on the number of people being served. • Economies of population scale, also called publicness, arise when the per-capita cost declines with population. • Diseconomies of population scale, also called congestion, arise when the per-capita cost increases with population.

14. State and Local Public FinanceLecture 17: Intergovernmental Relations Productive Efficiency, Economies of Population Scale • Elementary and secondary education has U-shaped cost functions. • The minimum-cost size is 3,000 pupils in New York and 58,000 in California. • This difference reflects different measures of school performance emphasized in each state and perhaps other factors. • Defense is a pure public good; there are diseconomies of scale for police.

15. Cost Per Pupil (for given output) Consolidate Split Up? (NY) 3,000 58,000 Number of Pupils in District State and Local Public FinanceLecture 17: Intergovernmental Relations Economies of Population Scale in Public Education New York California

16. State and Local Public FinanceLecture 17: Intergovernmental Relations Productive Efficiency, Economies of Population Scale, Cont. • All else equal, the responsibility for a public service should be assigned to the unit of government with the scale closest to the minimum-cost scale. • Suburban school districts meet this test. • Rural districts are too small, and, on cost grounds, at least, they should consolidate. • Urban districts are too large and, on cost grounds, they should be split up. • Different public services have different optimal scales—a reason for layers of government. • Cost considerations may, of course, be offset by other concerns.

17. State and Local Public FinanceLecture 17: Intergovernmental Relations Allocative Efficiency, 1 • Recall the normative argument by Tiebout: A federal system is efficient if there are many local governments and people are able to choose their preferred service-tax package. • This argument calls for assigning service responsibilities to small local governments, all else equal.

18. State and Local Public FinanceLecture 17: Intergovernmental Relations Allocative Efficiency 2, Spillovers • Spillovers from public services are an externality. • Example: Benefits from a state highway system to people in surrounding states. • One way to address spillovers is to assign service responsibility to a level of government high enough to internalize the externality. • Example: An air- or water-pollution district that encompasses an entire air- or water-shed. • Another way to address spillovers is with intergovernmental grants • Examples: Federal matching grants for highways, state aid for education.

19. State and Local Public FinanceLecture 17: Intergovernmental Relations Distribution • Most analysts call for the assignment of distribution to higher levels of government: • Truly equal opportunity requires a higher level of government. • E.g., national programs for social insurance or civil rights. • Redistribution may involve spillovers: • People in State A who believe in equality benefit from equality in State B. • Redistribution at lower levels of government may be undermined by mobility. • Wealthy individuals can escape progressive state and local taxes • Needy individuals may move to generous cities or states. • Evidence says these effects are small.

20. State and Local Public FinanceLecture 17: Intergovernmental Relations Behavioral Responses to Grants • Intergovernmental grants are intended to influence the choices made by lower levels of government. • The impacts of grants on the behavior of recipient governments has been widely studied. • Policy makers who design grants should know about this research!

21. State and Local Public FinanceLecture 17: Intergovernmental Relations Fisher’s Intergovernmental Grant Table

22. State and Local Public FinanceLecture 17: Intergovernmental Relations Lump-Sum Grants as Income • In theory: In a median-voter model, $1 of grants is equivalent to an increase in voter income that equals $1 after being multiplied by tax-price (= what the voter saves). • In practice: Grants have consistently been found to have a larger-than-predicted impact on public spending. • This is called the flypaper effect.

23. State and Local Public FinanceLecture 17: Intergovernmental Relations The Flypaper Effect • Estimates of the flypaper effect vary widely. • A typical estimate finds that $1 of aid has the same impact as $3 of income. • Bill Duncombe and I find that in some cases $1 of school aid has the same impact as $10 of income. • There is no consensus about the cause of the flypaper effect. • Some scholars think it represents a kind of illusion on the part of voters. • Others think it represents mis-measurement of some kind.

24. State and Local Public FinanceLecture 17: Intergovernmental Relations Impact of Grants on Efficiency • An issue at the frontier of knowledge is whether grants affect governmental efficiency. • This issue has 2 parts: • A grant to promote service A (math and English scores) may also boost service B (music education). • A grant may lead to bureaucratic waste. • Duncombe and I find indirect evidence of both effects. • So grants funds are transferred in a leaky bucket!

25. State and Local Public FinanceLecture 17: Intergovernmental Relations Categorical vs. General Grants • The decision as to which type of grant to use is analogous to that of cash versus food stamps. • There is no evidence that the flypaper effect (or the efficiency impacts) are different for general and categorical grants, so the standard graph applies. • Making a grant “categorical” often does not alter its impact.

26. State and Local Public FinanceLecture 17: Intergovernmental Relations Categorical Versus General Grant Everything Else Budget line with general grant Y+G Y 3 I I 2 City 1 I 1 I 2* City 2 I 1* Budget line with Original categorical grant budget line 0 Subsidized Category

27. State and Local Public FinanceLecture 17: Intergovernmental Relations Matching vs. Lump-Sum Grants • In deciding which of these grants to use, the standard figure for income and price subsidies is often used. • This figure implies that a matching grants has a larger impact on local performance than does a lump-sum grant with the same cost to the granting government. • This effect reflects the fact that a matching grant, unlike a lump-sum grant, has both an income effect and a price effect.

28. Budget Line with Lump-Sum Grant Tangency Point with Lump-Sum Grant Everything Else Tangency Point with Matching Grant I3 Budget Line with Matching Grant I2 I1 E1 E3 E2 Education Cost of Both Programs State and Local Public FinanceLecture 17: Intergovernmental Relations Matching Versus Lump-Sum Grant

29. State and Local Public FinanceLecture 17: Intergovernmental Relations Matching vs. Lump-Sum Grants • But this theorem ignores (a) the flypaper effect, which only applies to lump-sum grants and (b) the impact of grants on efficiency. • In a recent paper, Bill Duncombe and I show that when these two things are considered, lump-sum grants might be more simultative, particularly when given to disadvantaged districts. • In addition, matching grants are unpopular with elected officials because their cost is not known at budget time.

30. State and Local Public FinanceLecture 17: Intergovernmental Relations Fiscal Health • Fiscal health is the extent to which a jurisdiction’s ability to provide reasonable services at a reasonable tax rate is constrained by factors outside its control. • Fiscal health is relevant for policy: • It provides perspective on spending/performance differences. • It helps in designing aid to local governments, particularly schools. • The key philosophical issue here is whether a state should accept some responsibility for the fiscal disparities its actions help to create.

31. State and Local Public FinanceLecture 17: Intergovernmental Relations Fiscal Health, 2 • Fiscal health equals the difference between a jurisdiction’s expenditure need and its revenue-raising capacity, both based on factors outside the jurisdiction’s control. • A deficit is a poor measure of fiscal health because forecasting methods and assumptions are not outside a jurisdiction’s control.

32. State and Local Public FinanceLecture 17: Intergovernmental Relations Expenditure Need • Expenditure need depends on expected service quality (constant across jurisdictions), assigned responsibilities, and public service costs. • In symbols:

33. State and Local Public FinanceLecture 17: Intergovernmental Relations Revenue-Raising Capacity • RRC = the ability of a jurisdiction to raise revenue based on factors outside its control. • The Income-Plus-Exporting approach holds tax burden constant across jurisdictions. • How much could a jurisdiction raise if it placed the same tax burden on its residents as the average jurisdiction? • The Representative Tax System approach holds tax rates constant. • How much could a jurisdiction raise if it levied the same tax rates as the average jurisdiction?

34. State and Local Public FinanceLecture 17: Intergovernmental Relations Income-Plus-Exporting Approach • Define for jurisdiction j and tax i: • b = tax burden • Y = income per capita • e = taxes raised from nonresidents for every dollar raised from residents = export ratio • s = expected revenue share for given tax • Then

35. State and Local Public FinanceLecture 17: Intergovernmental Relations Representative Tax System Approach • Define for jurisdiction j and tax i: • t = tax rate • B = tax base per capita • Then

36. State and Local Public FinanceLecture 17: Intergovernmental Relations Fiscal Health, 3 • In short: • States influence fiscal health by setting service responsibilities, access to taxes, and tax rules. • Fiscal health is also influenced by a city’s economy. • Fiscal health varies widely across large cities and across school districts.