Lecture 08: Local Public Goods and Fiscal Federalism

Quick Overview

Optimal fiscal federalism, which determines the appropriate level of government for public goods provision, hinges on three main factors: the strength of tax-benefit linkages, the extent of spillovers, and economies of scale, with the Tiebout model suggesting efficient local provision occurs when individuals can 'vote with their feet' to match their preferences, although this efficiency is limited by costly moving, information friction, and financing methods like property taxes.

Key Points: Fiscal federalism addresses which level of government should handle specific responsibilities, exemplified by national defense being federal while road fixing is local. US government spending decentralized significantly between 1927 and 1952 due to World War II defense spending and the New Deal, followed by a shift toward state government responsibility funded by intergovernmental grants like Medicaid between 1952 and 2002. The Tiebout model posits that efficient public good provision can be achieved locally if people 'vote with their feet' by moving to communities matching their preferences, effectively solving the Samuelson public goods problem by revealing true preferences through mobility. The Tiebout model faces limitations including costly moving, information friction, the tension between economies of scale requiring larger groups and heterogeneity requiring smaller groups, and reliance on unpopular lump-sum taxes. Local public goods are typically financed by property taxes, which, when combined with income heterogeneity, incentivize rich communities to implement zoning laws to keep out the poor and avoid free-riding on their higher tax contributions. The optimal assignment of responsibilities is determined by tax-benefit links (pushing for local provision), spillovers (pushing for central provision), and economies of scale (pushing for central provision); for instance, redistribution is federal due to weak tax-benefit linkages locally. California's Proposition 13, which severely limited property tax increases, led to an enormous increase in house values (a $1 annual tax reduction increased home value by $7), demonstrating capitalization, but subsequently caused the public school system to decline significantly.