Chapter 18

Fiscal Federalism and State and

Local Government Finance
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 Levels of Government
 Federal
 State
 County (called a Parish in Louisiana)
 School, Water, Fire, Sanitation District
 City, Town, Village

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 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.

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 Fiscal Federalism
 Fiscal Federalism is the structure of the
levels of governments in which each
level has sources of revenues and
responsibilities.

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 Local Public Goods
Local public goods are goods where there
is no rivalry to the good within a certain
geographic area.
Examples:
 local streets
 sewer and sanitation
 parks
 police protection
 fire protection
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 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 that is seen as inequitable.

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 Centralized vs Decentralized
Decisions
 An important problem for a society is which
goods and services should be provided at
which level of government.
 Are the 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?

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 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 where
people chose 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.

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 Interjurisdictional
Externalities
 There are costs or benefits accruing 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.

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 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.

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

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 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.

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 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

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 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.

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 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.

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 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

2000 25.0 16.0 3.0

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 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;
 provide local governments with the means
to provide the good with categorical grants
or with block grants.

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

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

QP1 QP2 B B' C

Public Goods per Year
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 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.

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 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 MBN = MSB
8
MBL
Local Cost
per Unit of
Abatement

100 150
Pollution Abated per Year (Thousands of Pounds)
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 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.

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