FISCAL FEDERALISM

1
FISCAL FEDERALISM

• STATE AND LOCAL PUBLIC FINANCE

2
Levels of Governmentsin a Federal Structure

• While central government addresses matters of
  national concern, regional, state, or provincial
  public bodies and local government units have
  fiscal responsibilities for their own
  jurisdictions.
• Several important issues emerge form this
  federal structure of the Public Sector
• What is the proper allocation of fiscal functions
  among the different levels of governments
• How should the revenue responsibilities and
  specific tax instruments be assigned to the
  various levels
• What is the role of inter-governmental transfers
  between levels of governments

3
What is Fiscal Federalism?

• Fiscal federalism refers to a public sector with
  two or more levels of decision making.
• From an economic perspective any public sector is
  federal in character since fiscal decisions are
  taken at different levels even in a politically
  centralized system. The question may be of degree
  only.
• Fiscal federalism addresses a particular aspect
  of public sector its vertical structure and the
  fact that public decisions are made at different
  levels and therefore fiscal relations among them
  are crucial.

4
Patterns and Trends in Fiscal Decentralization

• Tendency over the first half of 20th century was
  overwhelmingly in the direction of
  centralization. In the US, for example, central
  governments share of total public expenditure
  grew from 35 in 1902 to 72 in 1952 while local
  governments share fell from 55 to 15.
• The trend during the second half of the past
  century has been in the other direction. In 1992,
  the share of public expenditures was about 60
  for central government and the rest for the
  states. Similar trends in other industrialized
  countries.

5
Degree of Decentralization in Developed and
Developing Countries

• Marked divergence in degree of decentralization
  between economically advanced and developing
  countries. The mean central-government share of
  public expenditure has been found to be 89 for
  the sample of developed countries while it is at
  about 65 for a sample of industrialized nations.
• A dominant feature of public sector of most
  developing countries is still a relatively small
  role for local government with heavy reliance on
  the center.

6
Division of Fiscal Functions

• Out of the three functions of government -
  allocation, stabilization and redistribution, the
  stabilization and distributive functions normally
  belong to the central government.
• Scope of macro-economic management of economy
  (fiscal/ monetary policies) at local levels of
  government may also be limited.
• States do not have monetary powers and if they
  exercised fiscal instruments e.g. lower taxes,
  consumption would increase but benefit might go
  to other states where goods are sold or produced.
  

7
Division of Fiscal Functions (Contd.)

• Distributive policies at local levels may result
  in attracting low-income individuals and chasing
  away of well-to-do. So distributive policies at
  local levels may have only limited efficacy.
• Some services provided by states and other local
  governments, however, may have important
  distributional implications, e.g. primary
  education and basic health.

8
Provision of Local Public Goods by
State/Regional/Local Governments

• This is the main function of sub-national
  governments as the output of local public goods
  may be easily catered to the particular taste and
  demand of the local population.
• It also conforms to Tiebouts model of local
  finance according to which people vote by their
  feet, i.e. they would move to those jurisdictions
  which best provide for their specific needs at
  prices (taxes) that they can afford.

9
The Tiebout Hypothesis

• One factor that individuals consider in choosing
  the community (local government) to live in is
  the tax and service package in the jurisdiction-
  tax burden a resident will bear and the benefits
  from public services the resident will enjoy.
• If there are many localities with different
  tax-service packages, individuals will select the
  one that gives them greatest satisfaction and for
  which taxes and subsidies are closest to their
  desired amount.

10
The Tiebout Hypothesis (Contd.)

• In essence individuals shop among localities
  and buy the one best suited to them.
• The hypothesis makes following assumptions
• People are mobile and are unrestricted by
  employment opportunities,
• they have complete knowledge about differences
  among communities,
• there are many communities from which to choose,
  
• There are no spillovers of public service
  benefits or taxes (externalities) among
  communities.

11
Provision of Local Public Goods

• Even if the people are not totally mobile, i.e.
  Tiebouts model is not fully applicable,
  provision of local public goods by local
  governments is bound to increase welfare.
• This may not be feasible with a centralized
  decision making process that may provide some
  uniform level of output across all jurisdictions.
• Thus the allocation function is at the heart of
  fiscal federalism (Musgrave).

12
Tax Assignment Between Different Levels of
Government

• Question Are certain tax instruments better
  suited for use by the central government and
  others more appropriate at the local government
  levels or it is simply a matter of administrative
  convenience?
• A scrutiny of revenue structures across countries
  reveals wide diversity almost all major forms of
  taxation may be found at central, state/
  provinces and local levels somewhere in the
  world.
• Does not mean no rational basis of tax
  assignment improper assignment may prove costly
  to society.

13
Tax Assignment Problem (contd.)

• Following principles of tax assignment may be
  adopted (Musgrave).
• Highly progressive taxes, specially for
  re-distributive purposes should be centralized.
• Such taxes at decentralized levels may create
  perverse incentives for migration among
  jurisdictions. Thus a personal income tax with a
  highly progressive rate structure should be
  reserved for the central government
• State/ provincial governments may take recourse
  to income taxes that have fairly flat rate
  structure (single rate or two rates at most).

14
Tax Assignment Problem (contd.)

• Local government levels should avoid taxes on
  highly mobile tax bases (corporate income for
  instance), unless it is strictly a tax based on
  benefit principle.
• Decentralized governments may be better off
  taxing relatively immobile tax bases (land, real
  estate).
• Taxation of land and property also fits the
  criterion of benefit principle as the local
  governments are the main providers of services.

15
Tax Assignment Problem (contd.)

• Central government should be the primary taxing
  authority over tax bases that are distributed
  across jurisdictions in a highly unequal fashion
  (e.g. natural resources).
• This is important for avoiding regional disparity
  and helping the re-distributive function of the
  central government.
• Decentralized governments should avoid temptation
  to use tax instruments that would export tax
  burdens to other jurisdictions but create nation
  wide inefficiencies and externalities.

16
Tax Assignment Problem (Contd.)

• While user charges and fees may be employed by
  all levels of government based on benefit
  principle, these are specially appealing tax
  instruments at the decentralized government
  levels. They do not create inefficiencies,
  externalities or distorting incentives for
  movements across jurisdictions.
• User fees/charges also give right cost signals to
  residents for determination of levels of local
  services and the affordability of such charges.
  

17
Tax Assignment Problem (Contd.)

• Thus a general prescription for vertical tax
  structure may be laid down
• Central government should primarily employ
  progressive re-distributive taxes.
• Local level governments at highly decentralized
  levels should tax relatively immobile tax bases
  (land, property) and rely on user charges
• Intermediate level governments at the state and
  provincial levels may use income and sales taxes
  that have flat rate structures.

18
Three Main Revenue Sources for Local Governments

• At the lower decentralized levels of government,
  three main revenue sources are
• property taxes,
• user fees, and
• grants or transfers from national/ provincial
  governments.
• Some local governments also borrow by floating
  bonds while state and regional governments borrow
  directly from international agencies (World Bank,
  Asian Development Bank).

19
Property Taxes

• Property Taxes Main source of revenue to local
  governments in most countries.
• In property taxes, both tax rate and tax base
  determined by government. In other taxes (VAT,
  income tax), rate determined by government but
  base (income, consumption) determined by private
  economic activity.
• The assessment of base, which is the property
  value, is an integral part of property tax
  system.

20
Various Steps in Property Tax Process

• Following steps to be followed in property tax
  
• First, the assessed value (taxable base) of each
  property computed by an assessor from an estimate
  of market value and by applying an assessment
  ratio rule established by law or common practice.
  Different assessment ratios used for different
  types of properties (residential, commercial).
• The local government determines the tax rate that
  is then applied on the tax base. Generally local
  governments constrained by state laws in setting
  property tax rates.

21
Steps in Property Taxation (contd.)

• Tax levy or bill prepared for each property by
  tax department of the local government.
• Property tax collected by tax collectors who are
  employees of the local government.
• Even when property tax revenues are shared by
  different levels of government (local, state),
  actual collection done by a single local
  government and then revenues are shared by a
  formula.
• Property taxes usually collected annually or
  semi-annually.

22
Assessment Methods

• Assessors use three basic methods
• Comparative sales approach which uses data from
  actual sales in the area and propertys
  characteristics,
• Cost approach based on historic cost adjusted for
  depreciation and construction cost changes,
• Income approach which measures the present value
  of future net income expected to be generated by
  the property (also called capitalized value).
• Generally comparative sales method used for
  residential properties while both cost and income
  methods used for commercial and industrial units.

23
User Charges

• User charges include direct charges for use of
  public facilities (road, park) or consumption of
  a service (sewerage and water supply, education
  and hospitals), license fees for privilege of
  undertaking an activity (driving license), or
  special assessment based on physical
  characteristic (front footage) of property (e.g.
  for side walk construction).
• User charges operate on benefit principle with
  individuals charges depending upon both benefit
  derived and cost of providing the service.

24
Theory of User Charges

• The basic principle of economic efficiency -
  marginal benefit should equal marginal cost - can
  be applied here (just as for private goods).
• In absence of this principle, consumers will
  believe that public services and facilities are
  free and there will be a tendency to waste
  resources.
• Hence one function of user charges is to make
  consumers face true cost of the benefit they
  receive, thus creating incentive for efficient
  use.

25
Allocation of Costs Between Direct Users and Rest
of Society

• Most services provided by local governments
  (education, hospitals, parks) for which user fees
  may be charged, benefit both the direct users and
  the rest of the society.
• The basic principle is to allocate costs between
  direct users and others in society in the ratio
  of their respective benefits.
• User charges financing becomes more attractive as
  the share of marginal benefits accruing to direct
  users increases.

26
Principles of Applying User Charges

• User charges financing requires that direct users
  are easily identifies and excluded from consuming
  the service unless charges are paid (basic
  characteristics of a private good).
• User charge financing more efficient if demand is
  comparatively price inelastic.
• The marginal cost equals marginal benefit
  principle should be applied to determine both the
  size of the facility (capital cost) and the level
  of operation (operating cost).

27
Allocating Capital Costs

• In addition to direct users, others in society
  may benefit from a facility in the following two
  ways
• Existence of a facility provides the individuals,
  who are not currently using the facility/service
  (bridge, park), the option of using it, should
  their demand change in the future (for instance,
  a present non-user can become a direct user if
  (s)he changes the residence in future).
• Individuals who are not direct users also benefit
  if the facility generates spillovers in the form
  of additional economic activities (shops near a
  park, providers of service to tourists that come
  due to certain attractions).

28
Allocating Capital Costs (contd.)

• Thus some charges should be applied to every one
  to cover that part of the capital costs that
  benefit all, and different charges be applied to
  actual users to cover their share of the capital
  costs.
• These charges might be flat per capita or
  per-household charges or charges based on
  property (e.g. fixed-service charge applied in
  public water system to cover capital costs like
  pumps, pipes and special assessments for street
  lights, side walks, neighborhood parks).

29
Allocating Use or Operating Costs

• Once a public facility (park, road, water supply
  college) has been provided, operating costs
  (entrance fee for park, toll on road, charges per
  gallon of water, tuition fees) are determined by
  how much and by whom facility is used.
• Principle of efficiency again is marginal
  benefit equals marginal cost.
• Operating costs should be allocated based on
  marginal benefit from use of service/facility.

30
Allocating Use or Operating Costs (contd.)

• If benefit from additional use goes only to users
  (going to park), users to pay full operating
  costs.
• If, however, some external benefits to non-users
  associated with additional use of the facility
  (benefit to all society from having an additional
  person educated), only a portion of marginal
  operating costs should be charged from direct
  users and the remaining should come from the rest
  of society (e.g. through general taxation).

31
Equity and User Charges

• User charges also make non-residents pay for
  benefits they enjoy (e.g. education). In a way it
  promotes equity between residents and outsiders.
• What about lower income consumers? Best is not to
  interfere with user fee principle and give income
  subsidy (e.g. scholarships) to the deserving but
  economically disadvantaged.
• Avoiding user charges in the name of equity may
  end up benefiting rich more than the poor.

32
Inter-government Grants and Revenue Sharing

• Inter-government transfers or grants a prominent
  feature of fiscal federalism in most countries.
  This is feasible as central or state governments
  have, or at least are expected to have, budget
  surplus.
• Four potential roles for inter-governmental
  grants
• To correct for externalities that arise from the
  structure of sub-national governments and thus
  improve the efficiency of fiscal decisions. If
  non-residents benefit from a local government
  service but are not considered in the decision
  about the amount of service, a grant can induce
  local government to provide for optimal amount.
  

33
Role of Inter-government Grants

• Potential roles (contd.)
• Explicit re-distribution of resources among
  regions or localities. Taxes collected by a
  central/state government can be allocated to
  lower level governments in inverse proportion to
  income or property values.
• To substitute one tax structure for another. A
  tax levied nationally may generate fewer
  inefficiencies than a set of similar sub-national
  Taxes. Also, collection of taxes by central
  agency provides economies of scale and then the
  revenues may be shared.
• As means of macro-economic stabilizing mechanism.

34
Types of Grants

• Inter-government grants may be characterized by
  four factors
• Whether use of grant is intended for specific
  service (specific or categorical grant) or may be
  used generally,
• Whether grants are automatically allocated by a
  formula or require an application associated with
  a specific project,
• Whether grant funds must be matched by recipient
  government funds or grant is lump sum
  non-matching,
• Whether potential size of grant is limited or not
  - closed ended or open ended.

35
Types of Grants (contd.)

• In practice, specific or categorical grants are
  the dominant type.
• If grant is lump sum or non-matching, the amount
  does not change as a recipient government changes
  its taxes or expenditures.
• In matching grants, size of grant depends upon
  expenditures or taxes of recipient government.
  Typically, a specific matching aid offers to
  match each dollar of recipient expenditure or tax
  by R grant dollars (R is called matching rate).

36
Types of Grants (contd.)

• In matching grant, if R 1, each additional
  dollar of service costs local residents 0.5 in
  local taxes.
• Both matching and non-matching categorical grants
  may be allocated either by formula or a
  project-by-project basis and may be either open
  ended or close ended.
• General grants without use restrictions are
  almost always allocated by a formula. If formula
  includes factors outside of control of recipient
  government (population, income), it is pure lump
  sum grant.

37
Types of Grants (contd.)

• If formula for a general grant includes factors
  controlled by recipient government (tax effort,
  tax collections), amount of grant can be altered
  by recipient government decisions.
• Block grant is the term used to describe specific
  grants in categories that may be broadly or
  loosely defined. If categories are broad enough,
  block grants effectively become general grants as
  recipient governments can reallocate funds among
  various activities.

38
Economic Implications of various Types of Grants

• Inter-governmental grants affect recipient
  governments fiscal decision either by increasing
  the resources (lump sum grant), called income
  effect or by increasing resources plus reducing
  marginal costs of additional services (matching
  grant), called price effect.
• A decrease in price has a greater effect on
  consumption of the good or service in question
  than an income effect now the item is cheaper
  and consumers purchasing power has also
  increased.

39
Implications of Grants (contd.)

• This means that an open ended matching grant is
  expected to increase government expenditures on
  the aided service by a greater amount than an
  equal size lump-sum grant.
• A matching grant will increase spending on the
  aided category but the increase will not be as
  great as the grant (going down the demand curve
  means quantity will increase but not equal to
  grant).
• Thus matching grant will increase government
  spending on other categories or allow tax relief.

40
Implications of Grants (contd.)

• A lump sum grant of G that is restricted for use
  in a specific category may be no different than a
  grant of G with no use restrictions from the
  view point of the recipient government. It means
  the two grants may have same effect on recipient
  government.
• This depends upon whether government can and does
  reallocate its own funds from specific category
  to others.

41
Debt Finance

• State or local governments borrow money for three
  primary purposes
• finance capital projects (roads, water and
  sewerage)
• support and subsidize private activities (student
  loan, private home mortgages)
• provide cash flow for short-term spending or for
  special projects
• Sometimes they borrow new funds to pay off old
  debts sooner, specially if interest rates fall
  (refinancing).

42
Instruments of Debt Financing

• Most common instrument of borrowing is selling
  bonds. Most bonds are long-term (repayment period
  more than 1 year, normally 10 or 20 years).
• Long-term bonds may again be of two types
• General obligation (GO) bonds which means issuing
  local government must use revenue from any tax or
  charges to pay interest and principle to
  bondholders. If for some reason the payment does
  not come on time, the government is said to
  default on the bonds. Effectively government is
  in bankruptcy.

43
Debt Instruments (contd.)

• Types of bonds (continued)
• Revenue or non-guaranteed bond. Only revenues
  from a particular source are pledged to pay
  interest and principle. If revenues from that
  source are not enough, the bond holders suffer
  the loss.
• In developing countries, state and provincial
  governments have begun to borrow directly from
  international agencies such as World Bank and
  regional banks. They have to fulfill certain
  conditionalities just like borrowing nations.