Chapter 19 Fiscal Federalism

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Chapter 19 Fiscal Federalism

• Intermediate Public Economics

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Arguments for multi-level government

• Fiscal federalism is the division of revenue
  collection and expenditure responsibilities
  between different levels of government.
• Arguments for multi-level government
• Information of local preferences
• Provision equally by a national government may
  sacrifice efficiency
• Tiebout hypothesis heterogeneous preferences.
• Distributive arguments equalization.

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The costs of uniformity
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Figure 19.1 The costs of uniformity
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Conclusion
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Optimal structureEfficiency versus Stability

• Trade off scale economies against diversity of
  preference.
• A simple model
• Assume a line segment 0,1, with points on the
  line representing different geographical
  locations. The public good can be located
  anywhere along the line and each individuals is
  characterized by their ideal location for the
  public good. And individuals are uniformly
  distributed.
• Compare centralized and decentralized.

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Figure 19.2 Centralization and decentralization
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Compare
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Compare
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Compare majority voting
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Conclusion
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Accountability

• A government is accountable if voters can
  discern whether it is action in their interest
  and sanction them appropriately if they are not,
  so that incumbents anticipate that they will have
  to render accounts for their past action.
• Problem information problem-agency problem.

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Political accountability and voter welfare
The payoff matrix the first number in
each cell is the government payoff and the second
number is voters welfare. If the government is
re-elected it gets the extra value Vgtr.
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Quandary

• The government knows the prevailing conditions
  but all that citizens observe is their current
  welfare.
• Quandary
• If the voters set the standard for re-election
  too high ,say at 3, then the incumbent has the
  incentive to obtain the rent r and leave office
• If the voters set the standard lower, say at 1,
  the incumbent will be able to divert rent when
  conditions happen to be good and be re-elected by
  giving voters less than what they could obtain.

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Decentralization
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Political perspective

• Federalism
• Authoritarianism

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A fundamental political dilemma

• A fundamental dilemma faces a government
  attempting to build and protect markets
• It must be strong enough to enforce the legal
  rights and rules necessary to maintain the
  economy
• It must be strong enough to commit itself
  credibly to honoring such rules.
• (Montinola et
  al.,1995)

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Market-preserving federalism

• F1 A hierarchy of government with a delineated
  scope of authority exists so that each government
  is autonomous within its own sphere of authority
• F2 The subnational governments have primary
  authority over the economy within their
  jurisdictions
• F3 The national government has the authority to
  police the common market and to ensure the
  mobility of goods and factors across
  subgovernment jurisdictions

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Market-preserving federalism

• F4 Revenue sharing among governments is limited
  and borrowing by governments is constrained so
  that all governments face hard budget
  constraints
• F5 The allocation of authority and
  responsibility has an institutionalized degree of
  durability so that it cannot be altered by the
  national government either unilaterally or under
  the pressures from subnational governments.
• (Montinola
  et al.,1995)

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Market- preserving authoritarianism

• M1 Subject to changing international and
  domestic constraints, in particular competitive
  pressures, senior leaders (or the dominant party)
  perceive that it is in their interests to
  preserve the market to facilitate catching-up
• M2 Senior leaders (or the dominant party) are
  able to make their policy on market-based
  catching-up more credible by imposing
  self-constraints through allocating sufficient
  autonomy (including authority, information, and
  resources) to a large set of political and, more
  importantly, economic decision makers in an
  institutionalized way

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Market- preserving authoritarianism

• M3 Senior leaders (or the dominant party) are
  able to control agency problems of bureaucrats,
  businessmen, as well as other politicians by
  imposing constraints on them through designing
  and fostering institutions such as incentive
  schemes, checks, coordination and enforcement
  devices, and to balance autonomy and control.
• (Shuhe Li
  et al.,1999)

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Decentralization

• Decentralization of information and authority and
  interjurisdictional competition, can provide a
  more credible commitment to secure economic
  rights and preserve markets.
• (Yingyi
  Qian et al.,1997)

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Self-enforcing federalism

• The twin dilemmas of federalism
• Dilemma 1 What prevents the national government
  from destroying federalism by overawing its
  constituent units?
• Dilemma 2 What prevents the constituent units
  from undermining federalism by free riding and
  other forms of failure to cooperate?
• (De Figueiredo et
  al.,2005)

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A model of Bottom-Up Federalism

• Trade-off mechanisms to mitigate one dilemma
  typically exacerbate the other.

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Institutional Game
Repeated Game

• BASIC FEATURES
• Federalism ongoing, repeated
• States choose to contribute, shirk or exit
• Center determines how much to provide for public
  goods and how to enforce penalties
• KEY QUESTIONS
• Can federalism be an equilibrium?
• What factors determine set of equilibrium
  federations?

• BASIC FEATURES
• Choose constitution
• Set of trigger points for disciplining center
• Definition of institutional power of center
• KEY QUESTIONS
• What triggers chosen?
• How strong is center?

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Conclusion

• For a federation to overcome the shirking
  problem, the center must have sufficient
  monitoring resources and penalizing capacity to
  punish shirkers
• To police the centers tendency to overawe the
  states, states must coordinate on punishment
  strategies, perhaps chosen at the constitutional
  or design stage of a federation. Appropriately
  designed punishment strategies limit the centers
  ability to extract resources from the states,
  increase the provision of public goods, and
  result in higher public welfare

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Conclusion

• Exit costs shift rents to the center
• In choosing the optimal amount of institutional
  power granted to the center, designers can
  effectively resolve the two dilemmas.
• (De Figueiredo et
  al.,2005)

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A top-down federation

• The threat of separation the possibility of
  secession has been a powerful force to limit the
  ability of the central government to exploit
  peripheral minorities of voters for the sake of
  the majority of the population.
• The threat of secession of rich regions
• Asymmetry fiscal federalism.