Abstract
This chapter provides a conceptual overview of the principles of expenditure and revenue assignment to local governments. Local government is seen to be more aware of local preferences and conditions and more accountable to local residents than senior governments. Core and noncore responsibilities are distinguished (e.g., local streets versus schooling). Financing follows function. Financing follows the benefit criterion; that is, local residents pay for the local services from which they benefit—with user charges and local taxes although grants may be needed. Various (especially) noncore services involve interjurisdictional spillovers and/or redistributive considerations and so, if assigned to local governments require intergovernmental transfers to achieve efficiency and equity objectives. Financing alternatives and appropriate uses are reviewed.
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Notes
- 1.
The vast number of references found in Bahl and Bird (2018) and Boadway and Shah (2009), two books providing comprehensive examinations of fiscal federalism and decentralization, illustrate the growth and extent of the literature. Earlier valuable contributions include those by Bahl and Linn (1992), Bird et al. (1995), Litvack et al. (1998), Manor (1999), McLure (1983, 1999), OECD (1987, 1997, 1999), Owens and Norregaard (1991), Shah (1991, 1994), and Ter-Minassian (1997).
- 2.
A resulting additional argument for decentralization is that it enhances political participation. Greater responsiveness, accountability, and enhanced participation have long been seen as advantages of decentralization in the political literature. Other widely noted potential positive features of local government are greater transparency of government to local residents and, of course, greater autonomy. Shah (2014) advocates for movements toward FAIR (fair, accountable, incorruptible, and responsive) local governance and outlines a framework for evaluation. Blending these desirable characteristics with the economics of fiscal federalism has created a powerful case for decentralization and a more valuable tool for the analysis of decentralized government.
- 3.
Besley and Coate (2003) have extended the theory underlying the conventional arguments for decentralization. Their more general model assumes cost sharing of centrally provided outputs under a nationally uniform tax system, allows for non-uniform central provision across localities, locally elected representation to the central government, cooperative and non-cooperative legislative decision-making, varying degrees of heterogeneity in local tastes, and varying interjurisdictional spillovers. Heterogeneity of tastes and the degree of spillovers are central to the centralization-decentralization choice with less heterogeneity and more spillover favoring centralization. However, the case for decentralization is surprisingly strong and prevails even when tastes are uniform and spillovers significant. Also see Ingram and Hong (2008, 17–108).
- 4.
Critical assessments of fiscal federalism and, particularly, decentralization have emerged—motivated in part by difficulties experienced within some countries. Oates (2005) characterized those as an emerging second-generation of fiscal federalism. He categorized the second-generation literature (notably in Oates2008) as having two strands. The first strand applies a broader range of economic modeling (i.e., beyond the more conventional public finance) to the questions of fiscal federalism while the second strand evolved from public choice with a focus on political institutions. Both address problems with decentralization that have or might occur. A dominant concern is the problems that emerge with soft (rather than hard) budget constraints on decentralized governments. Essentially, the second-generation literature focuses on problems that can arise when there are flaws in the decentralization design. Surveys of the impacts of decentralization generate mixed results but do point to the importance of good design and implementation (e.g., see Bahl and Bird 2018, Chapter 2). Also, there is some evidence that better-quality government enhances personal well-being (Helliwell and Huang 2008; Helliwell et al. 2018) and, though somewhat mixed and deserving of more detailed analysis, that decentralization can also increase well-being/life satisfaction (e.g., Bjornskov et al. 2008; Diaz-Serrano and Rodriguez-Pose 2012; Gao et al. 2014; Tomaney et al. 2011). Closely related is a literature on measuring the decentralization of government (e.g., Ivanyna and Shah 2014; Hooghe et al. 2010, 2016; Hooghe and Marks 2016). The OECD provides valuable recent overviews of fiscal federalism and decentralization (e.g., OECD2013, 2016, 2018).
- 5.
It is important to recognize that borrowing is not a substitute for adequate funding. Debt must be repaid and debt-servicing costs met from the borrowing government’s revenues. Borrowing only facilitates financing long-term capital investments, particularly when they are large and irregular.
- 6.
- 7.
See Tresch (2015, Chapters 26 and 27) for a discussion of a redistributional role for local government.
- 8.
- 9.
See a public finance text (e.g., Fisher 1996) for details of the ideal allocation of the cost of public goods. The basic idea is that each individual is charged a personal marginal cost equal to that person’s marginal benefit and the ideal level of output exists when, in the case of a pure public good, the sum of all individual marginal benefits equals the marginal cost of the output.
- 10.
The problem of distinguishing between economics of sharing and economies of scale is that it is often difficult to distinguish between units of output when many individuals benefit from the same unit of output. For example, there could be economies of scale in the operation of an air pollution abatement system (e.g., cost per unit of particulate matter removed decline to some point) but the benefits of the improvement in air quality resulting from some additional abatement (change in output) could be enjoyed by many or few people (economies of sharing).
- 11.
For insight into and a brief review of empirical economies of scale analyses, see Byrnes and Dollery (2002).
- 12.
- 13.
- 14.
Even when services are purely local, citizens may prefer having an upper-level government to review certain activities (e.g., water quality, sewerage treatment, refuse disposal) to provide an informed and independent assessment of performance and especially of the less observable aspects.
- 15.
See Dahlby (2001) for a “consensus view” of tax assignments. The shift of the payroll tax to the upper tier(s) of government has been prompted as well by its widespread utilization by senior governments to finance earmarked social benefit programs such as unemployment insurance and social security/pensions.
- 16.
This treatment reflects the usual top-down perspective on tax assignment in that the matter is decided at the center. In some cases, however, tax assignment is a bottom-up decision where federating states decide upon what tax powers the new central authority should have. See Dahlby (2001).
- 17.
In the interests of maintaining the advantages of an internal common market (i.e., free trade within the country) the only taxes, if any, on cross-border movements of goods and services should be national levies on foreign trade.
- 18.
Bird (1999) argues that the international adoption of national value-added taxes and their revenue importance have contributed to this centralization.
- 19.
A broader discussion of transfers—beyond the gap-closing role—appears in the latter part of this chapter.
- 20.
Dahlby (2001) notes several problems with the “consensus” view. Those are (a) the need to link expenditure and tax decisions, (b) a need to consider expenditure assignment and grant systems, (c) neglect of distributional impacts of subnational government policies, (d) overlooking certain problems of joint occupancy of tax fields, (e) ignoring that some economic shocks calling for stabilization are region specific, and (f) putting little emphasis on administration and compliance costs of alternative tax assignment regimes.
- 21.
It is important to remember that property taxes, and especially those taxing improvements as well as land, also may not match benefits exactly and, like a local personal income tax, involve some redistribution. On the other hand, a local personalincome tax may match better benefits and costs for a local service such as schooling.
- 22.
Kitchen and Slack (1993) found that about 40 percent of municipal government (i.e., nonschooling) expenditure benefited nonresidential property.
- 23.
Also see Bahl and Bird (2018, pp. 208–211).
- 24.
When prices for the services of local government enterprises are above the levels consistent with user charges (e.g., utility charges exceed full costs), the difference is effectively a special sales tax on those services.
- 25.
For those reasons, Bird (1999) has recommended a more uniform local business value-added tax.
- 26.
- 27.
At the local government level, however, fiscal disadvantages may be offset in part through capitalization into property values.
- 28.
Bird (1993) offers an additional rationale for conditional matching grants. Conditional matching funding can induce local governments to spend some of their own funds on the grantor’s priorities (e.g., achieving minimum standards or greater uniformity of local services) thus stretching the grantor’s budget. While a legitimate perspective, the basis for the mutual interest is in some shared or spillover benefits. Gramlich (1977) classifies conditional transfers aimed at such grantor policy objectives as also blending the advantages of centralized finance and decentralized supply as having a political-institutional justification. However, because those grants have an efficiency basis, they are distinguished here from the politically motivated grants below.
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Kitchen, H., McMillan, M., Shah, A. (2019). Expenditure and Revenue Assignment: Principles. In: Local Public Finance and Economics. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-21986-4_2
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