Public Economics Principles and Practice

Part Ten Multi-Government Systems Peter Abelson Applied Economics and University of Sydney

Multi-Government Systems
Multilevel Government Globalisation and Government

Chapter 33 Multilevel Government

Allocation of Functions in a Multilevel System Optimal Size of Local Governments Taxation with Multilevel Governments Household Choices and Local Government Intergovernmental Transfers Multilevel Government in Australia

Tiers of Government
Multilevel government exists in centralised states as well as in federations.

Allocation of Functions in a Multilevel System

Macroeconomic management: Aligning total expenditure with economic capacity is a central responsibility. Sub-national governments:
Should not have independent monetary policy Have limited macroeconomic influence because of leakages May distort efficient allocation of resources But judicious use of local fiscal policy may make marginal differences

Distributional policies
Mainly central government responsibility.
Only central government can achieve horizontal equity across country. Sub-national redistribution may be ineffective and counter-productive.

However most local communities want (legitimately) to have some redistribution programs.

Allocation functions: public goods

Decentralisation theorem: Decentralisation maximises economic welfare by equilibrating supply of services to demand.

Subsidiarity principle: Subject to cost considerations, public services should be supplied by the level of government closest to the users of the service.

Decentralisation theorem

Problems with shared responsibilities

Major problems can arise when different levels of government share responsibilities.
r.g in health and education.

This is hard to avoid in federations but also in centralised countries.

Optimal Size of Local Governments

Considerations similar to those for supply of public goods.
Diversity of preferences points to small areas. Cost efficiency points to larger areas.

One problem: optimal size may vary by type of public good provided. There is a shortage of empirical studies.
Most studies of costs of services in areas of different sizes focus on technical possibilities rather than behavioural factors. There are few studies of effects of area size on demand and preference satisfaction. More research is needed.

Taxation with Multilevel Governments

Criteria for taxes:
Distributional (equity) objectives Allocative efficiency (minimise deadweight losses) Fiscal adequacy. Accountability.

Two problems
Central taxes best meet first two criteria, but this creates problems for other two criteria. There are limited tax bases (income, consumption and wealth) so tax bases may have to be shared.

Fitting taxes to economic functions

Income redistribution function of central government implies that central government should have access to income tax. Sub-national government provision of local goods requires that it should have access to a major tax base. But two problems arise
Mobility of tax base Externalities Both create deadweight losses.

Sub-national taxes and efficiency

Taxes that are efficient at national level may cause deadweight losses at local level because of mobility of resources.
See areas ABC in Figure 33.3.

Evidence suggests that:

Location of consumption is sensitive to consumption taxes and do cuse deadweight losses.

Decentralised taxes create tax competition to attract resources.

This is efficient if taxes reflect marginal costs. It is inefficient if it reduces tax base of other areas and their revenue by more than the related expenses.

Deadweight losses of local taxes

Vertical fiscal imbalance

VFI occurs when central government raises more revenue than it needs and sun-national government rasies less than it needs. Problems include:
Over-spending by central government with weak constraints. Over-spending by sub-national governments provided with external funds. Central conditions on grants to sub-national governments that do not satisfy local preferences. Reduced opportunity for beneficial impacts of sub-national fiscal competition.

Equity issues
Sub-national governments cannot tax progressively because they would lose part of their tax base. Horizontal fiscal imbalance. Sub-national governments cannot provide equal public services. Note however that markets may offset HFI. Property prices capitalise all (or most) of the value of public services. House prices are lower in local areas that provide fewer public services. Therefore there is limited if any HFI.

Taxing the same tax base

VFI and intergovernmental transfers can be avoided if different levels of government can share the tax base.
This occurs to some extent in U.S. and Canada. Theory suggests that sharing a tax base may increase tax rates because externality effects are ignored. Evidence is mixed on this. However complications and inefficiencies can arise if the tax bases and rate structures are inconsistent.

Household Choices and Local Government

Tiebout hypothesis: if there are many competing local governments and households are mobile, local governments will efficiently provide the local goods that households want. These conditions and outcomes may occur in U.S. but not in Australia. Tiebout also requires that local jurisdictions can exclude low income households who would not pay their share of costs of public services. This exclusionary implication may not be equitable.

Intergovernmental Transfers
Intergovernmental transfers may be:
revenue sharing or intergovernmental grants.

Intergovernmental grants may be:

General purpose grants or Special purpose (tied or conditional) grants.

Special purpose grants may be

Matching or Non-matching grants.

General purpose grants

Objectives are to:
Compensate for VFI and Reduce HFI (differences in fiscal capacity)

Effects of general grants

VFI allocation may lead to inefficient allocation compared with general income increase (flypaper effect, Figure 33.4) HFI allocation may be inefficient as revenue is allocated to high cost areas to compensate for the high costs.

Special purpose grants

Tied grants are intended to influence service delivery.
If tied grant (unmatched) is less than recipients initial expenditure on a service, it is in effect an income grant, though it may affect some service features. If tied grant is matched grant, this changes relative prices and creates a substitution effect. It is more likely to increase consumption of a service than an unmatched grant of similar size. Tied grants more likely to have deadweight loss than untied grants in that they force a change away from local preferences.

Effects of special purpose grants

Multilevel Government in Australia

Very high VFI and high level of intergovernmental grants. Nearly 60% as general grants determined by CGC and
just over 40% in 90 specific purpose grants.

Issues in Australian Federalism

VFI lack of fiscal responsibility of central and state governments.
State taxes are inefficient and inequitable as well as limited. This is partly because they administer land and payroll taxes inefficiently. Central government block grants (based on flawed CGC methodology) are inefficient and inequitable. An excessive number of inefficient SPPs. Too many local (or state) governments?

Chapter 34 Globalisation and Government

The Nature of Globalisation Globalisation, Output and Prices Distributional Consequences of Globalisation Globalisation and Government Revenue Globalisation and Government Expenditure Globalisation and Government Policies

The Nature of Globalisation

Globalisation means the worldwide integration of markets in product and factor markets. It is driven by technical change and political decisions.

Four dimensions of globalisation

1. International trade. Since 1945, international trade in goods and services has grown at twice rate of world output. 2. Financial market integration (foreign direct investment in physical capital and financial/portfolio investment). In last 20 years cross-border flows of capital increased four times as fast as world output. 3. Production systems internationalised with changes in transport, logistics and communications and firms operate in more than one country. 4. Use of international standards and law as the basis of the global economic system.

Four measures of scale of globalisation

1. Cross-border transactions. International trade as a proportion of world output is the simplest general measure of globalisation.
Stocks of capital. Capital ownership (portfolio investment and FDI) at any point in time shows openness of the economy. Price equalisation. Prices become more equal between countries as transport costs fall and markets are more integrated. Transaction impediments. Examples are tariffs, quotas and capital controls, or risk premiums that reflect political instability.

2.

3.

4.

Measures of globalisation (cont.)

Globalisation, Output and Prices

Four drivers of increased output and welfare
Increased trade based on comparative advantage.

Lower transport costs increase competition, lowers prices, and encourages economies of scale.
Globalisation of finance allows capital to be employed in the most productive opportunities and reduces interest costs. Integrated production systems enable multinational firms to deliver their goods into each market at least cost.

Theorem of comparative advantage

Both parties to trade can benefit if one party has comparative advantage in the production of some good(s). Table 34.2, Australia has comparative advantage (lower opportunity cost) in producing wheat, China in cloth.

The evidence on output

Time series: integration of global markets greater and rate of world economic growth higher in 1990s than in any previous decade of the 20th century. Cross sectional analysis. Open economies achieve higher rates of growth (Chapter 5 and various studies).
e.g., Edwards, 1998, positive relationship between growth in total factor productivity and nine measures of openness for most countries.

Distributional Consequences of Globalisation

How does globalisation affect owners of capital and natural resources, skilled and unskilled workers, and consumers?
Theory suggests trade equalises product and factor prices in trading countries subject to transport costs. Abundant factors in an economy gain from trade; scarce factors lose.
Thus wages of skilled workers in rich countries and of unskilled workers in poor countries rise. Wages of unskilled workers in rich countries and of skilled workers in poor countries fall. This process continues until the ratio of skilled to unskilled wages is the same in rich and poor countries (subject to equal access to capital and no transport costs).

Distributional consequences (cont.)

Thus trade increases wage dispersion in rich countries, but reduces it in poor countries. With free capital movement, the marginal return to capital rises because capital can move to the most productive opportunities. Consumers generally gain from globalisation. But globalisation does not eliminate all transport costs and other barriers to factors and product movements.

Three critical issues

Although globalisation reduces real wages of unskilled workers in rich countries, there are usually compensating factors. More demand from high skilled workers; lower import prices; increased government revenue and services.

Unskilled labour in poor countries dont benefit if they are not part of global system for one of other reason.
Note controversy about multinationals and real wages.

Rules of globalisation reflects political forces and suit rich countries. Examples: agriculture, pharmaceuticals.

Globalisation and distribution: some evidence

Evidence supports the theories. Market integration closes the gap between product and factor prices in rich and poor countries. But markets are far from fully integrated.
Studies cited in text suggest that globalisation has reduced global poverty and inequality across countries. Plus significant gains in life expectancy and education over last 30 years. But globalisation has increased wage dispersion in developed economies. The amount is hard to measure because some dispersion reflects changes in domestic policies.

Globalisation and Government Revenue

Does globalisation affect total government revenue and its composition? Three factors.

1. Increased mobility of capital and labour means that governments must provide competitive (low) tax rates to attract or retain productive factors. 2. Modern technology facilitates worldwide movement of money and tax evasion, but also facilitates monitoring of financial transactions. 3. Tariff reductions reduce taxes on trade but tariffs are a small part of revenue in developed countries.

Government revenues and globalisation (cont.)

Globalisation has not reduced tax revenue as proportion of GDP.

Government revenues are generally higher in countries with open economies. Corporate tax rates have fallen (Table 34.3), but some concessions (e.g. investment credits) tightened. Overall taxes on labour have not fallen, but tax structures have become less progressive. Consumption taxes have risen. User charges may also be expected to increase, for example for road use, education, health services and so on. Both phenomena have occurred. Taxes on land and wealth have not changed much.

Tax competition and efficiency

Does tax competition affect economic efficiency? When capital is mobile across jurisdictions, the marginal social cost of taxation includes loss of output when capital moves abroad. Although this produces a positive externality to foreign jurisdictions, the taxing jurisdiction ignores this externality and sets a lower tax rate. This may result in an under provision of public goods by government. This model assumes that income from capital is taxed at its source rather than at its destination. If income is taxed according to the destination principal, a residents worldwide capital income is taxed at the same rate, regardless of its source. The worldwide allocation of capital, and hence production efficiency, is independent of local tax rates. However, due to lack of cooperation between tax authorities, worldwide income cannot be monitored completely.

Tax competition and efficiency (cont.)

In Australia, most income is taxed under the destination principle. Law-abiding owners of capital have no tax incentive to move capital overseas. But this is a strong assumption!

The Australian government also taxes income from Australian sources that accrues to nonresidents. Thus the Australian system has a source based element, which may discourage foreign capital and distort the worldwide allocation of capital and productive efficiency.

Globalisation and Government Expenditure

Text identifies four main economic determinants of expenditure (income, demographics, welfare needs, and production costs) and four political factors (political ideology, political and bureaucratic discretion, and interest groups). Two factors may increase expenditure.
Impact of globalisation on welfare needs. Increased activity of interest groups.

On the other hand,

Globalisation may reduce capacity of government to raise revenue. Also increased competition may reduce production costs.

Globalisation may therefore increase or decrease government expenditure, depending on which expenditure drivers are most influential.

Globalisation factors affecting government expenditure

Government expenditure: evidence

It is difficult to separate the influences of globalisation and politics on government spending. Overall studies find that both total expenditure and the share of welfare expenditure has increased and appears to be associated with globalisation.

It appears that governments can accommodate these demands despite the constraints on taxation due to more mobile factors.
The net impact of globalisation on spending is either a slight positive effect or a neutral one.

Globalisation and Government Policies

Globalisation has reduced government macroeconomic discretion. Governments cannot easily control cross-border capital movements.

Implications
Monetary policy: with free capital movements, governments cannot set both interest rates and the exchange rate. Fiscal policy: budget deficits that financial markets judge inflationary may produce capital flight, higher interest rates and a fall in the exchange rate. However markets have always punished unsustainable policies such as structurally over-valued exchange rates or persistent large budget deficits. What is new is the speed.

Government regulation of industry is also more restricted. Firms are less easily coerced.

Globalisation and government policies (cont.)

On the other hand the need for competition policy is reduced, e.g in telephone service where there is now a variety of electronic means and many competitive pressures. Also government has gained power through technology, e.g. genetic screening, monitoring traffic etc. Strictly, this reflects technology rather than globalisation.

International Agreements
Australia is a signatory to over 900 international treaties.
These treaties reflect both concerns about global use of resources and political issues such as child labour and human rights. Countries have also ceded power over trade restrictions to supra-national agencies such as the World Trade Organisation (WTO). International economic unions, such as the European Union, or free trade agreements, also result on countries foregoing national autonomy in order to gain the benefits of increased trade, specialisation and economies of scale.

International agreements (cont.)

Any government that wants good international relations and the benefits of international trade must accept some limitations on its ability to act autonomously. Australian High Court has ruled that Australian laws are invalid if they conflict with United Nations treaties entered into by the Commonwealth Government. These treaties do restrict Australian Government decisions, e.g. use of resources in Kakadu National Park, the Barrier Reef and in Tasmania.

Globalisation and government policies: summary

Integrated economic markets put pressure on national governments to align their economic policies those of other countries and restrict a governments macroeconomic and industry policy options. The strength of the tendency towards policy convergence depends on a countrys share of global trade and capital flows and its size.

Globalisation and government policies: summary (concluded)

But globalisation has not prevented governments from conducting many policies of choice.
Governments still determine the level and pattern of public spending. They often adopt mechanisms to offset the efficiency effects of globalisation. Technology has increased governments power in various ways. Globalisation is not about to eliminate the nation state.