1

Local Public Finance

Chapter 16

(All Economics is Local)

2

Collective Choice

• Median voter model

• Majority rule: median person’s preferences win

• How to influence median voter?– Decide who has standing in the decision– Facilitate “your side” to vote.

3

Evaluating Social Utility

• Pareto optimal improvement: at least one person gains and nobody is harmed from a change in policy. – Difficult to achieve in practice

• Potential Pareto improvement: the “winner” is able to compensate the “loser” and still have surplus remaining.

4

Valuation techniques

• Consumer surplus (Ch 6)– Ignores existence value

• Willingness to pay– How much are you willing to pay to see a project

through to its completion?– Implicitly assumes everyone has same income or at

least same preferences (high-income people dictate social preferences)

• Willingness to accept– How much will you need to be compensated be just

as well off with the status quo?

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Arrow’s Voting Paradox

• Solution to philosophical quagmire:• Majority voting:

– Everyone gets one vote independent of their income

– Not flawless: Social choices of rational people may not be transitive, and may seem irrational.

– Three Projects:α, β, and γ. α P β, β P γ a, and γ P α! (“P” means “preferred to”.)

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Table 16–1. Arrow’s Voting Paradox

Voters/projects Alpha Beta Gamma

Alan 1 2 3

Betty 3 1 2

Chris 2 3 1

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Local public goods

• Citizens can vote at ballot boxes or vote with their feet

• Congestion—public goods are mostly club goods– Neither government nor private sector is

always best at provision

• Spillover effects– Some pay but do not benefit– Others benefit but do not pay

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Assumptions of Tiebout Hypothesis

• All residents can move costlessly;• Everyone has perfect knowledge about the

qualities of each community;• Enough jurisdictions exist to provide a full

range of public goods;• All communities, regardless of size, have the

same cost functions for their services;• Public goods do not cause any positive or

negative spillovers; and• There is no social discrimination by

jurisdictions.

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Public Finance Viewpoints

• Traditional public finance theory – Government is benevolent, omniscient.– Government efficiently allocates resources to

provide optimal quantities of public goods; – It redistributes income to create a more

equitable and more just society; and– It is responsible for maintaining economic

stability. Public officials select policies that maximize social welfare.

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Public Finance Viewpoints

• Public choice theory– Civil servants maximize their personal utility functions – They cannot maximize the “common good” because

such a thing is neither definable nor measurable. – Maximization of social welfare results in the

maximization of benefits to the most zealous lobbyists, interest groups and rent-seekers

– Government will inevitably become excessively large, unaccountable and untrustworthy.

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Provision of club goods

• Market fails in efficiently providing club goods because of – externalities, – imperfect competition, – free-riders, – lack of precise information, – excessive regulation, – improper incentives to provide an adequate

amount of the quasi-public good.

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Provision of club goods

• Government fails in efficiently providing club goods because of – Unreliable signals of the electors’ preferences

• Arrow’s voting paradox• Rational ignorance (electors bear high costs of being well-

informed; marginal benefit—their one vote)

– Inertia inherent in bureaucracies, – Tendency to mandate quick fixes (and its associated

“law of unintended consequences”), – Distributional inequalities.

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Revenue Sources of Local Government

• Benefit principle: Whoever benefits from a public program should pay– Difficult to determine with spillovers– Free-riders– Marginal cost of provision 0

• Ability to pay– Equity and equal sacrifice – Results in progressive taxes

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Tax Incidence: Partial Equilibrium Analysis

• Who bears the tax?

• Excise tax: consumption tax paid when product is purchased.

• When imposed, an excise tax shifts supply inward– Consumers see higher prices– Producers see lower per-unit revenues– Society worse-off by deadweight loss

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Tax Incidence Partial Equilibrium Analysis

• Whether consumers or producers bear the most part of the tax depends on the relative price elasticities of supply and demand

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Incidence of an excise tax

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Tax Incidence: General Equilibrium Analysis

• Quantity sold falls, fewer workers are needed, so excise taxes increase unemployment in:– the taxed industry (direct effect),– the industries that supply products that the tax

industry needs (indirect effect), and– the industries that provide goods and services

that the affected workers would use (induced effect.)

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Laffer curve

• High tax rates decrease revenues– Reduce incentives to work– Encourage consumption of leisure activities– Encourage participation in shadow (hidden)

economy• Barter• Work for cash• Tax avoidance mechanisms

– Encourage out-migration

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Laffer curve

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Optimal local tax policy

• Traditional public finance theory– Government maximizes its tax revenue to allow

provision of sufficient quantities of public goods.

• Public choice theorists– Taxpayers exchange their money for an optimal

amount of public goods. – Politicians choose the tax rates and fees to minimize

their political cost function.– They respond to preferences of social income groups

and interest groups.

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Property taxes

• Controversial tax– Equitable: Property values benefit from

efficient provision of services and amenities.– Critics:

• Property taxes have nothing to do with either the ability to pay or the benefits received

• Homeowners on fixed incomes are hurt. • Property tax supports services that have an

inverse relation to property values.

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Incidence of property taxes:Three schools of thought

• Traditional view– Property composed of land and buildings– One jurisdiction raises its tax rate – If supply of land fixed, portion of tax

attributable to land falls on landowners– Portion of tax on buildings acts like excise tax– Households and firms flee to other

jurisdictions– Property tax regressive

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Incidence of property taxesThree schools of thought

• New view (Mieszkowski)– Extends traditional view – What if all jurisdictions increase rates by the

same amount?– Similar to national property tax—no migration

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Incidence of property taxesThree schools of thought

• New view (continued)– Taxes fall on all capital owners

• Property owners would sell, decreasing the value of real property everywhere.

• They would invest in assets not subject to property tax, like bonds.

• Increase demand for bonds, bond prices rise• Inverse relation between bond prices and interest

rates, so interest rates fall

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Incidence of property taxesThree schools of thought

• Benefit view (Hamilton) – Accounts for benefits and costs– Property tax is user charge. – Tiebout hypothesis – Value of services and value of tax are

capitalized into property values. – If the amount of taxes equals the value of

benefits, then the landowners both benefit from and pay for the local public goods.

– Property tax is distributionally neutral

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Municipal sales taxes

• Essentially excise taxes• Some consumers purchase goods from

outside the jurisdiction• Regressive (the poor spend a higher

proportion of their incomes)• Exportable• May cause retail firms to relocate just

outside jurisdictional boundaries (cause spatial mismatch?)

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Local income taxes

• Decrease the incentive to work

• Increase propensity to migrate

• Taxes on corporate income – Encourage firms to relocate– Firms act on after-tax income rather than pre-

tax income

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User Fees

• Prices for local services• (Close to) Marginal cost pricing• Efficient for financing club goods with few

externalities – Water provision– Sewerage– Garbage collection– Chimney sweeps (according to Norwegian

study)

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Tax Exporting

• Interspatial incidence– Taxes in tourist areas borne by vacationers– Works very well if area lacks nearby

alternatives (hotel room tax in Hawaii)

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Appendix

• Indifference curve analysis combines willingness and ability to determine quantity of two goods consumed by one individual

• Edgeworth box – Assumes fixed amount of output of two goods– Analyzes optimal distribution of these two goods.– If production possibilities curve shifts, Edgeworth

boxes change

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Edgeworth box within production possibilities curve

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Edgeworth box for Dick and Jane

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Edgeworth box

• Two goods, (grapes and carrots)

• Two protagonists (Dick and Jane)

• Original endowment– Dick: 15 carrots, 40 grapes– Jane: 60 carrots, 10 grapes

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Edgeworth box

• Pareto optimal redistribution: makes at least one person better off without decreasing the satisfaction of the other.

• Contract curve– The contract curve locus of points where the

two sets of indifference curves are tangent. – When a distribution ends up on the contract

curve, no Pareto optimal redistribution exists

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Edgeworth box

• NOTE: the optimal distribution does not have to be in the middle of the box. – Preferences can also be corner solutions.– To be equitable, a distribution may not be

equal.

• Equity vs. equality– If we take subsequent production incentives

into account, an equal distribution may affect the placement of production possibility curve during the next time period.