Federalism The Optimum Size and Shape of Governments

1. FederalismThe Optimum Size and Shape of Governments Alexander Tabarrok Department of Economics George Mason University Tabarrok@gmu.edu

2. Why Federalism? Before we answer that question, we need to ask why have government at all? or How should the production of goods be divided between market and government?

3. Public Goods • A “public good” is a non-excludable and non–rivalrous good. • Non-excludability means that people who don’t pay can still consume – free riders. • Non-rivalry means that your consumption of the good does not reduce my consumption. • Non-rivalry implies that even if it were possible to exclude it would not be efficient to do so.

4. Two Problems with Producing Public Goods:1) Free Riders Photo: REUTERS/Beawiharta

5. Two Problems with Producing Public Goods:2) Forced Riders Photo: GEOGroup.com

6. Maximizing the Value of Public Goods To maximize the value of public goods minimize free riders andforced riders.

7. The Geographic Range of Public Goods

8. Why Federalism? • The Pure Economic Theory • Federalism helps to maximize the value of public goods by matching the range of the public good to the range of the government or organization producing the public good.

9. Transaction Costs • If “transaction costs” were zero then in theory any type of public good could be produced optimally by any structure of government. • E.g. In theory, national defense could be provided by a combination of states that bargained with one another to reach an optimal plan. • At the other extreme, local parks could be provided by a national government which carefully gathered information on the demand for parks by location and allocated taxes to coincide with benefits.

10. Bargaining and Information Transmission Problems • In practice, bargaining is expensive, information is not free and information is difficult to transmit from the periphery to the center. • As a result, when range of public good does not match the range of government we can have failures of decentralization and failures of centralization.

11. Failure of Decentralization Defense, for example, is unlikely to be optimally provided by bargaining among a series of small units.

12. Failure of Centralization • Consider a city with three neighborhoods. • What will happen if there are city wide taxes and a city wide vote on parks? • The central urban area is densely populated, few homes have yards. • The near suburbs have homes with small yards. • The far suburbs have homes with large yards.

13. The Matching Rule for Public Good Production • Match the range of the public good to the range of the government producing the public good. • Subsidiary Principle: Assign finance and control to the smallest unit of government that matches the range of the public good. • Local public goods should be produced and paid for locally. (e.g. 3 park districts for the city.) • National defense should be provided by the national government. Support for basic research should be provided nationally, or even more appropriately internationally. • The WHO, for example, helps to finance and coordinate the production of influenza vaccines. Without world finance we are likely to get free riders and too little vaccine production (Similarly for basic research, asteroid detection and destruction, world defense?!).

14. Heterogeneous and Homogenous Preferences • Many activities that may be quite rationally collectivized in Sweden, a country with a relatively homogeneous population, should be privately organized in India, Switzerland, or the United States. • Buchanan and Tullock, The Calculus of Consent.

15. The Matching Rule is About the Optimal Size and Shape of Governments Photo: Associated Press What is the key public good/resource in this picture? What area should the relevant government cover? What area(s) does it cover?

16. Special Districts Special districts are often created for activities that have natural boundaries that do not coincide with political boundaries (as in the Detroit-Windsor river example). As a result, most special districts do not coincide with county boundaries, either crossing over or residing only partially within them.

17. Special Districts

18. Special Districts • Special districts do not have to follow the one-person, one-vote rule. • Limiting the right to vote to landowners and weighing votes by land value does not violate the equal protection clause of the 14thAmendment because of a water storage district's limited purpose and the disproportionate effect of its activities on landowners. • Salyer Land Company v. Tulare Lake Basin Water Storage District (1973) • Homeowner Associations, including condominiums, also often weight votes (and taxes!) according to property value. • Similar to matching principle – match those who pay with those who receive benefits in order to maximize value of public good by minimizing free riders and forced riders.

19. Special Districts • A virtue of special districts is that they can grow or shrink over time. • Special districts have tripled in number since 1952. • Why? Suggests that spillover effects requiring better matching have become more important or that the cost of having multiple governments has fallen.

20. Not everyone likes Special Districts (trigger warning!)

21. The Case for More States • In 1789 the United States had 13 states and four million people. • Not that much different from contemporary Switzerland which has 26 cantons and approximately 7 million people. • If the number of states had grown as fast as the number of people we would today have about 1000 states. • If that sounds extreme why is 50 the magic number? And why is 50 the magic number when the population is 150 million as when it is 300 million?

22. Principal-Agent Problems • Bundle nature of political goods makes it more difficult to articulate demands for individual goods. • Larger populations makes voting individually less effective and rational ignorance more rational. • Slack allows politicians more opportunities for self-aggrandizement and rent seeking. • Decentralize to more tightly monitor and constrain politicians. • Decentralization allows more choice-people can move around to find optimum bundle.

23. Tiebout Competition

24. Aside: The ideal conditions for Tiebout competition are best approximated in the real world by virtual communities!

25. Tiebout Competition and the Rise of Private Governments • Private governments such as homeowners associations and condominium cooperatives provide all manner of public goods, from road maintenance, trash collection, and snow removal to transportation, policing, and medical care. • Practically unheard of in 1960, in 2012 some 63.4 million people in the United States live in various neighborhood associations. • A majority of new housing units in rapidly growing urban areas are privately governed.

26. Leisure World • “Leisure World of Maryland is a private, age-restricted community located in Montgomery County, Maryland. • Community amenities, which are held in Trust for benefit of the residents, include an 18-hole golf course, two clubhouses, indoor and outdoor swimming pools, tennis courts, dining facilities, bus transportation (within the Community and to outside shopping centers), a medical center with pharmacy, and full maintenance services.”

27. Federalism, Innovation and Yardstick Competition “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.” Justice Brandeis, New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (dissenting Louis Brandeis, 1856-1941

28. Yardstick Competition The existence of other governments provides a yardstick to measure the quality of your government which is useful even if you never move. • Corporate law advances at a quicker pace in the US in response to technological change than in Europe. • Improved policing strategies in New York were adopted by other cities when crime fell in New York. • The East Germans knew what life was like in the West and this knowledge helped to ferment the revolutions of 1989-1991. • Governors who raise taxes are more likely to be reelected if neighboring states also raise taxes.

29. Minimal Federalism • A minimal definition of federalism (Riker 1964): • At least two hierarchical governments over the same land and people. • Each government with institutionalized autonomy in its own sphere. (Autonomy protected by more than legislation.) • Minimal federalism is not sufficient to generate important benefits. • Tiebout competition (and yardstick competition) doesn’t do much if the field of competition is unimportant.

30. Market Preserving Federalism • Market preserving federalism (Weingast 1995) is defined as minimal federalism plus: • Subnational governments have primary regulatory responsibility over the economy. • Subnational governments cannot erect trade barriers against one another – national free-trade is ensured. • Subnational governments face hard budget constraints. • MPF means that Tiebout/yardstick competition will be over something important, economic policies set by subnational governments. • Competition encourages the subnational governments to adopt good policies while bad policies are limited by hard budget constraints.

31. Market Preserving Federalism (cont) • MPF helps to depolitize economics. • The governments with the right to bail out inefficient firms are limited by competition and hard budget constraints. • The central government does not face competition and has a soft budget constraint but it does not have the right to bail out firms. • MPF requires real autonomy of the subnationals. If the subnationals are greatly subsidized they are insulated from competition.

33. Market Preserving Federalism (cont) • MPF is inspired by the original Federalism of the United States: The powers delegated by the proposed Constitution to the Federal Government are few and defined. Those which are to remain in the State Governments are numerous and indefinite. The former will be exercised principally on external objects, as war, peace, negotiation and foreign commerce;... the powers reserved to the several States will extend to all the objects, which, in the ordinary course of affairs, concern the lives, liberties and prosperities of the people. The Federalist, #45

34. Argentina as an Example of What Not To Do • On paper, Argentina has a very decentralized government. The provinces have the primary responsibility for education, health services, poverty programs, housing, economic infrastructure and so forth and they also have the primary rights to collect taxes. • On paper, Argentina could be an example of MPF in action.

35. Argentina as an Example of What Not To Do • But in practice, Argentina’s fiscal structure is bizarrely inverted. Spending is decentralized but the provinces have ceded taxing authority so that taxes are centralized. Taxes flow to a single large bucket in the center before being redistributed back to the provinces. • About half of the total spending is done by the provinces (two-thirds excluding pensions) but a majority of the spending is financed by transfers from the center. • In fact, most of the provinces finance less than 20 percent of their own spending! • What incentives does this create?

36. Argentina as an Example of What Not To Do • The provincial governments spend someone else’s money and tax their own citizens for the benefit of other people! Thus expenditures are high but provincial taxes are low. • Why tax the people who elect you in order to benefit the people in another province? • The Federal government has repeatedly bailed out the provincials. • This is both a sign of the problem (undisciplined provincial expenditures) and a cause of the problem (moral hazard). • Add to this that each province has its own central bank and the provinces borrow extensively in both the national and international markets. • The provinces do not have hard budget constraints.

37. Argentina as an Example of What Not To Do • At the national level some taxes are required by law to be shared with the provinces (and vice-versa) but tax revenue from other sources is non-shared. This leads to an inefficient focus on the non-shared taxes which are too high at the same time as the shared taxes are too low. • Spending is based not on demand/need but on archaic rules and regulations and/or who is in power on that day. • Thus in practice Argentina violates most of the principles of MPF.

38. Minimal Federalism is Not Enough Market Preserving Federalism requires the discipline of competition - the subnational governments responsible for economic policy must bear the costs and benefits of their political choices both economically and politically.

39. The Spillover Problem

40. Wiping up the Spillovers:Intergovernmental Relations • Coordination: If interests are common sometimes coordination is enough to solve problems. • Coordination of tax systems. • Joint agreements over pollution, public good production etc. • Regulation of air travel. • When bargaining is not enough Federalization, i.e. relinquishment of control to the central government, may be justified. • The federal government “internalizes” the spillovers and so doesn’t have an incentive to underinvest or overinvest as would the sub-nationals but lack of incentive to do wrong is not the same as a positive incentive to do right!

41. Redistribution and the Problem (?) of Welfare Magnets • British 19th century poor laws tried to limit mobility by restricting the poor to their home parishes. • Articles of Confederation excluded “paupers” from right to free travel across the states. • 1996 welfare legislation said benefits to newly-arrived residents could be limited to the amount they would have received in the state of exit. But this was ruled unconstitutional in the 1999 Supreme Court case Saenz v. Roe.

42. Wiping up the Spillovers:Intergovernmental Relations • Federalization is one solution but there are others requiring less central control. • Intergovernment grants. • Matching grants versus block grants. • Welfare reform of 1996 moved from matching grants to block grants – block grants give the states greater room and incentive for innovation (perhaps leading to diffusion via yardstick competition) at price of reduced cost-sharing and thus a higher price on the margin for increasing welfare. • Note also, however, that the “decentralization” to the states was also accompanied by strings. • There is a very real danger that central finance becomes central control.

43. Federalism and CrimeApplying the Tools Prior to the twentieth century the states defined and prosecuted nearly all criminal conduct – withexceptions fortreason, bribery of federal officials, theft of government property and a fewother clearly federal issues.

44. Federalism and Crime • Theory suggests decentralized approach to crime was efficient. • Crime is mostly a state and especially a local matter, preferences and circumstances differ, experimentation can spread innovations, Tiebout competition can create a competitive market in crime fighting. • The expansion of interstate commerce and with it interstate crime certainly suggests, however, that increasing federalization of crime may be justified. • But how much federalization is necessary and of what crimes?

45. Federalism Theory and the Federalization of Crime A federal role in crime control can be justified in two circumstances. • Positive Spillover: The states underinvest in crime-fighting because the costs of fighting crime are theirs alone but some of the gains spillover to other states. • Negative Spillover: The states overinvest in crime fighting because the benefits of fighting crime are theirs alone but some of the costs spillover to other states.

46. Positive Spillovers • Who should/will prosecute a hacker who lives in Georgia but who hacks into computers in New York City? • Who should prosecute a kidnapper who crosses state lines. (Lindbergh Act) • Crime fighting in border cities to detect and capture imports of contraband and exports of stolen property. • Federalization of crime may be best way to handle examples but subsidies and mutual enforcement agreements may also be sufficient.

47. Negative Spillovers 1 How should these spillovers be handled?

48. Negative Spillovers 2 How should these spillovers be handled?

50. Negative Spillovers 3 How should these spillovers be handled?