Local Public Finance

1. Local Public Finance Chapter 16 (All Economics is Local) 1

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. 2

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. 3

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? 4

5. 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. αP β, β P γ a, and γ P α! (“P” means “preferred to”.) 5

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7. 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 7

8. 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. 8

9. 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. 9

10. 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. 10

11. 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. 11

12. 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. 12

13. 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 13

14. 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 14

15. 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 15

16. Incidence of an excise tax 16

17. 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.) 17

18. 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 18

19. Laffer curve 19

20. 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. 20

21. 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. 21

22. 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 22

23. 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 23

24. 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 24

25. 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 25

26. 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?) 26

27. 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 27

28. 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) 28

29. Tax Exporting • Interspatial incidence • Taxes in tourist areas borne by vacationers • Works very well if area lacks nearby alternatives (hotel room tax in Hawaii) 29

30. 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 30

31. Edgeworth box within production possibilities curve 31

32. Edgeworth box for Dick and Jane 32

33. Edgeworth box • Two goods, (grapes and carrots) • Two protagonists (Dick and Jane) • Original endowment • Dick: 15 carrots, 40 grapes • Jane: 60 carrots, 10 grapes 33

34. 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 34

35. 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. 35