Using the theory of fiscal federalism Essay Example

Using the theory of fiscal federalism Essay There is much economic literature and debate concerning the classic trade-off between a centralized versus decentralized system of local public good provision. The standard problem goes as follows. Most economies around the world are made up of geographically discrete areas. An obvious example is America, which is composed of distinct states, which are often even completely geographically isolated from the whole (Alaska, Hawaii). Each local area has a local public good, the provision of which benefits the local society. However, public goods often have a spillover effect to other districts, in which case, there are benefits accruing to wider society. The subsequent question is that given the existence of benefits to both local and general society, is it more efficient to have a centralized or decentralized system of decision-making and/or financing? The standard approach to the problem of public good provision assumes that in a centralized system, the government will adopt a standardized level of spending for each area. This is in essence a one size fits all result that doesnt show an appreciation of different local requirements. However, while a decentralized system will be able to respond to heterogeneous local needs, local governments will neglect the wider benefits, which accrue citizens and areas beyond their jurisdiction. Drawing on these assumptions, Oates Decentralization Theorem states that in the absence of spillovers a decentralized system is more efficient. Otherwise, Oates claims there will be a trade-off between the extent of heterogeneity in tastes and the degree of spillovers. 1 However, the argument for a decentralized system relies on the assumption that only a decentralized system will cater for local preferences. In fact, while decentralization may be more effective at tailoring public goods to local requirements, a centralized system in no way implies uniformity of provision across districts. We will write a custom essay sample on Using the theory of fiscal federalism specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Using the theory of fiscal federalism specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Using the theory of fiscal federalism specifically for you FOR ONLY $16.38 $13.9/page Hire Writer This logic is neither theoretically, or indeed empirically satisfactory. From a theoretical standpoint it is unclear, Besley and Coates question why it must be the case that a government charged with providing public goods in a centralized system cannot differentiate the levels according to the heterogeneous tastes in each district. 3 An empirical example of centralized differentiation of public good provision is that of federal highway spending in the United States. In the Federal Highway Aid Program a significant proportion of resources have been dedicated to specific projects in the legislators districts. Furthermore, Besley and Coates argue that the general spending formula has been manipulated to target spending to particular favored states. 4 Therefore, I believe that Oates Decentralization Theorem is flawed. A decentralized system may well be preferred as a more efficient arrangement to tailor goods to local needs, but this is not a clear-cut argument, and hence it is difficult and controversial to argue for decentralization solely on this basis. In fact, given that the standard approach is based on a trade-off between non-uniformity (decentralized output) versus spillovers (centralized output), once the constraint that central governments always choose uniform levels of public spending across districts is relaxed, the standard approach suggests that a centralized system will always be preferred. However there is a different case for a decentralized system of provision of local goods, which is based on the theory of fiscal federalism. The argument in this case goes as follows. In a centralized system, local public spending costs are shared creating a conflict of interest between citizens in different areas. When spending decisions are taken by a legislature of locally elected representatives, the conflict of interest for resources will take place in the legislature. Thus, Besley and Coates argue, the drawbacks of centralization stem from the basic conflict of interest among citizens of different districts working through the decision-making process. 5 Spending decisions in the legislator will be determined by a minimum winning coalition of representative, which can creates two major resource allocation problems. Firstly, there will be a misallocation of resources as spending will be skewed towards those areas who have representatives in the winning coalition. Secondly, uncertainty about the makeup of the winning coalition will mean districts are unsure of the amount of public good it will receive. Even if the legislature is committed to maximising the surplus of all its members, this would not necessarily be sufficient to achieve surplus maximizing results, as there would be an incentive for voters to elect representatives which high demand for public spending, and hence lead to overprovision. Hence, Besley and Coates say that: if decisions on local public goods are made by a minimum winning coalition of representatives, the allocation of public goods may be characterized by uncertainty and misallocation across districts. If decisions are made in a more cooperative way, then strategic delegation via elections may produce excessive public spending. 6 The drawbacks of a centralized system stemming from conflicting interests over shared costs might suggest a completely decentralized system whereby decisions are made solely by local government and financed from local taxation. However, as with the standard approach, the drawbacks of the centralized system must be weighed against the benefits of improved coordination of spillovers. If interests are fairly homogenous and spillovers high then a centralized system will produce good results regardless of how the legislature is constituted. This leads Besley and Coates to conclude that, the desiderata determining whether decentralization of centralization is best are the same as under the standard approach. However, the logic is different. 7 So how does this argument relate to the empirical example of the European Union? Unions such as the EU are collectives of nations that jointly decide on the provision of certain supranational goods (such as traditional public goods like defence or legal and regulatory frameworks), which will affect and benefit all members. In a multi country union, some competences are taken away from national control and decided instead at union level. The process of European integration has become far-reaching and quickened in pace. However, Gordon Brown says that the EU must abandon old flawed assumptions that a single market should lead inexorably to fiscal federalism. 8 What is the case for keeping decentralized provision of local public goods or for greater integration in the form of a centralized system of public good provision? The case of centralized system of provision of local public goods rests fundamentally on the trade-off between the internalisation of externalities and the costs of heterogeneity. On the one hand, even when looking at the difficulties that accompany reaching compromises and solutions at EU summits, there is little debate that median preferences in EU member states vary considerably. The efficient level of output of a public good will typically vary from one local jurisdiction to another. Furthermore, there is a worry that coordination of fiscal measures will result in an increase in tax rates in all jurisdictions. However, if the union centralizes to little, it runs the risk of not benefit from externalities, which were a key motivation in the creation of a union and the purpose of attending summits. Two main areas of externality proposed in the fiscal federalism literature are firstly equalisation of welfare across countries, especially targeted at poor relief. And secondly at macroeconomic stabilization. In the case of poor relief, sub-central government will be considerably constrained by the potential mobility of the poor and crucially the tax base. Oates says that this is a basic fiscal externality that results in sub optional levels of support under a purely decentralized system of poor relief. 10 In terms of macroeconomic stabilization, the central government is in a position to influence overall levels of aggregate demand and through tax revenue and transfer payments can respond to changes in the macro-economy. However, the present picture is one where, according to Oates, the central government is not well equipped to take a leading role in addressing Musgravess redistribution and stabilization functions. 11 One response would be to enlarge central government powers, but Oates says that the costs of overall public expansion in the public sector would outweigh the benefits. Instead there is a strong case for decentralization to promote inter-jurisdictional competition to limit growth of public sector on encroaching on the private sector. At the moment, it seems to me that there is too much heterogeneity amongst the European nations, which outweighs externality gains. The integration of Europe has been relatively fast and I believe it will take a longer period for homogeneity of interests across the Union to come about, especially given the integration of the young market economies of Eastern Europe who are lagging behind in economic development. Furthermore, concerning Besley and Coates legislature worries, the EU seems to be dominated by the more powerful countries. For example, amongst the net beneficiaries of CAP (common agricultural policy) are some of the richest countries in the EU. A centralized system of provision of public goods in the EU might suffer from similar problems of a skewing of resources to favour the dominant coalition in the legislature. It seems to me, that the European Union is not yet ready for fiscal federalism.