Multi-government systems

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Public Economics

Principles and Practice

Part Ten

Multi-Government Systems

Peter AbelsonApplied Economics

and University of Sydney


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Multi-Government Systems

Multilevel Government

Globalisation and Government


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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


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Tiers of Government

Multilevel government exists in centralised

states as well as in federations.


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Distributional policies

Mainly central government responsibility. Only central government can achieve horizontal

equity across country.

Sub-national redistribution may be ineffective andcounter-productive.

However most local communities want

(legitimately) to have some redistributionprograms.


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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.


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Decentralisation theorem


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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.


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Optimal Size of Local Governments

Considerations similar to those for supply of publicgoods. Diversity of preferences points to small areas.

Cost efficiency points to larger areas.

One problem: optimal size may vary by type of publicgood 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 andpreference satisfaction.

More research is needed.


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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.


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Fitting taxes to economic functions

Income redistribution function of central governmentimplies that central government should have access toincome tax.

Sub-national government provision of local goodsrequires that it should have access to a major tax base.

But two problems arise

Mobility of tax base Externalities

Both create deadweight losses.


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Sub-national taxes and efficiency

Taxes that are efficient at national level may causedeadweight losses at local level because of mobility ofresources. 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 attractresources. This is efficient if taxes reflect marginal costs.

It is inefficient if it reduces tax base of other areas and theirrevenue by more than the related expenses.


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Deadweight losses of local taxes


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Vertical fiscal imbalance

VFI occurs when central government raises morerevenue than it needs and sun-national governmentrasies less than it needs.

Problems include: Over-spending by central government with weak constraints.

Over-spending by sub-national governments provided withexternal 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.


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Equity issues

Sub-national governments cannot tax progressivelybecause 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. Propertyprices capitalise all (or most) of the value of public

services. House prices are lower in local areas thatprovide fewer public services. Therefore there is limited ifany HFI.


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Taxing the same tax base

VFI and intergovernmental transfers can be avoided ifdifferent 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 increasetax rates because externality effects are ignored.

Evidence is mixed on this.

However complications and inefficiencies can arise if thetax bases and rate structures are inconsistent.


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Household Choices and Local

Government Tiebout hypothesis: if there are many competing local

governments and households are mobile, localgovernments will efficiently provide the local goods thathouseholds want.

These conditions and outcomes may occur in U.S. butnot in Australia.

Tiebout also requires that local jurisdictions can exclude

low income households who would not pay their share ofcosts of public services. This exclusionary implicationmay not be equitable.


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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.


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Special purpose grants

Tied grants are intended to influence service delivery.

If tied grant (unmatched) is less than recipients initial expenditureon 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 andcreates a substitution effect. It is more likely to increaseconsumption of a service than an unmatched grant of similar size.

Tied grants more likely to have deadweight loss than untied grantsin that they force a change away from local preferences.


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Effects of special purpose grants


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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.


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Issues in Australian Federalism

VFI lack of fiscal responsibility of central and stategovernments.

State taxes are inefficient and inequitable as well as

limited. This is partly because they administer land andpayroll taxes inefficiently.

Central government block grants (based on flawed CGCmethodology) are inefficient and inequitable.

An excessive number of inefficient SPPs.

Too many local (or state) governments?


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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.


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Four dimensions of globalisation

1. International trade. Since 1945, international tradein goods and services has grown at twice rate ofworld output.

2. Financial market integration (foreign direct

investment in physical capital and financial/portfolioinvestment). In last 20 years cross-border flows ofcapital increased four times as fast as world output.

3. Production systems internationalised with changes

in transport, logistics and communications and firmsoperate in more than one country.

4. Use of international standards and law as the basisof the global economic system.


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Four measures of scale of globalisation

1. Cross-border transactions. International trade as aproportion of world output is the simplest generalmeasure of globalisation.

2. Stocks of capital. Capital ownership (portfolioinvestment and FDI) at any point in time showsopenness of the economy.

3. Price equalisation. Prices become more equal

between countries as transport costs fall and marketsare more integrated.

4. Transaction impediments. Examples are tariffs, quotasand capital controls, or risk premiums that reflect

political instability.


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Measures of globalisation (cont.)


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Globalisation, Output and Prices

Four drivers of increased output and welfare

Increased trade based on comparative advantage.

Lower transport costs increase competition, lowersprices, and encourages economies of scale.

Globalisation of finance allows capital to be employed in

the most productive opportunities and reduces interestcosts.

Integrated production systems enable multinational firmsto deliver their goods into each market at least cost.


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Theorem of comparative advantage

Both parties to trade can benefit if one party hascomparative advantage in the production of some

good(s).

Table 34.2, Australia has comparative advantage (lower

opportunity cost) in producing wheat, China in cloth.


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The evidence on output

Time series: integration of global marketsgreater and rate of world economic growthhigher in 1990s than in any previous decade ofthe 20th century.

Cross sectional analysis. Open economies

achieve higher rates of growth (Chapter 5 andvarious studies).

e.g., Edwards, 1998, positive relationship betweengrowth in total factor productivity and nine measuresof openness for most countries.


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Distributional Consequences

of Globalisation

How does globalisation affect owners of capital and naturalresources, skilled and unskilled workers, and consumers?

Theory suggests trade equalises product and factor prices intrading countries subject to transport costs.

Abundant factors in an economy gain from trade; scarce factorslose.

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 isthe same in rich and poor countries (subject to equal access tocapital and no transport costs).


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Distributional consequences (cont.)

Thus trade increases wage dispersion in rich countries,but reduces it in poor countries.

With free capital movement, the marginal return tocapital rises because capital can move to the mostproductive opportunities.

Consumers generally gain from globalisation.

But globalisation does not eliminate all transport costsand other barriers to factors and product movements.


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Three critical issues

Although globalisation reduces real wages of unskilledworkers in rich countries, there are usually compensatingfactors. More demand from high skilled workers; lowerimport prices; increased government revenue andservices.

Unskilled labour in poor countries dont benefit if they arenot part of global system for one of other reason. Note controversy about multinationals and real wages.

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


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Revenue

Does globalisation affect total government revenueand its composition? Three factors.

1. Increased mobility of capital and labour means thatgovernments must provide competitive (low) taxrates to attract or retain productive factors.

2. Modern technology facilitates worldwide movementof money and tax evasion, but also facilitatesmonitoring of financial transactions.

3. Tariff reductions reduce taxes on trade but tariffs are

a small part of revenue in developed countries.

G t d


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Government revenues and

globalisation (cont.)

Globalisation has not reduced tax revenue as proportion of GDP.

Government revenues are generally higher in countries with openeconomies.

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 lessprogressive.

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.


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Tax competition and efficiency

Does tax competition affect economic efficiency?

When capital is mobile across jurisdictions, the marginal social cost oftaxation includes loss of output when capital moves abroad. Althoughthis produces a positive externality to foreign jurisdictions, the taxingjurisdiction ignores this externality and sets a lower tax rate. This mayresult in an under provision of public goods by government.

This model assumes that income from capital is taxed at its sourcerather than at its destination.

If income is taxed according to the destination principal, a residentsworldwide capital income is taxed at the same rate, regardless of its

source. The worldwide allocation of capital, and hence productionefficiency, is independent of local tax rates.

However, due to lack of cooperation between tax authorities, worldwideincome cannot be monitored completely.


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Tax competition and efficiency (cont.)

In Australia, most income is taxed under thedestination principle. Law-abiding owners ofcapital have no tax incentive to move capitaloverseas. But this is a strong assumption!

The Australian government also taxes incomefrom Australian sources that accrues to non-residents. Thus the Australian system has asource based element, which may discourageforeign capital and distort the worldwideallocation of capital and productive efficiency.


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Globalisation and

Government Expenditure

Text identifies four main economic determinants of expenditure (income,demographics, welfare needs, and production costs) and four politicalfactors (political ideology, political and bureaucratic discretion, and interestgroups).

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.


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Government expenditure: evidence

It is difficult to separate the influences of globalisation and politics ongovernment spending.

Overall studies find that both total expenditure and the share ofwelfare expenditure has increased and appears to be associatedwith globalisation.

It appears that governments can accommodate these demandsdespite 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.


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Policies

Globalisation has reduced government macroeconomicdiscretion. Governments cannot easily control cross-bordercapital 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 judgeinflationary may produce capital flight, higher interest rates and afall in the exchange rate.

However markets have always punished unsustainable policiessuch as structurally over-valued exchange rates or persistent largebudget deficits. What is new is the speed.

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


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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 ratherthan globalisation.


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International agreements (cont.)

Any government that wants good international relationsand the benefits of international trade must accept somelimitations on its ability to act autonomously.

Australian High Court has ruled that Australian laws areinvalid if they conflict with United Nations treatiesentered into by the Commonwealth Government.

These treaties do restrict Australian Governmentdecisions, e.g. use of resources in Kakadu NationalPark, the Barrier Reef and in Tasmania.


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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 industrypolicy options.

The strength of the tendency towards policy

convergence depends on a countrys share ofglobal trade and capital flows and its size.

Gl b li ti d t


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Globalisation and government

policies: summary (concluded)

But globalisation has not prevented governmentsfrom conducting many policies of choice.

Governments still determine the level and pattern ofpublic spending. They often adopt mechanisms tooffset the efficiency effects of globalisation.

Technology has increased governments power in

various ways.

Globalisation is not about to eliminate the nationstate.

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Multi-government systems