What is the rationale for inter governmental transfer of resources in a fiscal federal system?

4.2.1 Remedies for Escape

If intergovernmental transfers were possible without a transaction cost, then the first-best outcome could be implemented. With costless transfers, an efficient breach rule could be designed such that a government is allowed to deviate from the baseline agreement as long as it compensates affected countries for their losses due to the deviation. Feenstra and Lewis (1991) confirm this result in a model where the affected exporting country is compensated with a portion of the tariff revenues or quota rents.u

Monetary transfers are not normally observed in trade negotiations. But transfers can be effected through the use of trade restrictions such as voluntary export restraints or retaliatory tariffs. Feenstra and Lewis (1991) consider a transfer mechanism in which the exporting country shares the rent from protection by imposing an export restraint. In a competitive market setting, an export restraint leads to an increase in the export prices and, thus, an increase in the producers surplus in the exporting country.

In the two-country setting, this framework suggests that the “grey market” agreements that arose in the latter stages of the GATT agreement would be welfare improving and raises the question of why they were discouraged under the WTO. However, in a many-country model such bilateral agreements will violate the MFN principle and have spillover to other exporters and importers who are not part of the agreement.

The GATT escape clause operates under a rule generally known as the reciprocity principle. Based on the reciprocity principle, if a government invokes the escape clause in response to a domestic political economic emergency, the affected parties are free to withdraw equivalent concessions immediately, so that a balance of concession is maintained among parties at all time. Withdrawal of previously granted concessions by the affected countries can be interpreted as a form of remedy for breach of contracts. Sykes (1991) and Schwartz and Sykes (2002) interpret the authorization of reciprocal reaction to an initial deviation as an award of “expectation damages,” which places the victim in as good a position as it would have been in if the violator had honored its obligations. Following this definition, Schwartz and Sykes (2002, p. S182) argue that “expectation damages thus deter inefficient breach because the promisor will not wish to violate and pay expectation damages unless the promisor gains more from the breach than the promisee loses, in which case breach is efficient.”

Beshkar (2010a) shows that reciprocal retaliations and expectation damages both constitute suboptimal levels of remedies. To demonstrate this point, suppose that political pressure from the political sector can take two levels, ie, low and high, denoted by θ¯ and θ¯, with probabilities ρ and 1 − ρ, respectively, where, 0 < ρ < 1. The problem of designing an optimal trade agreement is to set a pair of tariffs τ, r, where τ and r denote the tariffs of home and foreign countries, respectively. Assuming symmetric countries and with a slight abuse of notations, the welfare of the home and foreign countries as a function τ,r could be written as Vτ,r;θ and V*τ,r;θ, respectively.

Given asymmetric information about θ, this problem may be solved as a direct revelation mechanism. Formally, before the realization of political pressure, parties agree on a mechanism that maximizes their expected joint welfare. At the beginning of a given period, political pressure is realized in the home country and is privately observed by the home government. The home government then announces its political pressure, and the mechanism determines the tariff rates of the home and the foreign countries.

The mechanism must be incentive compatible, meaning that the home government must have proper incentive to announce its political pressure truthfully. Letting τθ and rθ denote the home and foreign countries’ tariffs as a function of the home announcement, the incentive compatibility constraints are given by

(4)Vτθ¯ ,rθ¯;θ¯≥Vτ θ¯,rθ¯;θ¯,

and

(5)Vτθ ¯,rθ¯;θ¯≥V τθ¯,rθ¯;θ¯.

The first inequality above implies that the home government is better off by announcing a high political pressure when it actually faces a high pressure. Similarly, the second inequality ensures the home government's truthfulness at the time of a low political pressure.

The expected joint welfare of the governments is given by

(6)ρVτθ¯,rθ¯;θ¯+V *rθ¯,τθ¯ ;θ¯+1−ρVτθ¯,rθ¯;θ¯+V*rθ¯,τθ¯;θ¯.

The first line of the above expression indicates the joint welfare of the governments when the home country faces a high political pressure, multiplied by the probability of a high political pressure in the home country. The second line gives the joint welfare when political pressure is low, multiplied by the probability of a low shock.

An optimal mechanism is one that maximizes the expected joint welfare of the governments, (6), subject to the incentive compatibility constraints (4) and (5). The optimal solution is shown graphically in Fig. 2. In this figure, points A and A′ represent the first-best tariff pairs under low and high political pressures, respectively. The ovals centered around A (A′) are the joint political welfare contours when political pressure at home is low (high). The outcome of the bargaining game is given by points B and B′. The curve that goes through B and B′ is one of the home country's iso-welfare contours under low political pressure. This implies that when political pressure in the home country is low, the home government is indifferent between B and B′. Therefore, the tariff pair given by B will be implemented when the home country is facing low political pressure. On the other hand, B′ will be the tariff pair implemented under high political pressure, as under such conditions the home government will be strictly better off at point B′.

It is worth noting that the optimal remedy rule for the escape from the negotiated tariff does not fully compensate the injured party for its loss due to contract nonperformance. Therefore, the expectation damages rule is suboptimal in the trade policy setting.

Studying the sensitivity of the optimal solution to the likelihood of high political pressure, ρ, is useful in obtaining a better intuition about the location of the optimal tariff schedule in Fig. 2. As high shocks become more likely, the curve B-B′ shifts towards A′. As a result of this shift, the tariff pair under high political pressure becomes more efficient (since B′ will be closer to A′), while it becomes less efficient under low pressure (since B will be farther away from A). In an extreme case where ρ = 1, B ′ coincides with A′, meaning that the tariff pair under high political pressure coincides with the first-best outcome. That is because when ρ = 1, there is no asymmetric information and the mechanism's outcome must be efficient. Similarly, when ρ = 0, B coincides with A.

Beshkar (2016) and Maggi and Staiger (2015b) show that incorporating an arbitration system, such as the WTO's DSB, could further decrease the need for breach remedies. In both models, the benefit of the DSB emerges from the presumed ability of the arbitrators to evaluate facts and produce an impartial and informative opinion about the state of the world.v The arbitrator's opinion works as a public signal that mitigates the information asymmetry between the disputing parties, which enables them to coordinate on a more cooperative equilibrium.w

The optimal agreement under Beshkar (2016) is an “Arbitrated-Liability Regime,” where the breaching party is liable if and only if the DSB disapproves of the deviation. Similar to the Arbitrated-Liability Regime, a safeguard-imposing country under the WTO is not liable for damages unless the adopted measures are ruled illegal by the DSB. The results of Maggi and Staiger (2015b) also show that the magnitude of the breaching country's liabilities is a function of the DSB's signal; such that the optimal compensation is (weakly) decreasing in the DSB's assessment of the benefits of protection.

5.4 Intergovernmental Transfers and Basic City Services

As discussed in Section 2, intergovernmental transfers account for about one-third of the total revenues of local governments. Historically, these transfers have been tied to specific local services, such as public housing or transit systems. In recent decades, education has become less local and had more funding from state and local sources. The federal government also began funding local police services during the Clinton Administration.

These funds can either take the form of pure transfers or they can be tied to local performance. Both No Child Left Behind and Race to the Top explicitly aimed at improving local performance by using federal aid to improve incentives. State-initiated school finance equalization schemes also create incentives at the local level that can either increase or decrease the incentives to spend on education (Hoxby, 2000).

There are two core rationales for providing funding for local governments with intergovernmental transfers: redistribution and incentives. Each of these rationales has two different variants as well. The simplest redistribution-related story is that the money is being given for a service that is targeted at the poor and the locality would not provide that service on its own. Housing support is a clear example of this phenomenon.

A second redistribution-related explanation is that intergovernmental transfers are essentially an in-kind transfer to the poor to purchase government services. When state aid to a locality is tied to the number of poor people in a community, it is as if each poor person has a voucher that helps pay for local government. The case for providing aid in this fashion, rather than with direct cash transfers, is the same as for any in-kind transfer. Either there are paternalistic reasons to encourage the poor to consume more government services, or non-poor taxpayers receive positive benefits from seeing the poor consume more government services, as opposed to other forms of consumption.

The first incentive-related explanation is that higher level of government just thinks that, for whatever reason, the locality does not have the right incentives to spend enough on a given service, such as policing. In this case, the optimal strategy would not be to just give cash grants, but to tie grants to increases in local spending. A second incentive-related explanation is that the higher level of government believes that the locality is taking the wrong actions, like retaining below par teachers or making it too hard to open a charter school. Tying aid to performance along these metrics seems to provide one means of improving performance.

The No Child Left Behind Act tied federal aid to education to performance on standardized tests. While the act has been roundly criticized, a number of academic papers have found significant test score improvements, not just on the high stakes tests (Dee & Jacob, 2011) but also on low stakes tests taken by the same students (Ballou & Springer, 2008). Reback, Rockoff, and Schwartz (2011) present a particularly comprehensive analysis of the act and find “either neutral or positive effects on students’ enjoyment of learning and their achievement gains on low-stakes exams in reading, math, and science.” These results parallel the results found on federal aid for policing found by Evans and Owens (2007).

The Great Recession that started in 2007 represents a particularly radical departure in the federal role in spending for local governments. The federal government structured its recovery support in the form of significant transfers to states and localities that enabled them to sustain existing expenditure levels without significant increases in tax rates. Essentially, the federal government has taken on the role of providing insurance against a downturn, which may be desirable if localities are unable to save or borrow enough to smooth their own spending. Still, this would seem to reduce some of the incentives that do exist for fiscal prudence at the local level. I now turn to city services and redistribution.

6.5.2 Tax-Sharing System (1994–)

Since 1994, China has implemented a so-called ‘tax-sharing system’ (fenshui zhi). At this stage, Chinese fiscal policy, through transferring much of the revenue collection function from local to central government, attempted to tackle the principal–agent problem of the revenue-contracting period. The solution was essentially to transpose the principal and agent. Under this system, China’s tax revenues have been collected by and shared between central and local governments, as follows:

‘Central taxes’ (i.e., those that are collected by the central government): these include customs duties; the operations tax paid by the railways, various banks, and insurance companies; and import-related VAT and consumption tax collected by the customs

‘Local taxes’ (i.e., those that are collected by local governments): these include operation tax (excluding the part paid by railway, various banks, and insurance companies) and city and township land use tax

‘Shared taxes’ (i.e., those that are shared between central and local governments): these include domestic VAT (75 percent for central government); income tax (60 percent for central government); resource tax (except the tax paid by offshore oil enterprises, all the rest goes to local government): and stamp tax in the stock market.

It can be shown that since the early 1980s China’s diversified fiscal systems have resulted in differences in central–local relations. During the period 1980–84, during the implementation of the first stage of fiscal reform, China’s share of local revenue to total revenue decreased from 75.5 percent to 59.5 percent; over the course of the same period its share of local expenditure to total expenditure increased from 45.7 percent to 47.5 percent. In the following years, both of these shares had increased considerably (see Figure 6.6). It can also be seen from Figure 6.6 that since the implementation of the ‘tax-sharing system’ in 1994, China’s fiscal transferring mechanism has been reversed from its previous pattern (i.e., the ‘local-to-central transference’ during the 1980s) to the present ‘central-to-local transference’ pattern. As a result, China’s central government has become more powerful than it was in the 1980s.

14.4 Expected Future Emissions and Caps

The size of the resulting emission trading markets, and the size of intergovernmental transfers, all depends on the pattern of initial emission permits and the degree to which the caps will be reduced in the future. At first, the caps were designed to limit growth of emissions, but, as global warming accelerates, there is an increasing recognition that absolute emission levels must actually decrease, perhaps even substantially. Such emission gaps continue to evolve.

The United Nations Environmental Programme (UNEP) regularly publishes an analysis of the level of emissions and the gap between emissions and allowances. Their report from November of 2012 noted that the increasing trend for carbon dioxide emissions will well exceed the need for cutbacks to arrest and then reverse annual emissions consistent with the science that would allow the global average temperature to be restricted to a 2 °C increase (Figure 14.4).

Clearly, there will be an increasing pressure for subscribers and other nations to reduce their allotments of emission permits if the global temperature rate of increase is to be limited to 2 °C. Reductions in the order of 25% over current trends will be necessary.

5.1.2 Taxes and transfers based on nominal income

An important redistributive implication of the spatial equilibrium model has to do with federal taxation and federal transfers. Federal taxes and transfers are calculated based on nominal income. By setting taxes and federal transfers in nominal terms, the federal government engages in a hidden form of location-based redistribution, because workers with the same real income pay higher federal taxes in high-cost areas than in low-cost areas. Albouy (2009) estimates that workers in cities where nominal wages are above the national average pay up to 27% more in federal taxes than similar workers in cities where nominal wages are below the national average. As a consequence, $270 billion each year are transferred from areas with high nominal wages to areas with low nominal wages.

In equilibrium, if workers are mobile, wages and land prices should adjust to compensate workers. However, the resulting geographic distribution of employment is inefficient, since it penalizes highly productive cities and favors less productive cities. In other words, this policy artificially lowers economic activity and property values in cities where labor is more productive and nominal wages are higher. At the same time it increases economic activity and property values in cities where labor is less productive and nominal wages are lower. The net result is a loss in overall welfare. Albouy calculates that the long-run employment loss in high nominal wage areas is about 13%, while the loss in land and housing values is about 21% and 5%, respectively. Albouy suggests that one solution is to make taxes independent of where workers live so that they are effectively lump sum location-wise.

A related problem arises when thinking about transfer payments. Should they be based on nominal or real income? Using a spatial equilibrium model similar to the one in Section 3, Glaeser (1998) derives the conditions under which welfare payments should be adjusted for differences in the local cost of living. He concludes that the optimal transfer depends on mobility and preferences for amenities. In the case of perfect mobility, transfer payments that correct for differences in the local cost of living are inefficient, because they end up being capitalized in the price of land, further raising land costs in expensive areas. With limited mobility, a correction for local cost of living differences is optimal under the assumption that amenities and income are complements.

Data on Elections and Intergovernmental Processes

Kenneth Bickers and Robert Stein have developed a useful tool for analyzing how elections to the U.S. Congress affect the distribution of federal grant aid to local areas. They aggregate FAADS data on intergovernmental grant awards to the congressional district level. At present, they have created data sets for each year from 1983 to 1997. In their own work, Bickers and Stein use these data to test theories of distributive policymaking. The records of the National Election Studies' Senate Election Study, conducted each election year from 1988 to 1992, contain state data samples that researchers may use to examine state electoral phenomena. This data set has been most productive in comparing gubernatorial elections to senate elections.

Financing

Government sources make up 70% of total health expenditures mostly through the income tax system, with the remaining 30% almost evenly split between VHI and OOP [11]. This is a lower percentage for government/statutory coverage than any of the European countries covered in this book except Switzerland. Japan is much higher than Canada, Australia a little lower, and the United States, far lower [11]. Here we focus on government spending, with VHI and OOP discussed later.

Nearly all (93%) of government expenditures are made by the provinces and territories, but about one-fourth of this is recouped by contributions from the federal government. The sources of both provincial and federal spending are tax revenues [12, p. 68]. The transfer of funds from the federal government to the provinces is called the Canada Health Transfer [25]. Prior to 2014, provinces with lower per capita tax revenues received greater per capita federal transfers, but now these transfers are based only on the number of people in the province; they are not adjusted for average health status in the provinces [12 (p. 71), 26, 27].g From 2004 to 2017, the federal government raised the amount it paid the provinces by 6% per year. This annual increase has since been lowered to about 3% per year or by growth in GDP, whichever is larger [28]. It is noteworthy that provinces are fully at risk for spending above the fixed federal transfer. This means that health care must compete against all other provincial spending priorities.

As noted, the bulk of healthcare funding comes from the provinces. On average, 50% of provincial revenues are derived from income and corporate taxes, 40% from sales taxes, and 10% from payroll taxes. About 80% of the federal revenues from which the transfer is taken are from income and corporate taxes and the remainder from sales taxes [12, p. 58]. Overall, the mixture of revenues leans somewhat toward progressive sources although more regressive sales taxes are a substantial component. The conclusion that the system is somewhat progressive overall is supported by research that indicated that the wealthiest 20% of Canadians are responsible for 50% of tax revenue used to fund health services, but use fewer than 20% of those services [12, p. 151].

4.2.4 Inter-governmental grants, “soft budgets” and future generations

The danger of “soft” budget constraints in generating excessive debt under fiscal decentralization has been emphasized in the debate on the difference between competition between nation states (whose budgets are “soft” due to their ability to print currency) and sub-national governments (whose budget constraints are “hard”). This literature emphasizes the role of political constraints that credibly combine monetary centralization with fiscal decentralization to generate hard budget constraints for those political units that compete.74 Thus, decentralized governments are forced to make economic trade-offs within their jurisdictions without being able to rely on passing costs to future generations or to others taxed by the central government. Qian and Roland (1998) set up a formal framework and apply this to an analysis of economic transition in China, and Weingast (1995) argues that such considerations were important in the development of England and the U.S. in the 18th and 19th centuries.75 A fuller and more formal treatment which identifies more precisely the conditions under which central government access to monetary policy softens local budgets and leads to exploitation of future generations remains for future research.

3.3.2 Regression Discontinuity

There are only few papers in the local fiscal multiplier literature using a regression discontinuity approach. Since the exploited policy rules that generate the discontinuities are close to the research question at hand, these papers are closer in spirit to the second group of papers cited above than to the first group, which relies more obviously on natural experiments. Corbi et al. (2014) exploit the fact that, as in the United States, Brazilian federal transfers to municipal governments rely on the population at the local level. In contrast to the United States, a specific step function exists that specifies the total transfer amount for certain population classes. Thus, sharp discontinuities arise in the transfers per capita around the cut-off values in this step function, whereas all other variables should change smoothly around the cut-off. This is the identifying assumption for their regression discontinuity approach. Another advantage of their experiment is that several cut-off values exist (rather than, eg, only one cut-off value as in the paper by Trezzi and Porcelli, 2014), which gives the test high statistical power. Sixty percent of the municipalities in the sample switch the population class at least once in the sample period. Because the data show that adherence to the cut-off is not implemented 100%, and, in fact, some judiciary disputes surround them, the authors confront a fuzzy regression discontinuity design and use the theoretically predicted transfers based on the actual population count as an instrument for the actual transfers. They employ different bandwidths around the cut-off values, and also report results from regressions with a rectangular kernel. In a similar spirit, Becker et al. (2010) and Becker et al. (2013) use a regression discontinuity design to analyze the effect of EU grants on local development, relying on a discontinuity in regional GDP per capita eligibility for the grants.

1.2 Administrative Planning

In the West, it is in the realm of public administration that one can identify genuine attempts at synoptic planning. Comprehensive government planning has long been central to normative theories of public administration. The influential French administrator Henri Fayol (1841–1925) argued that a ‘good plan’ requires clearly defined, written, comprehensive objectives together with the resources necessary to carry out these tasks. In the USA, broadly similar concepts found expression in the scientific and executive management movements of the Progressive and New Deal eras. The normative commitments and pragmatic understandings that emerged from these movements (e.g., ‘one-best way’ thinking; the emphasis on hierarchy and span of control; the separation of politics from administration) have had a significant impact on USA administrative practice and doctrine. In a classic statement in 1937, Luther Gulick, a member of the New York Bureau of Municipal Research who served on Franklin Roosevelt's famous Brownlow Committee, defined the executive function by the acronym POSDCORB (planning, organizing, staffing, directing, coordination, reporting, and budgeting). Effective planning was thus held to be the crucial first step to the achievement of rationality and technical efficiency in government administration. In the USA, administrative planning enjoyed a revival in the 1960s (Schick 1975). Hundreds of federal and local statutes mandated the formulation of plans for allocating intergovernmental grants, designing cities, and other purposes. The centerpiece of the new administrative planning was PPBS—Planning, Programming, Budgeting Systems—which essentially demanded that federal agencies engage in synoptic planning to promote the public interest. Administrators were to (a) articulate precise program goals, (b) comprehensively list alternative ways of achieving these goals, and (c) analyze the costs and benefits of each significant option. PPBS was introduced in the Pentagon in 1961 by Defense Secretary Robert McNamara. By 1965, President Lyndon Johnson ordered PPBS to be extended to nearly all federal, civilian departments. The promise of PPBS was considerable: Planning and policy analysis would be used to increase administrative effectiveness. Defective programs would be found wanting and, it was hoped, replaced with superior alternatives. The actual results of PPBS were disappointing to say the least, however. The reporting and monitoring requirements of the planning effort created a paperwork burden that quickly overwhelmed government officials. PPBS performed especially badly where, as was the case in many domestic agencies, bureaucratic outputs were soft and hard-to-measure. Most importantly, PPBS failed to accommodate the political and organizational incentives of budget actors. The Nixon Administration formally abolished PPBS in 1971 (Knott and Miller 1987, Kettl 1992). The failure of PPBS lends support to Aaron Wildavsky's argument that a fragmented and seemingly uncoordinated budget process generally does a better job of allocating public resources than does a system in which central planners make a synoptic, integrated evaluation of budget alternatives (Wildavsky 1964). Despite the manifest failures of PPBS, similar, comprehensive-planning exercises were adopted subsequently by US governments (e.g., zero-base budgeting and management-by-objectives).

Given the severe limits of synoptic planning, why have so many governments persisted with these sweeping reform efforts? Probable reasons include: there may be a political benefit to appearing ‘rational’; planning exercises may enable elected officials to give respectability to things they wish to do for other reasons; and focusing on planning procedures is often easier than making substantive decisions (Knott and Miller 1987). The enduring interest in synoptic government planning may actually rest less on science and rationality than on a secular faith in the perfectibility of man (Wildavsky 1973). Indeed, in an important account of paradigmatic failed attempts at ‘state simplification’ (e.g., the Great Leap Forward in China, collectivization in Russia, compulsory villagization in Tanzania, Mozambique, and Ethiopia), political anthropologist James Scott argues that the hegemonic planning mentality is supremely unscientific in the sense of being uncritical, unskeptical, and contemptuous of the importance of practical, local knowledge and informal processes in the face of unpredictability (Scott 1998).