The Power to Tax: Analytical Foundations of a Fiscal Constitution

Geoffrey Brennan.
Brennan, Geoffrey and James M. Buchanan
(1919- )
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Indianapolis, IN: Liberty Fund, Inc.
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Chapter 9Open Economy, Federalism, and Taxing Authority


It is better to keep the wolf out of the fold, than to trust to drawing his teeth and claws after he shall have entered.
—Thomas Jefferson, Notes on Virginia:
The Writings of Thomas Jefferson,
p. 165


Implicit in all of the analyses of earlier chapters has been the assumption that the polity and the economy are perfect mappings of each other with respect to geography, membership, and the extent of trade and resource allocation. That is, we have assumed the economy to be closed: neither trade nor migration extends the economy beyond the boundaries of the political unit. Consequently, all fiscal activities are carried out exclusively within the polity.


In this chapter we propose to relax the closed-economy-closed-polity assumption. We shall do so in two stages, the first of which contains two parts. In Section 9.1, we allow the economy to be open to trade; hence, citizens may buy and sell goods from citizens of other polities-economies. In that section, however, we continue to assume that migration across governmental boundaries does not occur. The model is the relatively familiar one of a small, independent, national state whose citizens trade in an international market but who remain resident within the small state. In Section 9.2, this model is modified to allow for interunit migration. The analysis of this section provides a bridge between the first and second stages of the analysis of this chapter. In the remaining sections, we examine the prospect of deliberate constitutional partitioning of the political power (and hence of the taxing power) within the confines of a larger and more inclusive political jurisdiction, within which internal trade and migration are unrestricted. Federalism is a means of constraining Leviathan constitutionally; hence, it becomes a topic of some importance in the framework of our analysis.

9.1. Toward a Tax Constitution for Leviathan in an Open Economy with Trade but without Migration


The analysis of this section is obviously related to that which has been developed by international and public-finance economists under the rubrics of "optimal tariffs" and "tax exportation." As before, however, the difference between our discussion and that of the orthodox literature lies in our concentration on the constitutional calculus of the potential taxpayer under Leviathan-like assumptions about the workings of the political process. A Leviathan government, interested solely in maximizing net revenue surplus for its own purposes, need not make any significant distinction between citizens and foreigners. This distinction is, however, quite crucial to the potential taxpayer, in his determination of the range and extent of taxing powers granted to government. The reason is straightforward: to the extent that government can be assigned taxing powers that impose costs on foreigners rather than on citizens, resources both for the provision of public goods and for the generation of Leviathan's net surplus are not drawn directly from the private incomes of citizens.


Recall our simple algebraic formulation, in which Leviathan's maximand, S, is determined by the difference between revenues, R, and G, the amount that it must spend on providing public goods:

S = R - G. (1)

If, as we previously postulated, government must spend a fixed share, a, on G, we get

S = (1 - a)R. (1)

If R can be increased without any increase in domestic taxation, it follows that G can be increased without cost, no matter how small the value of a may be. Of course, it remains true that the citizen-taxpayer would prefer a to be as large as possible and will take appropriate constitutional steps to increase its value whenever possible. But for a given a, the citizen-taxpayer will rationally attempt to raise maximal taxes from foreigners.


The potentiality for shifting the burden of taxes from citizens to foreigners depends on the degree to which domestic demand and supply may be separated from foreign demand and supply and upon the relative elasticities of the relevant demand and supply functions. In considering possible tax bases that might be assigned to government, the individual would favor those for which foreign demand looms large relative to domestic demand, and for which domestic supply is relatively elastic. Hotel rooms in Bermuda offer an example. At a constitutional level, the Bermuda government might be assigned the authority to levy taxes on hotel rooms with the assurance that only a relatively small part of the cost will fall on Bermuda citizens. In such a case, there need be little or no concern about the size of the aggregate revenue potential in relation to some globally efficient level of public goods and services. At essentially zero cost, the ideally desired level of public goods provision for local citizens may be very high indeed.


The domestic supply elasticity of the possible tax bases is, however, of critical importance. If domestic supply is available at sharply increasing costs, or if supply is such as to ensure that prices embody large elements of economic rents, any attempt to export tax burdens to foreigners may fail. Regardless of demand elasticities, the potential taxpayer (who will also be potential supplier of the taxed good and, hence, a potential rent recipient) may not want to allow government to have access to a tax base characterized by low supply elasticity.


The conclusions above relate to taxes on domestically produced goods and services, on exports, broadly considered. The same sort of analysis may, of course, be applied to imports, with the obverse relationships being relevant. If foreign supply to the domestic market is relatively inelastic whereas domestic demand is relatively elastic, the levy of a tax on such a good would be borne largely if not exclusively by foreign citizens rather than those who are resident of the tax-levying jurisdiction. Burden shifting by means of taxes on imports may not be an important instrument for exploitation by a small country, however, since foreign supplies of most goods, to that country, may be highly elastic. On the other hand, when large countries are considered, the whole problem of possible retaliation among a small number of trading countries must be incorporated into the analysis.


Detailed consideration of various possible cases need not be worked out here. It should be clear that the constitutional assignment problem in an open economy involves a set of different prospects from those that are relevant to the closed economy setting. With precisely the same model of political process, and with the same preferences for publicly provided goods and services, an individual in an open economy will select a differing range and mix of taxing powers to be allowed to government. He will allow Leviathan access to tax bases that promise a higher potential revenue yield than would be true in a closed economy, and he will tend to choose different bases in accordance with the export-potential criteria sketched out above.


The "prisoners' dilemma" aspects of tax competition among separate states cannot substantially modify these general results. The individual, at the constitutional choice stage when initial taxing authority is assignable to government, may recognize that if different governments try to export tax burdens to citizens beyond their jurisdictions, the net result, for citizens of all jurisdictions, may be harmful. It would be better, for everyone, if each government should be constrained so that no tax burden exportation could exist. But the individual is not placed in a position, even conceptually, to choose "the tax constitution for the world." At best, he can partially constrain the taxing powers of his own national state by constitutional means. In such a choice setting, the individual must consider tax exportation prospects, regardless of the dilemma created by a world regime of mutual retaliation. If he fails to do so, if he selects domestic tax rules on some Kantian-like principle of generalization, he must reckon on being exploited fiscally by the taxing powers assigned to governments other than his own and over which he has no control. The individual will find himself, and his fellow nationals, paying the ultimate costs of public goods and services enjoyed by citizens of other states and also financing the surpluses of the Leviathan rulers of those governments. At the same time, citizens of other countries will be escaping possible payments for at least some share of domestically supplied public goods and some share in the financing of the home-grown Leviathan's surplus. In a world of dog eat dog, the dog that does not eat gets eaten.

9.2. Tax Rules in an Open Economy with Trade and Migration


The economic interdependence among persons in different political jurisdictions changes dramatically when trade in final goods is supplemented by the prospects of resource mobility across governmental boundaries. If persons are free not only to engage in trade but also to shift capital and labor resources in response to differential economic signals, the economy becomes genuinely international, even if political units remain separate. It should be evident that the constitutional choice problem concerning the initial grant of taxing authority becomes different in this setting from that faced in either the closed-economy-closed-polity model of earlier chapters or the open economy-with-trade model examined above.


Freedom of trade and migration among separate governmental units acts as a substitute for overt fiscal constraints. In this sense, free trade and migration parallel in effect some of the Wicksell-like procedural rules examined in Chapter 8. By contrast with the latter, however, the indirect controls over Leviathan exercised by free international economic exchange seem closer to the realm of the institutionally politically feasible, at least in Western nations, than do the required procedural departures from majoritarian electoral processes.


The limiting case of free trade and migration is the idealized Tiebout world.*103 Assume a world of competing governments, each one of which supplies some public goods to its citizens, public goods whose benefits do not spill over beyond the boundaries of the individual polity. Each "national" government is, we assume, modeled as a revenue-seeking, surplus-maximizing Leviathan. Migration across governmental boundaries is, however, also assumed to be costless. Further, let us assume that persons are motivated exclusively by the economic returns available to them. No persons exhibit personal preferences as to jurisdiction of residence, and no persons earn locational rents. In this extreme case, there is no surplus available for potential exploitation by any potential Leviathan in the resource equilibrium generated by the voluntary decisions of persons in the whole international economy. Each governmental unit, regardless of its motivations to maximize net revenue surplus, will find it necessary to offer public goods in the efficient quantities desired and to finance these goods efficiently. In this limiting case, freedom of trade and migration will render any overt fiscal constraints unnecessary.


Once we depart ever so slightly from this extremely restrictive model, however, the idealized Tiebout process will not fully substitute for constitutional tax rules or limits, even if we continue to allow for costless migration.*104 If locational rents accrue to persons in particular places of residence or occupation and/or if personal preferences as among the separate locations are known to exist, a potential surplus for governmental exploitation becomes available. Interestingly, the governmental jurisdiction that is most "favorably situated" in terms of the generation of locational rents, on the production or the utility side of the individual's choice calculus, opens up the prospect for the relatively greater degree of fiscal exploitation. Those governmental jurisdictions that are "pedestrian" in the sense that they offer no locational rents at all, in utility or in production (they have neither sunny beaches nor oil beneath the rocks), may remain immune from the fiscal inroads of Leviathan.*105


At the constitutional stage of consideration, the individual who looks upon his jurisdiction as possessing, actually or potentially, the capacity to generate locational rents, may seek to impose overt constraints on the taxing power. But even in such cases, the effectiveness of freedom of trade and migration in serving as a substitute for such direct constraints should not be overlooked. On the other hand, unless free trade and free migration are themselves constitutionally guaranteed, the indirect limits that these controls might impose on the fiscal proclivities of Leviathan cannot be predicted to operate. Nor is an individual, at some initial constitutional stage, likely to prefer open migration on a one-way basis. That is, the individual may not want to ensure that migrants from other jurisdictions can freely enter into his own unless reciprocal guarantees of free outmigration and immigration into other jurisdictions are also offered. These latter guarantees cannot, of course, emerge in the constitution making for a single jurisdiction. Further, even in a world where such guarantees might emerge from some multinational convention, predicted disparities in income and wealth levels among persons of separate jurisdictions may make free migration undesirable for members of particular jurisdictions. The protection against the fiscal exploitation of Leviathan that the opening up of governmental boundaries offers may not outweigh the predicted costs in locational rents destroyed by such action.


For the foregoing and other considerations, the full substitutability of trade and migration for explicit constraints on governmental fiscal authority does not seem likely to characterize the constitutional calculus. Although he might well recognize the relationships here, the person who has an option at the constitutional stage would presumably select some constraint on governmental taxing power even in a world that is predicted to be characterized as truly international or interjurisdictional.

9.3. Federalism as a Component of a Fiscal Constitution


The analysis of Section 9.2 provides a useful introduction to that of federalism. In the earlier analysis, we adopted a model that contained a large number of political jurisdictions, each one of which defined the "range of publicness" for the goods and services to be supplied governmentally, but all of which were contained within a suprajurisdictional economy, characterized by open migration and free trade among persons in all the governmental units. Here we introduce a different model. We define the inclusive jurisdictional-political boundary to be coincident in both membership and territory with that of the economy. In this respect, we are back to the implicit closed-economy-closed-polity models of earlier chapters. There are no "independent nations" to be considered; there is only one political community. We want, however, to examine the prospect of using federalization of the political structure as an indirect means of imposing constraints on the potential fiscal exploitation of Leviathan. It may be possible that an explicit constitutional decision to decentralize and hence to disperse political authority may effectively substitute for overt fiscal limits. In conducting this discussion, we wish to contrast both the approach and the results with the reigning orthodoxy in the economic theory of fiscal federalism. We begin, therefore, with a brief descriptive statement of the main elements of that theory.


The conventional theory of fiscal federalism.  In what might be called the conventional or orthodox "economic theory" of federalism, the various functions of government are assigned to different levels (central, state or provincial, local) in accordance with the spatial properties of the public-goods externalities embodied in the carrying out of these functions.*106 In terms of the efficiency norm of the economist, this theory places or specifies for any particular public good or service a lower bound on the size of the political (or administrative) jurisdiction that should be assigned powers to finance and supply that good or service. In this framework, assignments to jurisdictions of smaller size (below such a boundary limit) would generate interunit spillovers. Efficiency in the overall organization of public-goods financing and supply, therefore, seems to dictate "merger" into "optimal-sized" units.


Note, however, that this argument does not establish any case for federalism, per se, because there are no logical grounds against assigning functions to jurisdictions larger or more extensive than the lower bound determined by the appropriate ranges of publicness. There would seem to be no reason why strictly localized public goods should not be provided by supralocal governmental units, which might, of course, decentralize administratively as the relevant externality limits dictate. In other words, the conventional theory offers no basis for deriving an upper bound on the size of political jurisdictions. There is no analysis that demonstrates the superiority of a genuinely federal political structure over a unitary structure, with the latter administratively decentralized.


This result is not, in itself, surprising when we recognize that the "economic theory" of federalism is no different from standard normative economics in its implicit assumptions about politics. The normative advice proffered by the theory is presumably directed toward the benevolent despotism that will implement the efficiency criteria. No support can be generated for a politically divided governmental structure until the prospects for nonidealized despotism are acknowledged. Once government comes to be modeled either as a complex interaction process akin to that analyzed in standard public choice or, as in this book, in terms of Leviathan-like behavior, an argument for a genuinely federal structure can be developed. Further, the normative theory that emerges can be as "economic" as the conventional one. The individual, at the initial stage of constitutional deliberation, may find it "efficient" to decentralize and to disperse the effective taxing power as between the central and the subordinate units of government.


The central government and protective-state functions.  Let us continue to model government in Leviathan terms. Whether central, provincial, or local, we assume that government will try to maximize net surplus within the set of internal and external constraints that it confronts. The question to be examined is whether or not explicit constitutional decentralization and dispersal of fiscal authority can provide effective substitutes, in whole or in part, for direct controls over the taxing power.


We must first take account of the initial leap out of Hobbesian anarchy, the primal establishment of government as the enforcer of individual rights and contracts, sometimes called the minimal or the protective state.*107 The protective functions will almost necessarily be assigned to the governmental unit that is coincident in area and membership with the area of the potential economic interdependence. Political subdivision into fully sovereign national units will create prospects for internal conflict, quite apart from internal barriers to trade and migration.*108 If protective-state functions are assigned to the central government, with no constraints on the taxing power, the individual will predict Leviathan provision of protective-state services (internal security, enforcement of rights and contracts, and external defense) but that taxes will be imposed so as to maximize the net surplus over and above the costs of supplying such services. Since the size of the potential tax base (income and wealth in the economy) is clearly dependent on the size and quality of the protective-state services offered, government may well be in the position discussed in Chapter 7. (See, particularly, Figure 7.2 and related discussion.) At the constitutional stage, the individual will clearly seek to restrict the central government's power to tax while leaving it with sufficient authority to finance the desired level of protective-state services. This objective may be accomplished by assigning to the central government a relatively narrow revenue potential through an appropriate base-rate restriction, one that directly relates revenue potential to the services provided.*109


Productive-state functions: "national" public goods, costless migration, no locational rents.  Our concern is not primarily with the financing of protective-state functions assignable to the central government. It is, instead, centered on the possible extension of central government competence beyond such limits with the corresponding extension of taxing power. For purposes of analysis in this and succeeding subsections, we assume that the central government carries out its protective-state functions satisfactorily. It guarantees rights of property and contract, protects against external threats, and ensures free internal trade and migration within its boundaries. It finances these activities by some appropriately limited taxing power, one that restricts the central government's possible exploitation of taxpayers within relatively narrow bounds.


We shall develop our argument in a series of models, arrayed in some rough order of increasing complexity (and realism). In the first three models discussed below, we shall make the extreme assumption that migration is costless. There are no moving costs, and no one has personal preferences as to location within the inclusive territory. Further, there are no locational rents to be earned anywhere in the economy.


In the first case, let us assume now that there is a single public good potentially desired by citizens, a good that is technologically nonexcludable throughout the whole "national" territory. Further, we assume complete nonrivalry in consumption. The good is ideally Samuelsonian. (No such good may exist, but the polar case is useful for expository purposes.)


From the precepts of the orthodox theory of fiscal federalism, the financing and provision of such a "national" public good under these conditions should be assigned to the central government rather than to subordinate units of less-than-optimal size for the function. In the latter assignment, interunit spillovers emerge to generate inefficiency, and total supply of the good will tend to be suboptimal. What emerges from the Leviathan perspective?


Assignment of the "national" public good to central government fiscal authority will require constitutional constraints to ensure both that revenues will be expended on provision of the good and that there will be limits on total revenue collections. Some such constraints could surely be constructed, in accordance with the norms emergent from the analyses of earlier chapters, and as we have already assumed to be present with respect to protective-state services. Nonetheless, as the analyses have also suggested, the constraints that might be imposed will accomplish these purposes only within certain tolerance limits and cannot be expected to ensure "efficiency" in any narrowly defined sense. Government could, in other words, be expected to secure some net surplus, a surplus that represents net efficiency loss to taxpayers.


The problem to be posed is one in comparative institutional analysis. It would be possible, at the constitutional stage, to assign the financing and provision of the "national" public good to subordinate units rather than to the central government, despite the "national" range of both nonexcludability and nonrivalry. The predicted results of such a federal assignment may then be compared with centralized assignment.


Under the extreme conditions postulated, the equilibrium solution under the federal assignment will be zero taxation along with zero provision of the public good. Any attempt on the part of any single subordinate unit of government, under Leviathan motivation, to levy taxes, even for the provision of the good, will result in total and immediate outmigration to the remaining jurisdictions in the economy. There will be no tax or fiscal exploitation in this solution. But the net efficiency loss will be measured by the potential difference between the benefits of the public good and its costs. There is no way of determining a priori whether these efficiency losses will be greater than, equal to, or less than those that are to be expected under centralized assignment. For our purposes, it suffices to demonstrate that the federal assignment may involve lower efficiency loss than the equivalent assignment of the function to the central government authority. The mobility constraint that prohibits local governments from exploiting citizens is tantamount to a constitutional rule that restricts the domain of public spending in such a way as to prohibit provision of the public good.


Productive-state functions: costless migration, no locational rents, complete "national" jointness efficiency but with provincial excludability.  The efficiency argument for federal assignment increases dramatically if we drop the nonexcludability assumption from the model considered above while leaving all other assumptions of the model invariant. Let us continue to assume that the "range of publicness" defined in terms of costs of provision over numbers is genuinely "national." We assume now, however, that subordinate units of government may, without undue cost, effectively exclude noncitizens from enjoying the public-goods benefits from localized provision.


In this model, by contrast with that examined above, any single unit of government can tax-finance and supply the public good without motivating mass outmigration from its boundaries to other units within the inclusive territory. To the extent that taxes are imposed so as to leave citizens with more surplus than they could obtain in competing jurisdictions, individuals will be motivated to remain in the fiscally responsive jurisdiction.


The equilibrium solution in this model will involve the concentration of all members of the inclusive jurisdiction into only one of the subordinate governmental units. This concentration will be necessary to exploit fully the jointness efficiency aspects of the public good. The single government that remains fiscally viable, however, will, in the extreme conditions postulated, be unable to secure any net fiscal surplus. Taxes will be levied on citizens strictly in terms of their relative public-goods evaluations; all taxes will tend to approximate Lindahl prices. Any attempted departure from this pattern of taxation will immediately set up the potentiality for a competing government to offer better terms to everyone; immediate mass outmigration from the unit that tries to undertake any fiscal exploitation will result.


In this model, therefore, there is a clear efficiency gain in adopting the federal rather than the centralized assignment for the public good, even though the range of publicness defined in the jointness sense remains "national." There are no efficiency losses in the federal solution, whereas, as earlier indicated, there may be efficiency losses in the centralized solution stemming from the failure of taxing constraints to eliminate all Leviathan surplus prospects. Note that the federal assignment secures the reduction of predicted efficiency loss to zero without the introduction of any overt fiscal constraints on the authority of the local governmental units. The fiscal discipline that is forced upon these units in the solution emerges from the mobility of resources across subordinate governmental boundaries within the inclusive territorial jurisdiction. These units of government cannot spend revenues for other purposes than public-goods provision, and they cannot tax in any arbitrary way so that net surplus may be generated.


Production-state functions: costless migration, no locational rents, localized public goods.  If we now modify the model by relaxing the assumption concerning the range of publicness, and allow for local-governmental limits on the jointness efficiency in public-goods provision, we are back in the idealized Tiebout world discussed earlier in this chapter. Elaboration at this point is unnecessary. The equilibrium solution differs from that immediately above in that, with localized public goods, population will not be concentrated in single units but will instead be dispersed among separate units, with each unit producing an efficient level of public goods, and with each unit imposing essentially Lindahl tax prices. As in the earlier case, the solution will be fully efficient. A federal assignment is dictated, both from our Leviathan set of assumptions about government and from the set of assumptions that characterize the orthodox theory of fiscal federalism.


Locational value, costs of mobility, and localized Leviathans.  The models introduced to this point in our discussion of federalism are grossly unrealistic in their assumptions about locational value and costs of mobility. They should be considered to be preliminary to more realistic models that incorporate locational preferences of taxpayers, locational rents earned by economic resources, and positive costs of moving as between locations. Once any or all of these elements are allowed for in the distribution of people and resources throughout the territory of an economy, the efficacy of the indirect constraint in reducing or eliminating fiscal exploitation by subnational units of government is decreased. If a person, for any reason, simply prefers to live in X rather than in Y, within an inclusive jurisdiction containing both X and Y, he becomes vulnerable to some fiscal exploitation by the government of X, even if it remains in "competition" for people and resources with the government of Y.


The existence of locational value implies that local governments should not be allowed unconstrained taxing power, as might have been implied by some of the extreme models when this value was assumed away. Acknowledgment of the existence of positive locational value does not, however, directionally modify the argument for federal assignment of functions sketched out in the simpler models given above. To the extent that the indirect mobility constraint is operative at all, subordinate governments will be limited in their fiscal powers in comparison with centralized government powers.


Toward an "optimal" federal structure.  The argument for a constitutional-stage federal assignment of functions, with accompanying taxing powers, under certain conditions may be accepted, and the suggested modification of the "range of publicness" mappings implicit in orthodox analysis may be rejected. But we have not, to this point, offered a definitive set of suggestions concerning "optimality" in the design of a federalized structure itself, given our Leviathan assumptions about political process. How small or how large should competing subordinate units of government be? How many subordinate units should be contained within the inclusive protective-state jurisdiction?


There are at least four elements that need to be considered as relevant to any answer to this question: costs of mobility, potentiality for collusion, ranges of publicness, and economies of scale in administrative organization.


The costs of moving presumably increase with geographical distance. "Costs of moving" include here not only actual costs of shifting among locations, but, also, subjective or psychological costs involved in shifts among locations along scales of preference. (A person may be relatively indifferent as between Broward and Dade County in Florida. She may place a high value on Florida over any other state.) Empirical evidence confirms the simple analytical results here; persons tend to shift among jurisdictions more readily if these jurisdictions are geographically close one to another. From this fact it follows that the potential for fiscal exploitation varies inversely with the number of competing governmental units in the inclusive territory. This element, taken alone, implies the efficacy of a large number of subordinate governmental units.


A second element also points toward the desirability of a multiplicity of jurisdictions. For reasons equivalent to those familiar in oligopoly theory, the potentiality for collusion among separate units varies inversely with the number of units. If there are only a small number of nominally competitive governments, collusion among them with respect to their mutual exercise of their assigned taxing powers may be easy to organize and to enforce. On the other hand, the costs of organizing and enforcing collusive agreements increase disproportionately as the number of competitors increases.


The "range of publicness" or "economies of scale in consumption" element offsets the first two elements, at least to some degree and for some functions. As the orthodox analysis suggests, the equivalence mappings between the size of political jurisdictions and the range of publicness is of relevance, if not necessarily of dominating importance. It is worth noting as an analytic footnote in this connection that it is the nonexcludability characteristic of public goods rather than the economies of scale in consumption as such that is the more crucial limit on the capacities of decentralization.


A final element involves the costs of administration and organization, which tend to point in the direction of a smaller number of units and toward a combination of functional authorities within single units. There is economic content in the familiar argument for fiscal consolidation among localized jurisdictions. What is often neglected in discussions of consolidation, however, is the offsetting potential for fiscal exploitation, a potential that only emerges when something other than the benevolent despotism model of government informs the analysis.


A normative theory of the "optimal" federal structure would have to incorporate each of the elements noted, along with other relevant considerations, among which would be the locational fixity of productive resources, the homogeneity of the population, and the predicted efficacy of explicit constitutional constraints on central-government and local-government taxing powers. Our purpose here is not to offer such a "theory," even in the form of a few highly abstracted models. Our purpose is the much more limited one of suggesting a rationale for introducing a dispersal of fiscal authority among differing levels of government as a means of controlling Leviathan's overall fiscal appetites.

9.4. An Alternative Theory of Government Grants


The orthodox theory of fiscal federalism includes as one of its parts a theory of intergovernmental grants. The traditional justification for such grants can take three forms: first, certain functions of government allocated to lower levels may generate interjurisdictional spillovers, which can be internalized only by payments between jurisdictions, or appropriate transfers from higher levels of government; second, economies of scale in the administration of taxation may be obtained if central (or higher-level) governments are responsible both for revenue raising and for disbursing funds to lower-level jurisdictions for expenditure; or third, interregional disparities in income (or possibly population) may be seen to require interregional redistribution on more-or-less standard "equity" grounds, by higher-level governments.


As elsewhere in this book, we set aside this third possible justification as lying outside the domain of the current discussion. The other two arguments are, however, of a type that would make them relevant to the constitutional calculus of the typical voter-taxpayer as we have posited it. In principle, they are arguments that ought to bear weight, but like other aspects of the economic theory of federalism, they presume a model of government as the benevolent despot—far removed from our own.


The Leviathan model does, however, readily enough generate a theory of "government grants," with both positive and normative aspects. Within a constitutionally designed federal structure, we would predict that there would be constant pressures by competitive lower-level governments to secure institutional rearrangements that would moderate competitive pressures. One obvious such arrangement would be one that established a uniform tax system across all jurisdictions: this would remove one major element of the competitive government process. And the logical body to administer any such agreement is the higher level of government. In return for an appropriate share of the additional revenue, the central government would act as an enforcer of the agreement between lower-level governments, doling out financial penalties to those jurisdictions which attempted to breach the agreement. Appropriate "fiscal effort" would become an important criterion for determining the share of total revenue that went to each lower-level government: if some state-province levied a low rate of tax in relation to some revenue instrument over which it retained jurisdiction, other states would need to be able to penalize it by means of its grant appropriation by the central government.


With revenue-raising powers thus reassigned to the central government, we would expect both some pro rata return of revenues to state governments and some remaining "special" grants to particular states. The reason for these latter "redistributions" in this model lies in the presence of differential locational rents among states. Those states where locational rents are high, and which could therefore charge higher taxes in the genuinely competitive setting, would no doubt expect a larger share of total revenues per capita in the cartelized case where the central government organizes revenue collection. Correspondingly, in those states where locational rents are lowest, we would expect states to obtain a lower per capita share of total revenue. Additionally, since any lower-level government unit can effectively break the cartel by remitting taxes and attempting to attract extra residents-taxpayers thereby, one might expect that some proportion of the additional tax proceeds from cartelization would be shared on a more-or-less equal-share basis. In this sense, we ought to expect small states to obtain a larger per capita share than large states. There are, then, clear empirical implications here that could be tested to determine the extent to which this explanation of revenue sharing and the structure of grants is an acceptable one. In this connection, there is one observation that deserves mention. With conventional explanations-justifications of intergovernmental grants, one would expect that a considerable amount of intergovernmental transfer could and would occur bilaterally between governments at the same level: interjurisdictional spillovers, for example, would seem to be most appropriately handled in this way. With our alternative theory of the central government as monitor of a cartel among lower levels of government, simple bilateral negotiation between particular jurisdictions would be almost useless since it increases monopoly power only modestly, and we would expect it to be a rare phenomenon. In practice, of course, it is: in very few federations do we observe any significant transfer of funds between jurisdictions at the same level—virtually everything is channeled through the higher level of government.


The normative implications of our alternative theory are clear. Revenue sharing is undesirable, because it subverts the primary purpose of federalism, which is to create competition between jurisdictions. Each jurisdiction must have responsibility for raising its own revenue and should be precluded from entering into explicit agreements with other jurisdictions on the determination of uniform rates. This conclusion is, of course, congruent with the one that emerges from more familiar models of public choice; in a setting where electoral choices are constraining, it is desirable to have expenditure and revenue decisions determined at the same jurisdictional level. The Leviathan construction, however, arrives at similar conclusions from a quite different route.

9.5. A Tax Constitution for a Federal State


It is interesting to consider here the nexus between the structural constraints imposed by an internally competitive federal polity discussed in this chapter and the explicit revenue limits that have been our concern in earlier chapters. To do so, we pose the question: How will (or how should) the power to tax be allocated among jurisdictions? The answer to this question seems clear. Recognizing that mobility will constrain governments at lower levels more severely than governments at higher levels, the citizen will, in making his constitutional determinations, be forced to rely more heavily on fiscal constraints at those higher levels. Assignment of taxing powers to jurisdictions should reflect this. At the lowest level of government, access to even minimally distorting taxes (such as head taxes, or possibly property taxes) may be appropriate, because the discipline of mobility restricts the capacity of government to exploit those tax instruments to the fullest. Equally, at the central level, since there will be little discipline exerted by the possibility of mobility, tax limitations of the sort discussed in earlier chapters remain crucial. Therefore, we would expect that, at this level, the taxpayer-citizen would select tax instruments with limited revenue potential (excises on specific items, perhaps), and otherwise choose fiscal rules designed to limit central government spending.


The tax recommendations that are derived here are, of course, somewhat at variance with practice: central governments have access to broad-based instruments with enormous revenue potential, whereas in many cases more localized governments have much more modest revenue instruments, though the property tax—widely a local government revenue instrument—does have substantial revenue potential. The fact that the property tax is not in practice levied at revenue-maximizing levels is perhaps a casual test of the severity of the mobility constraint.

9.6. Conclusions


The predicted intergovernmental competition for fiscal resources and the predicted mobility response of persons and resources to the exercise of governmental fiscal authority provide the relationship between the open economy and the federal political structure and, hence, the basis for this chapter's organization. The constitutional-level choice facing the individual in a potentially open economy-open polity is significantly different from that faced in a closed system. Intergovernmental competition for fiscal resources and interjurisdictional mobility of persons in pursuit of "fiscal gains" can offer partial or possibly complete substitutes for explicit fiscal constraints on the taxing power. In prospect rather than retrospect, however, the individual cannot constitutionally ensure that his economy-polity will remain open to trade and/or migration with differing national entities. Critical dependence on "openness" of the economy seems, therefore, unlikely to characterize the rational constitutional choice of an individual.


The substitutability between intergovernmental competition for fiscal resources and explicit constitutional constraints on governmental taxing power becomes important, however, even in a closed-economy-closed-polity setting, once the possibility of federalization is introduced. Since the constitutional rules are, in this setting, presumed to remain binding, the individual may choose to rely on the indirect mobility constraints guaranteed by dispersed political-fiscal power in partial substitution for the more direct constraints that would otherwise have to be imposed. Protective-state functions would, presumably, be assigned to the central government, along with some appropriately restricted powers to tax sufficient to finance these functions. Beyond this minimal limit, however, the intergovernmental competition that a genuinely federal structure offers may be constitutionally "efficient," regardless of the more familiar considerations of interunit spillovers examined in the orthodox theory of fiscal federalism.


The normative "theory of federalism" that emerges from our analysis differs sharply from the orthodoxy which places primary emphasis on the spatial properties of public goods. These properties become only one of several elements worthy of consideration in a constitutional choice among alternative functional assignments. And as our analysis has indicated, federalization may be efficient even when the desired public goods are estimated to be "national" in the polar Samuelsonian sense. Our emphasis is on federal assignment as a means of ensuring that individuals have available options as among the separate taxing-spending jurisdictions, and on the effect that the potential exercise of these options has on the total fiscal exploitation in the system.


In much modern policy discussion, local governments are allegedly "starved" for funds. Our analysis suggests that this situation is perhaps dictated by the competitive setting within which such governments find themselves, and, indeed, the analysis implies that this situation may well be efficient in the constitutional sense. Total government intrusion into the economy should be smaller, ceteris paribus, the greater the extent to which taxes and expenditures are decentralized, the more homogeneous are the separate units, the smaller the jurisdictions, and the lower the net locational rents.


Possibilities for collusion among separate governmental units, either explicitly organized and enforced by the units themselves or mandated by the central government, must be included in the "other things equal." When the central government collects and administers taxes on behalf of the subordinate units, the effect is identical to explicit collusion on the part of these units. Local units should tax and spend independently. But the point here is not the traditional one to the effect that jurisdictions should be responsible for both the tax and expenditure decisions in order to ensure some proper balancing of the two sides of the account, as driven by some cost-benefit-public-choice model of electoral choice. Our point is the quite different one to the effect that tax competition among separate units rather than tax collusion is an objective to be sought in its own right. The argument is, of course, obvious when the parallel is drawn with the monopoly-competition relationship in economic theory. But notions that are obvious in one area are often neglected elsewhere, and restatement of the familiar from one setting becomes a challenge to orthodoxy in another. The modified vision of federalism that emerges here suggests, once again, the critical relationship between the normative evaluation of institutions and the political model that is employed in positive analysis.

Notes for this chapter

Charles M. Tiebout, "A Pure Theory of Local Government Expenditures," Journal of Political Economy, 60 (October 1956), 415-24.

David Friedman has analyzed a regime of competitive revenue-maximizing nations, with costless migration, but with attractiveness related to population density. See his "A Competitive Model of Exploitative Taxation," mimeographed, Virginia Polytechnic Institute and State University, August 1979. See also Dennis Epple and Allan Zelenitz, "Competition among Jurisdictions and the Monopoly Power of Governments," Working Paper, Graduate School of Industrial Administration, Carnegie-Mellon University, March 1979.

Does Hong Kong offer a real-world example? Interestingly, we observe little or no fiscal exploitation of Hong Kong citizens by the Hong Kong government.

For a clear example, see Albert Breton, "A Theory of Government Grants," Canadian Journal of Economics and Political Science, 31 (May 1965), 175-87. But also see Gordon Tullock, "Federalism: Problems of Scale," Public Choice, 6 (Spring 1969), 19-29; Mancur Olson, "The Principle of 'Fiscal Equivalence,' " American Economic Review, 59 (May 1969), 479-87; Albert Breton and Anthony Scott, The Economic Constitution of Federal States (Toronto: University of Toronto Press, 1978); Richard A. Musgrave, "Approaches to a Fiscal Theory of Political Federalism," in National Bureau of Economic Research, Public Finances: Needs, Sources, and Utilization (Princeton: Princeton University Press, 1961), pp. 97-122; and Charles M. Tiebout, "An Economic Theory of Fiscal Decentralization," in Public Finances: Needs, Sources, and Utilization, pp. 79-96.

For further discussion, see James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975). Also, see Robert Nozick, Anarchy, State, and Utopia (New York: Basic Books, 1974).

Historically, of course, federalized political structures have emerged from some coordination between previously independent units rather than from the deliberative dispersal of political power at a constitutional stage of decision. For our purposes, however, the conceptualization of the latter model of origination of federalisms is more helpful analytically.

Earl Thompson has implied that protective-state services are directly related to "coveted wealth." From his argument a case can be made for allowing a central government to tax nonhuman wealth, presumably with designated rate limits. See Earl Thompson, "Taxation and National Defense," Journal of Political Economy, 82 (July-August 1974), 755-82. Thompson derives his theory from the predicate that governments are totally efficient and entirely constrained to produce results desired by the electorate. Our alternative model of public choice generates a quite different normative evaluation of the wealth tax. (See Chapter 5.)

End of Notes

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