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Fiscal policy making at the local level involves three distinct allocation decisions: setting the mix between private and local public spending, setting the mix between different spending categories, and determining the intertemporal distribution of spending. These will be referred to as the revenue, spending, and borrowing decisions, respectively.
According to the "classical" theory of fiscal federalism, subcentral authorities have an important part to play in the allocation function of government because decentralized provision of services allows communities to adapt to variations in circumstances and taste (Oates 1972; King 1984). When communities have different preferences for the size, composition, and intertemporal distribution of public spending, there is a strong case for decentralizing revenue, spending, and borrowing decisions to local authorities.
However, surveys of central-local relations in Western Europe show that, for all three aspects of local fiscal policy, central regulations are pervasive.(1) The center controls local revenues by setting intergovernmental grants, the type of taxes the local sector may levy, and, in some cases, upper and/or lower limits on tax rates.(2) Spending decisions are regulated by categorical grants or statutory and administrative arrangements.(3) Borrowing regulations take the form of ceilings on interest payments, budget balance requirements, or borrowing limits for individual authorities.(4)
In the fiscal federalism literature, there are three broad strands of contributions that can explain the prevalence of revenue, spending, and borrowing regulations. The most commonly suggested rationale for regulations is externalities across jurisdiction borders. Revenue controls dampen distortive competition for scarce capital and prevent tax exporting that shifts the burden to nonresidents.(5) Spending regulations prevent local authorities from neglecting services that attract welfare recipients or produce benefit spillovers while spending too much on services that attract firms or wealthy taxpayers (Brown and Oates 1987; Taylor 1992).
Borrowing controls are required because central authorities must assume the main role for the stabilization policy due to demand leakage across jurisdictions and because voters discount the price of debt financing in the presence of migration (Wagner 1970). Borrowing controls may also be warranted when debt accumulation is used as a strategic instrument to affect the outcome of tax competition between jurisdictions (Jensen and Toma 1991).
A second strand of literature focuses on the interaction between local authorities and bureaus producing local public services (Denzau, Mackay and Weaver 1979; Toma and Toma 1980; Courant and Rubinfeld 1981; Carlsen 1994). By restraining local authorities' discretion to respond to strategic actions, revenue and spending limits prevent bureaus from exploiting agenda control and private information in order to elicit excessive budgets and raise slack. Spending regulations deter strategic manipulation of budget priorities as local authorities are prevented from transferring funds between activities.
The third category of contributions considers regulations to be the outcome of a bargaining process involving local distribution coalitions and national policy makers (Inman 1985, 1988; Hoyt and Toma 1989; Leyden 1992). Regulations evolve because distribution coalitions lobby for measures that alter the spending mix and the balance between private and local public spending in their preferred direction and because central policy makers attach strings to intergovernmental grants in order to benefit politically powerful interest groups.
This article suggests another possible explanation for central regulation of local revenue, spending, and borrowing decisions. It argues that regulations give the government leeway in setting intergovernmental grants because local authorities are prevented from distorting allocation decisions.
In a series of articles, Denzau, Mackay, and Weaver show that a bureau that possesses monopoly power will manipulate the budgetary mix, as well as benefit shares and tax shares, in order to raise its budget.(6) Their basic argument is relevant for the relationship between local and central authorities because governments always have some discretion to adjust grants in response to local policy decisions. The implementation of a grant system requires an element of judgment, since future needs cannot be assessed with certainty and state-dependent contracts with individual communities cannot be specified, verified, and enforced due to prohibitive transaction costs.(7)
All three fiscal policy decisions can be used by local authorities as strategic instruments to influence grants. If a community distorts the mix between private and local public spending or accumulates debt by incurring deficits, the government must provide generous grants if excessive tax raises or cutbacks in public services are to be avoided. If the community distorts the spending mix, for instance by targeting cutbacks at politically sensitive tasks such as education and health care, the government will be under heavy pressure to bail out local institutions in trouble.
This article analyzes the effects of strategic distortions on the interaction between the state and the local sector in the context of a two-period game involving two players: central and local government. Local government is responsible for funding two activities that can be interpreted as either two categories of local public spending or private and local public spending, respectively. In each period, central government first appropriates ordinary grants. Then, local government provides funding for the two activities. Finally, central government decides whether to channel supplementary grants directly to the activities.
In the absence of central regulations, local government controls two strategic instruments. Local government can raise second period grants by running a deficit in the first period and/or achieve supplementary grants in one or both periods by distorting the spending mix; that is, the allocation of a given budget between the two activities.
Whether local government prefers to distort allocation decisions depends on the marginal benefit of intergovernmental transfers. When local government is wealthy, achieving an even allocation across periods and activities is more important than obtaining higher transfers. When local government is poor, raising overall transfers is the most important objective. Therefore, central government can induce local government to abstain from strategic actions by raising ordinary grants in the first period.
This article shows that, in equilibrium, central government appropriates neither supplementary grants nor ordinary grants in the second period, whereas local government does not exercise any of the strategic options. As seen by central government, it is better to give generous grants in the first period than to be forced to intervene after distortions have taken place. Avoiding distortions yields welfare gains that benefit central government.
In equilibrium, local sector spending is "too big" in the sense that the marginal benefit of spending is below the opportunity cost of intergovernmental transfers. To prevent strategic distortions, central …