Local Government Finance: Taxes, Expenditures, and Fiscal Policy

Posted on Mar 11, 2025 in Economy

Functions of Government Expenditures

Government expenditures contribute to:

Current effective demand
A coordinated impulse on the economy, which can be used for stabilization and growth purposes
Increases in the public endowments of goods for everyone
Positive externalities to the economy and society, especially through its capital component

Oates’ Decentralization Theorem

For a public good, the consumption of which is defined geographically and for which the costs of providing each level of output in each unit, at all levels, are the same:

It will always be more efficient to provide these goods locally.
The bigger the differences among level units, the more efficient decentralization is.
Decentralization is more efficient if the demand is price inelastic.
Decentralization is less efficient if economies of scale occur.

Oates’ Correspondence Principle

This principle dictates how local governments (central and lower) share responsibilities and what duties they perform:

Each public good should be provided in the smallest government which internalizes the benefits of this good.

Stabilization – central
Distribution – mutual
Allocation – local

State Welfare State and Globalization

Gains from trade lead to wage and price convergence:

The spill-over of technological knowledge
Capital flows to countries with higher returns
People migrate from low-wage to high-wage countries
Specialization of countries

The result is that developed countries are losing jobs in the manufacturing sector, and unemployment is increasing.

As people stop working, they stop making contributions to GDP and GNP.

Local Taxes: Principles and Qualities

What taxes can be local, why, and list local taxes, qualities of a good local tax:

The tax base should be widely and fairly dispersed throughout the country.
A local tax should be economical to administer on a small scale and difficult to evade.
A local tax must be localized within the jurisdiction of the taxing authority.
Local taxes need to generate high and reliable revenues.
A local tax should not emphasize local disparities.
It is desired but not needed for the tax to be reserved for local use.
A local tax shall be visible and promote local accountability.

Qualities of a Good Tax

Vertical equity: Taxes should be paid according to income; people with higher incomes should pay more than people with lower incomes.
Horizontal equity: People with similar income and assets should pay the same amount of taxes.
Efficiency of tax collection
Right level of taxation

Functions and Limits of Taxes

Describe three functions of taxes. Why is fiscal policy so rarely maintained within its limits? What are the rules?

Functions of Taxes

Providing financing for the state
Redistributing income and wealth
Stimulating and discouraging via repricing (correcting externalities and other market failures)
Giving information about the state of the economy

Reasons for Fiscal Policy Exceeding Limits

Impatience
Common pool problem
- Shifting burden to future generations
- Externalities of extra spending not internalized by pressure groups
- Externalities of extra spending not internalized by members of a union or federation
Informational problems
- Overestimated long-term growth
- Uncertainty regarding optimal path of deficits

Similarities to Inflation Bias in Monetary Policy

Types of Rules

Upper limit on debt
Upper limit on spending
Upper limit on (structural) deficit: annual or over a cycle
Lower limit on tax
Subnational limits, supranational rules
Retirement age
Saving clauses if ex-ante spending assumptions exceeded

Reasons for Government Deficit Increase

Why did the government decide to increase the deficit?

This relates to the roles of public expenditures and reasons for government growth.