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«International Center for Public Policy Working Paper 13-23 INTERNATIONAL In October 2013 CENTER FOR PUBLIC POLICY Local Taxes and Local Expenditures: ...»

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International Center for Public Policy

Working Paper 13-23


October 2013



Local Taxes and Local Expenditures:

Strengthening the Wicksellian Connection

Richard M. Bird

Enid Slack

International Center for Public Policy

Working Paper 13-23

Local Taxes and Local Expenditures:

Strengthening the Wicksellian Connection

Richard M. Bird

Enid Slack

October 2013 International Center for Public Policy Andrew Young School of Policy Studies Georgia State University Atlanta, Georgia 30303 United States of America Phone: (404) 651-1144 Fax: (404) 651-4449 Email: hseraphin@gsu.edu Internet: http://aysps.gsu.edu/isp/index.html Copyright 2006, the Andrew Young School of Policy Studies, Georgia State University. No part of the material protected by this copyright notice may be reproduced or utilized in any form or by any means without prior written permission from the copyright owner.

International Center for Public Policy Andrew Young School of Policy Studies The Andrew Young School of Policy Studies was established at Georgia State University with the objective of promoting excellence in the design, implementation, and evaluation of public policy. In addition to two academic departments (economics and public administration), the Andrew Young School houses seven leading research centers and policy programs, including the International Center for Public Policy.

The mission of the International Center for Public Policy is to provide academic and professional training, applied research, and technical assistance in support of sound public policy and sustainable economic growth in developing and transitional economies.

The International Center for Public Policy at the Andrew Young School of Policy Studies is recognized worldwide for its efforts in support of economic and public policy reforms through technical assistance and training around the world. This reputation has been built serving a diverse client base, including the World Bank, the U.S. Agency for International Development (USAID), the United Nations Development Programme (UNDP), finance ministries, government organizations, legislative bodies and private sector institutions.

The success of the International Center for Public Policy reflects the breadth and depth of the in-house technical expertise that the International Center for Public Policy can draw upon. The Andrew Young School's faculty are leading experts in economics and public policy and have authored books, published in major academic and technical journals, and have extensive experience in designing and implementing technical assistance and training programs. Andrew Young School faculty have been active in policy reform in over 40 countries around the world.

Our technical assistance strategy is not to merely provide technical prescriptions for policy reform, but to engage in a collaborative effort with the host government and donor agency to identify and analyze the issues at hand, arrive at policy solutions and implement reforms.

The International Center for Public Policy specializes in four broad policy areas:

 Fiscal policy, including tax reforms, public expenditure reviews, tax administration reform  Fiscal decentralization, including fiscal decentralization reforms, design of intergovernmental transfer systems, urban government finance  Budgeting and fiscal management, including local government budgeting, performancebased budgeting, capital budgeting, multi-year budgeting  Economic analysis and revenue forecasting, including micro-simulation, time series forecasting,

–  –  –

One way to design a local tax system is to determine the desired size and nature of local expenditures and then put in place a tax (and transfer) system providing incentives that lead local decision-makers to choose to finance that expenditure package. In practice, however, there are seldom clear links between local taxes and local expenditures and accountability at the local level is often both confused and confusing. This paper discusses how the Wicksellian connection between local services and revenues might be strengthened by changing the ‘package’ of local services, by altering the ‘package’ of local revenues, and by altering the way in which the two packages are tied together, although it considers in depth only the second of these points. The potential importance of this issue is illustrated by a brief review of an on-going discussion about how to finance the regional public transit system in Toronto, Canada. We conclude that, although advances in technology may make an economically more rational local finance system achievable, it is unclear that people (or politicians) are willing to face the economic realities of local finance.

Keywords: Local taxation; local budgeting; user charges; earmarking; Toronto; transit finance JEL classification: H11, H71, P43, R48 * The authors are with the Institute on Municipal Finance and Governance, Munk School of Global Affairs, University of Toronto. An earlier version of this paper was presented at a workshop on local taxes and local expenditures sponsored by the Korea Institute of Public Finance and the Danish Ministry of Interior and Economy in Copenhagen, September 12-13, 2013. We are grateful to the participants in this conference for their helpful comments on the paper.

2 International Center for Public Policy Working Paper Series

1. Introduction

“…Wicksell (1896) and Lindahl (1919) … recognized that if genuine links or connections were to emerge between revenue and expenditure decisions and if true demand functions were as a result to be revealed, the public (collective) provision of goods and services would be efficient…. I will henceforth call this connection the Wicksellian Connection (Breton, 1996, 3).

Common sense suggests that there should be a strong and logical connection between the two sides of the budget. If an average citizen in any country is asked what he or she thinks about the desirability of a particular expenditure increase, the answer may depend on how the respondent thinks the increase will be (or should be) financed. Similarly, while people do not like tax increases, again their attitudes seem to depend at least to some extent on what they think will be financed. People are right. Revenues and expenditure are inextricably linked. The central problem of public economics is what governments should do, but what governments actually do is inseparably entangled with the question of how what they do is financed. If one aim of policy is to ensure that the public sector operates efficiently it is important to establish as clear a linkage between expenditure and revenue decisions as possible – to strengthen what Breton (1996) calls the Wicksellian Connection.

Since concern for efficiency in the allocation of resources in the sense of maximizing consumer welfare is central to what Harberger (1971, 785) defined as “… the package of expertise that distinguishes the professional economist from the rest of humanity” it is not surprising that many economists, if few others, have long recognized that strengthening the Wicksellian connection in this sense is essential to improving the efficiency of public sector outcomes. In a paper written to celebrate the centennial of Wicksell’s original formulation of this idea, for example, Richard Musgrave (2000, 101), one of the doyens of modern public finance, placed his own work squarely in the Wicksellian tradition and concluded that in order to provide “…public goods in an efficient and also just manner…in the absence of an omniscient referee … a mechanism for preference revelation [is needed with] tax and expenditure decisions…joined as they should be, rather than pursued as independent parts of the budget.” Indeed, the essential aim of the literature on fiscal federalism originating from Musgrave and others has been characterized as “…to improve the responsiveness and accountability of politicians and bureaucrats and to ensure closer correspondence of the basket of publicly provided goods and services with the preferences of beneficiaries and taxpayers in the various sub-central jurisdictions …. [by] promoting the coincidence between the three circles of budgetary policy: those who decide, those who benefit, and those who pay (Bird et al. 2003, 351).”1 This is close to the ‘fiscal equivalence’ principle of Olson (1969).

Local Taxes and Local Expenditures: Strengthening the Wicksellian Connection 3 If the benefit principle in this sense of a link between taxation and spending – the Wicksellian Connection – is central to achieving the aims of fiscal decentralization, then charging for public services and earmarking revenues to the services provided should be equally central to a sound local finance system. In such a system, expenditure responsibilities would be matched with revenue resources, revenue capacities matched with political accountability, and benefit areas matched with financing areas. Following this approach, services provided by the public sector would be (so to speak) sold to those who receive them and the revenues yielded by such sales would be sufficient to pay for the cost of providing the service. In effect, this approach treats local governments as essentially ‘firms’ producing and selling services to their customers. In a sense, Tiebout (1956) started this line of thinking by treating localities as competing firms.

However, his local governments sold only pure public services, enjoyed equally by all local residents and only by them, and operated in an extremely artificial institutional setting (Bewley 1981). In reality local governments operate in many different institutional settings, offer some services that are essentially ‘private’ in nature (that is, consumed by specific persons) and others that ‘spill over’ local boundaries to varying degrees, and often have little discretion with respect to either the services they offer or how they pay for them, with many in the end being paid for neither by local residents nor the (overlapping but not identical) group of beneficiaries.

Although few countries seem to have paid much attention to the importance of the Wicksellian Connection for efficient and effective fiscal decentralization, some elements of the benefit approach are visible in many countries. Indeed, since most services for which local governments are responsible are assigned either constitutionally or by central (or provincial) laws, all local government finance from all sources is in a sense earmarked to those responsibilities. Sometimes certain intergovernmental fiscal transfers to local governments are specifically earmarked to specific local expenditure functions, although both the efficacy and the efficiency of such earmarking may often be questioned (Kim, Lotz and Mau 2010).2 However, surprisingly little attention has been paid to the basic idea that local governments should charge for services provided whenever possible, earmark the revenues received to the services for which they are paid, and – barring ‘externality-related’ subsidies from outside – spend only those amounts on those services. A century ago, two Nordic experts – Wicksell (1896) and Lindahl (1919) – set out principles that imply that for the local public sector to be efficient, one should bring together the circles of deciders, beneficiaries, and payers mentioned earlier. In contrast, the current approach in the Nordic countries, in which the welfare state has largely been implemented through local instrumentalities (see section 2), implies that local Interestingly, none of the papers in the volume cited appear to recognize that since “conditional grants can be equivalent to a centralization of constitutional powers” equalization transfers intended to place local governments on a more equal ‘competitive’ footing in providing local public goods must be unconditional in nature (Breton 1996, 258). For simplicity, we assume here that that at the margin all local (more broadly, sub-central) governments are in essentially equal positions when it comes to making purely local fiscal decisions, while recognizing that in reality such perfection is never achieved (Bird and Smart 2002).

4 International Center for Public Policy Working Paper Series taxation is essentially to be thought of as a subset of national taxation – that is, as a matter of balancing off equity against efficiency within administrative constraints independently of the spending side of the budget. This new ‘administrative federalism’ view (Bird 2011) may indeed well be more in accordance with current sensibilities than the old ‘Wicksellian view.

Nonetheless, since it remains important to strive for efficiency in local public finance, it may be useful to explore further the implications of the Wicksellian approach for local public finance.

Wicksellian influence is of course evident in a number of aspects of the local finance literature:

 For example, a standard recommendation in the literature on fiscal federalism is that some local expenditure should be financed through user charges (Sjoquist and Stoycheva 2012).

 Moreover, one rationale sometimes offered in support of local property taxation is as a sort of surrogate user charge through which residents who benefit from local services pay for those services.3  At the same time, it has been argued that non-residential property tax rates should be lower than residential rates because they use fewer municipal services (Bird, Slack, and Tassonyi, 2012).

 Occasionally, benefit arguments have been used as one argument for local payroll taxes or sales taxes as ways of getting non-residents (commuters or visitors) to pay for at least some of the benefits they received from local services.

 More commonly, similar arguments are used to support constraining localities from imposing taxes that finance services benefiting residents when the taxes can be ‘exported’ to non-residents (Bird 1993).

 A similarly ‘split’ view of the appropriate link between financing and service provision underlies the standard Pigouvian argument for intergovernmental transfers to compensate for external benefits provided to others than local residents from locally-provided services.

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