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Institutional Foundations of Public Finance: Economic and Legal Perspectives.

Article Excerpt
Institutional Foundations of Public Finance: Economic and Legal Perspectives. Edited by ALAN J. AUERBACH and DANIEL N. SHAVIRO. Cambridge, MA and London: Harvard University Press, 2008, pp. 282.

INTRODUCTION

This book contains the proceedings of a May 5, 2006 conference held at the NYU Law School in honor of the late David E Bradford. The book has seven chapters: Alan J. Auerbach writes on the choice between income and consumption taxation, David A. Weisbach on implementation of the two tax systems, Louis Kaplow on the transition to consumption taxation, Wallace E. Oates on fiscal federalism, Roger Gordon and Martin Dietz on dividend taxation, and Jerry Green and Laurence J. Kotlikoff on the "language" of fiscal policy. Each chapter is followed by comments by two discussants.

The book is exceptionally well suited to serve as a tribute to David Bradford. The authors and discussants address the questions that Bradford studied and they do so at the same broad and conceptual, but policy-relevant, level at which he addressed them.

FISCAL FEDERALISM

The chapter by Oates on this topic is usefully organized around the Oates (1972) decentralization theorem, which concludes that, under certain assumptions, local decisions on the supply of a public good are at least as good as a centralized decision. The key assumptions are perfect decision making by local governments, no differences in the costs at which the two levels of government can provide the good, no spillovers across localities from the public good, and no ability of the central government to vary output levels across local areas. Because the assumptions are clearly restrictive, Oates focuses on surveying the robustness of the theorem.

Oates sensibly concludes with a general presumption in favor of decentralization, but aptly observes that "a delicate balancing act" between central and local governments is required. Harvey S. Rosen's comment provides additional support for the decentralization presumption, noting that centralized decisions can be flawed for various reasons and therefore need not improve on local decisions even when the Oates (1972) assumptions do not hold.

Of course, the merits of decentralization vary across policy issues, a point unintentionally reinforced by two examples of allegedly excessive centralization that Oates cites. He is on firm ground when he refers to an Environmental Protection Agency rule restricting arsenic in drinking water as "an especially dramatic case of welfare losses from centralization," noting that the rule imposes the same standards on all localities, even though the per-person costs of attaining the standard are hundreds of times larger in small localities than in large ones. But he is on weaker ground when he criticizes efforts to reduce cross-district variations in per-pupil public school spending within metropolitan areas. As he acknowledges, and as Bradford and Oates (1974) discuss at greater length, there may be valid arguments for equalization of spending across rich and poor districts, making this a dubious choice to showcase the drawbacks of centralization.

Oates devotes some attention to the problems that arise if localities face soft budget constraints due to transfers from the central government. But neither he nor the discussants address the related topic of countercyclical intergovernmental transfers. The February 2009 stimulus package gives states increased Medicaid matching funds, as the March 2002 stimulus package had done on a smaller scale. Because the additional funds are not targeted to states that have encountered financial problems, they do not raise the classic soft-budget-constraint problem. Because the grants are linked to Medicaid program size, though, their availability allows states to run larger programs while letting the federal government absorb the costs of preventing undesirable cyclical variations. And, while the grants are conditioned on states not adding to their rainy-day funds during the recession (to avoid diluting the desired stimulative effect), they are not conditioned on states adding to, or even maintaining, their funds...

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