Governments are like onions (or: Fiscal federalism 101).

Governments execute a wide array of tasks in modern societies, from maintaining infrastructure for traffic and water management, via providing health care and education to providing national defense and safety. With the exception of a few tiny countries like the Vatican, countries tend to have multiple levels of government to execute these tasks. For instance, The Netherlands has municipalities, provinces and the central government, and additionally police regions, water boards and other regional organizations focused on a specific task. What these different levels of government do exactly, differs from country to country. In this blogpost I will discuss why we have different levels of government, and what level of government should execute which task. These two topics lie at the core of what is called ‘fiscal federalism’, a topic on which I will publish more posts in the future. 

Why go local?

One important reason we have different levels of government is that different people may have different preferences for what service level they want and what services they expect from their government. For instance, people in one area may love ice skating, and in another they might love football. Building football stadiums everywhere clearly is not the best strategy. Building an ice skating ring in the first area, and a football stadium in the second will make more people happy. The same can be said for the preference for using your own car versus using public transport. In the countryside there is plenty of space to use your own car, so this is often the more convenient option. In busy cities traffic would end up completely congested if everybody used their own car. Public transport can prevent such congestion, so public transport is a good investment for the average taxpayer living in a city.

Besides, local circumstances may affect the prices of certain services differently. Even with equally strong preferences for public transport, the countryside will have less dense public transport networks, because such dense networks are expensive to maintain. So instead of building an extensive public transport network, cars will probably be used more in the countryside. Not just because there are fewer traffic jams, but also because public transport networks are relatively more expensive in the countryside.

However, central governments are typically thought to struggle to tailor services to local circumstances and preferences. This is predominantly because they lack sufficiently precise information about those local circumstances and preferences: local, unelected bureaucrats do not have the same incentive to find out what local preferences are as elected politicians have, nor is there a similar system like elections to convey the preferences of the electorate to local bureaucrats. Besides, central government means centralised decision making, which means that voters from other areas get a say in local decision making. This means centrally decided policies which are differentiated per locality (e.g., the central government decides the state of Utah gets ice skating rings, and Florida gets baseball stadiums) would still reflect national preferences, rather than only local preferences – whether that is a good or a bad thing depends on how local policies affect other localities, we’ll go into this later. Decision makers in the central government, be they members of the legislature, a minister or a civil servant, need to know the details of many different localities to make adequate decisions for these localities. In reality this requires a very large and expensive bureaucracy to gather information locally, relay it to the central government, for the central government to process it, and then make decisions based on that. Even then central government bureaucrats often will not outperform local politicians rooted in local society.

Of course, in real life people are never perfectly sorted into different areas based on their preferences. However, there is evidence that people move to localities that have policies that match their preferences. This is a second reason we may want multiple levels of government. If people do not like their current local government, they can move to a place which they like more. So called ‘voting with the feet‘. This can also help to keep a government in check: if it tries to tax too much in return for too little, citizens will move, which will in turn reduce tax income. In response to this, the government may reduce taxes, or in anticipation of it, the government may never raise taxes too high

Additionally, when there are multiple local governments, citizens can compare their performance. By looking at how other local governments are doing, they can answer the question: ‘Am I getting value for money with my current government?’ This is so-called yardstick competition. Based on this information, they can vote politicians out of office who do not perform well enough. We may also want to have many local governments with different policies, because this leads to experimentation with policy. When the entire country has the same policy, much fewer policy options can and are tried. Local governments are our policy laboratories.

Ok, why do we need a central government, then?

However, not all tasks should be executed at the local level. For some tasks it is simply so much cheaper to execute them on a massive scale, that it is better to have a very cheap one size fits all policy, than to have many expensive choices. For instance, levying taxes requires intricate knowledge of people’s income and property. Imagine having each municipality having to build their own database for tax purposes. This would be extremely expensive, having one centralized tax service doing this once is clearly superior. Economies of scale are at play when the price per product decreases as you produce more products. However, perhaps it is possible to make decisions on service provision locally, while the production of these services is done by a higher level of government? Then we could maybe have the best of both worlds.

Another reason for executing tasks at the central level is if there are clear negative or positive externalities for producing a certain good or service. For instance, maintaining a theatre is expensive and requires subsidies from the government. However, theatres are located in one municipality, but benefit the entire region. The municipality with the theatre may not want to bear the burden of providing a theatre that is big enough for the entire region. This means there is an undersupply of theatres. In this case local decision making with production done by a higher level of government is not going to solve the problem, because local decision making would still not take into account the preferences of citizens outside the jurisdiction.

Taxation and redistribution of income are also tasks which are typically executed to a large degree by the central government. This is because when taxes increase in one locality, people and businesses tend to leave another locality. Remember voting with your feet? Moreover, with the way economies work some areas will be richer than others. To ensure a basic living standard, including sufficient healthcare and education, you may need to transfer resources from the richer areas in the country to the poorer areas in the country.

Fiscal transfers

If central governments are better at levying taxes than local governments, and some areas are poorer than others, we end up in a situation in which the central government must transfer the taxes they levy to the local governments that execute various tasks. This is indeed very common, as a comparison between the two graphs below shows. The first graph shows the share of local and state government expenditure out of total government expenditure in OECD members. The second graph shows the tax revenues of local and state governments as a share of total government tax revenues. As you can see, typically local and state governments spend more than the taxes they levy themselves. Unfortunately, these fiscal transfers lead to potential problems. What these problems are, and how we can prevent them, I will discuss in the next post on fiscal federalism.

Data: http://www.oecd.org/tax/federalism/fiscal-decentralisation-database/

Data: http://www.oecd.org/tax/federalism/fiscal-decentralisation-database/

Bottom line: Governments are like onions. Onions have layers, governments have layers. They both have layers. The trick is to find out which level of government should execute which task.