Discipline with Lessons from U.S. Federalism
Lesson 8: Balanced Budget Rules Enforced by a Politically Independent Court Can Control Inefficient Local Borrowing
2.3 Conclusion
The growing importance of local and provincial governments as providers of public services and the importance of local services for the overall performance of the national economy have led to a careful reexamination of how public resources are allocated by decentralized governments (Oates 1999). The Tiebout (1956) proposition that local governments automatically guarantee efficient local taxation and service spending is true only in the special environment of mobile and informed taxpayers, no spillovers, and many competitive jurisdictions.
While perhaps a valid characterization of local suburban governments in a large U.S. metropolitan area, it is not an accurate description of most local public sectors in most economies, ones dominated by a few large cities each surrounded by a few residential suburbs, all overseen by a still larger provincial government. There is no guarantee that this more realistic local public sector will efficiently allocate public services.
This chapter has described the likely incentives of local governments in this more general institutional setting and then outlined those political and market institutions needed to encourage efficient resource allocations given those incentives. Three such institutions have been identified here:
1. A stable central government managed by nationally elected political parties or presidents capable of making (second-best) efficient interpersonal redistributions of income while at the same time denying inefficient intergovernmental transfers or access to nonresident taxation, or both
2. A mature banking system and fully integrated national capital markets capable of containing within the jurisdiction the economic consequences of a local government’s failure to repay its debts
3. A network of local land markets with informed investors capable of evaluating local services and finances so as to shift back onto local residents the full economic consequences of inefficient local govern- ment fiscal choices
Efficient central governments, an efficient banking system, and efficient capital and land markets are seen here as necessary institutional pre- conditions for an efficient local public sector, even a Tiebout local public economy.
Lacking these efficient political and market institutions, regulatory policies will be necessary to hold local fiscal inefficiencies in check.
Three such regulatory regimes were identified, each a replacement for a failed political or market institution:
1. To replace a weak central government, fiscal assignment limiting central transfers to demonstrable economic spillovers and local taxa- tion to resident taxation
2. To replace an immature banking system and less than fully inte- grated capital markets, a no-bailout requirement for the central gov- ernment and bankruptcy standards requiring full local repayment of all local debts
3. To replace missing local land markets, a balanced budget rule requir- ing tax financing of all current-accounts spending
These fiscal rules must be enforced by courts or agencies uninfluenced by local political pressures, and they must be constitutionally grounded, requiring a supermajority to overturn. To the extent such regulations are effective, they may constrain other useful local choices.
If so, they must be considered second best to the efficient political and market institutions.
A review of the U.S. fiscal record spoke to the importance of these institutional preconditions. Lacking either strong political parties or a strong president to manage fiscal policies, U.S. local governments have succeeded in extracting inefficient intergovernmental transfers and obtaining access to inefficient taxation of nonresident incomes and assets. The U.S. performance in controlling bailouts of local defaults has been more successful. The economy’s mature banking system at least since 1850, a nationally integrated capital market, and in more recent years local bankruptcy standards protecting creditors’ interests have helped minimize the financial spillovers from a local government default; thus, the economic incentive for local government bailouts has been muted. Historically, poor households within the United States have been geographically dispersed, and U.S. governments have always used individually targeted transfer programs; thus, the dis- tributive incentive for local bailouts has been held in check. Finally, while U.S. local land markets seem to be a weak check on inefficient local deficits, the U.S. regulatory regime of constitutionally based bal- anced budget rules has proven an effective substitute. On balance, U.S.
local governments do face a mostly hard budget constraint. If there is
room for improvement in enforcing local fiscal discipline in the U.S.
public sector, it is in checking local influence over national fiscal policies.
Notes
1. The analysis here differs from the principal-agent approach to federalism as studied, for example, by Tirole (1994). That approach is appropriate for public economies run as administrative states where local officials have little or no independent policy or (perhaps most important) revenue discretion apart from that given to them directly by the central government’s elected officials.
2. This inefficiency can be significant. Area Dcan be approximated by the formula: area [D] =.5 ·epx· (X· MC) ·F2, where epxis the absolute value of the price elasticity of demand for local government services (see Rosen 1999). The average rate of inefficiency per dollar of local government subsidy is therefore: area[D]/area[B+C+D] =area[D]/(F·X· MC)
=.5 ·epx·F. For small changes in the rate of subsidy, the marginal rate of inefficiency per incremental dollar of subsidy will be: ∂area[D]/∂(F·X· MC) = epx·F.
3. Matching grants and in-kind service provision provide direct subsidies at rate F.
Closed-end matching grants, which give a lump-sum transfer greater than Xe, can create an “implicit price” subsidy of F. Only fully unconstrained lump-sum transfers, called general revenue sharing in the United States, will be efficiency neutral. Such grants have no role to play in a system of efficient intergovernmental transfers, however (see Inman 1999). Their only possibly valid role is income redistribution, a goal more efficiently pursued through individual, not governmental, transfers (see Bradford and Oates 1971).
4. See, for example, Weingast (1979), Weingast, Shepsle, and Johnsen (1981), and Chari, Jones, and Marimon (1997) for formal models of legislative voting with local interests.
5. From Exhibit 2.1, the cost-shifting game will be a prisoner’s dilemma game if Psg> Pgg> Pss > Pgs. This is in fact the case for the cost-shifting game described in figure 2.1, where Psg=area [A+B+C] > Pgg=area [A] > Pss=area [A-D] > Pgs=area [A-D-B-C].
6. That is, the payoffs in the legislative game of exhibit 2.1 must be changed so that the cooperative strategy (g) becomes the dominant—“best no matter what”—strategy. This will occur when Pgg> Psgand when Pgs> Pss. When local governments behave as shown in figure 2.1, these two conditions will be met when either (1) cooperators—legislators who vote against local cost shifting—are rewarded with a transfer for their constituents worth at least area [B+C] in figure 2.1, or (2) noncooperators—legislators who vote for local cost shifting—are penalized by losing other valuable federal services worth at least area [B+C] in figure 2.1. This result follows directly from the definitions of Pgg, Psg, Pgs, and Pssin note 5. Note that area [B+C] equals the maximal net gain to the local district when it acts noncooperatively rather than cooperatively; see figure 2.1. These rewards and penalties do not have to be paid to, or imposed on, every legislator, only enough legislators to repeal existing local cost-shifting legislation or to block new legislation (see Fitts and Inman 1992).
7. Local debt, whether accumulated through rollovers, underfunded pensions, or reallo- cated capital grants, operates as an implicit subsidy to the marginal costs of buying addi- tional current public services, that is, F >0 in figure 2.1 (see Inman 1982).
8. I assume here that there are no national spillovers from the provision of the local public good so as to concentrate on bailouts created by financial market spillovers.
Wildasin (1997) provides an analysis of bailouts when there are significant allocative spillovers from the provision of local public services. The Wildasin analysis may be appropriate for one U.S. bailout, however: the case of Washington, D.C., in 1997; see below.
9. If there were important positive spillovers (Bc=Qc>0), then the central government might indeed want to subsidize the provision of local public goods, but there are better ways to proceed (e.g., targeted matching grants) than fiscal bailouts (see Inman 1999).
10. Net benefits B1-C1bto the citizens of the local government from the debt-shifting strategy will be area [A+B+C]. (I ignore the fact that these local net benefits are reduced slightly by the local government’s own tax share of the national bailout: (1/N) · [B+C+ D].) The net benefit from the status quo balanced budget strategy is only area [A]. Thus B1-C1b=area [A+B+C] >Q1=area [A], and condition 2a of exhibit 2.2 holds.
11. In figure 2.1, Bc∫0, Ccb=area [B+C+D], [B1-C1b] =area [A+B+C], Qc∫0, and Q1
=area [A]. Upon substitution, area [A - D] < area [A] as required by exhibit 2.2, condition 3.
12. If Cch<Ccb, then the central government would choose the no-bailout strategy, h, even if the local government adopts the deficit strategy, D. Knowing this, the local government will then choose the status quo if B1-C1h<Q1(condition 2b). For the local fiscal choice specification in figure 2.1, condition 2b holds. If no central government bailout occurs, then the local government must repay the local debt and cover the full costs of the initial X1allocation. In this case, the local government’s net benefits equal area [A+B+C+E +F] -area [B+C+D+E+F] =area [ A-D], which is less than the status quo alloca- tion of area [A]; thus B1-C1h<Q1holds and condition 2b is met.
13. Note that the financial costs of no bailout (Fi) are larger for larger governments as measured by ri, but this fact alone is not sufficient to justify the typically offered argu- ment that large local governments are simply “too big to fail” and must be bailed out.
What is relevant is the comparison of Fito the cost of the local bailout to national tax- payers (= ri·D), which also grows with ri. What will be sufficient for a “too big to fail”
argument is evidence that inefficiencies per dollar of defaulted debt increase with debt:
Yi= Y(ri·s·D), where Y(·)¢ >0.
14. The parameter Yiis defined as the ratio of the dollar value of market inefficiency fol- lowing default to each dollar of defaulted local debt. Estimates of Yifollowing a default- induced banking crisis can be calculated using estimates by Bordo and Eichengreen (2000, table 9) of the economic consequences of a banking crisis. They estimate the lost output from banking crises to range from 3 percent of trend GDP for modern crises (1973–1998) to perhaps as much as 5 percent for historical and modern crises (1880–1998).
Assuming the probability of a banking crisis following a local default equals the ratio of lost bank liquidity following default (dL) to all bank demand deposits per capita (M0) and that lost bank liquidity equals defaulted local government debt multiplied by the local default’s “contagion” or spillover effect (k) affecting all bank liquidity (dL= k·ri·s·D), then the expected present value loss per dollar of defaulted local debt from a banking crisis will equal:
yi=(.03 · GDP) · (dL/M0) · (1/ri·s·D) =(.03 · GDP) · (k·ri·s D/M0) · (1/ri·s·D) or
yi=.03 · (GDP/M0) ·k.
In economies with immature banking systems, the contagion effect kis likely to be greater than 1 and to increase with the size of the local default: ki= k(ri·s·D), where k¢(·)
≥0 (see Allen and Gale 2000). The (GDP/M0) ratio ranges from 10 to 15 in developing economies (e.g., India, Chile, Brazil, South Africa) and typically equals 3 to 5 in advanced economies (see Diamond and Rajan 2000). For developing economies with (GDP/M0) 10 and k1.25, a value of Yinear .40 is likely and indeed may be a conservative esti- mate. In more developed economies where (GDP/M0) 3 and k1, a value of Yicloser to .10 seems appropriate.
15. The failure to bail out a municipal default will reallocate productive capital from the national capital market to the (potentially) less efficient local capital market. National lenders to the defaulting local government will lose ri·s·Din income because of the no-bailout decision, while local taxpayers in the defaulting community will gain an equal amount. (We ignore the fact that with no bailout, national lenders and local taxpayers will not pay their—likely small—share of national taxes needed to support a bailout.) The loss of income of ri·s·Dwill lead to less future capital returns of rn· mpsn· (ri·s·D), where rnis the annual rate of return foregone on national investments and mpsnis a national market lenders’ marginal propensity to save. Similarly, the gain in income of ri·s·Dto local taxpayers will lead to an increase in future capital returns of r1· mps1· (ri·s·D), where r1is the annual rate of return now earned on local investments and mps1 is local taxpayers’ marginal propensity to save. The net annual loss in capital income will equal [rn· mpsn-r1· mps1] · (ri·s·D). Discounting at rn, the present value loss per dollar of defaulted local debt from capital market failures equals:
yi=(1/rn)[rn· mpsn-r1· mps1] · [(ri·s·D)/(ri·s·D)]
or
yi=[mpsn-(r1/rn) · mps1].
When local taxpayers do not save, Yi=mpsn.20; this seems a plausible upper limit to the consequences of default when capital markets are imperfect. In fully mature capital markets, where r1 =rn, then Yi =[mpsn-mps1], which may be close to zero in rich economies.
Note that the discussion here does not consider as an allocative inefficiency the effects that a no-bailout decision might have on municipal or national interest rates and subse- quent public investment. Two comments are relevant here. First, in this initial, simple world where all the benefits and costs of the bailout decision are known by both the local and central governments, there will be no interest rate effect from the no-bailout choice.
If the central government decides not to bailout the local government, then the local gov- ernment will not create a deficit, and thus there can be no default risk. If the central gov- ernment does offer bailouts, then local governments will run a deficit, but the subsequent default is covered by the central government—again, no bailout risk. Second, in a world where the central government’s bailout decision is uncertain, there will be financial risk attached to the no-bailout decision, but sophisticated bond markets will have rationally anticipated the likelihood of that outcome and priced local debt accordingly. In this case, a central government’s no-bailout choice will only confirm what the market had already anticipated. Only when a decision to deny a bailout actively changes the market’s expec- tations of future bailouts will there be an interest rate effect. There are instances when this can occur, but I expect the effect to be of second-order importance and unlikely to affect any of the conclusions presented here.
16. The share of local debt borne by bondholders through default, s, is assumed to be exogenous. A richer analysis would add the determination of sto the default-bailout game as the outcome of a third-stage bargaining game between taxpayers and
bondholders, conditional on the local government’s having first chosen Din the first stage and the central government’s having chosen hin the second stage. For a general dis- cussion of bargaining in bankruptcy, see Bebchuk and Chang (1992). For evidence on the outcomes of such bargains from the U.S. historical record, see p. 61–62 (lesson 4).
17. The analysis here assumes that Dis small relative to the income of all participants so that vican be taken as constant for the purposes of selecting bailout strategies.
18. Formally, viis defined as the percentage difference in the politically weighted mar- ginal utility of a dollar to person i(vi) relative to the politically weighted marginal utility of a dollar (v•) to some reference (e.g., median income) voter: vi=(vi-v•)/v•= Dv/v•. Specifying evas the elasticity of the marginal utility of income schedule for central government politicians, then vi= ev·Dy/y•, where Dy =yi-y•, and yiand y•are the incomes of the person i and the reference individual, respectively. For example, if ev
= -1.5 (as estimated by Mera 1969 for U.S. tax policies), yi=$30,000 (median household income in a typical U.S. city) and y•=$39,000 (median household income for the United States as a whole), then vi=.34. For the very poorest U.S. cities, such as Camden, New Jersey, with a median household income of only $17,000, virises to .85.
19. For example, the pre-tax-and-transfer differences in median household income between a very poor U.S. city such as Camden, New Jersey ($17,000) and the median U.S. household ($39,000), or more directly relevant the median household income in New Jersey ($49,000), ranges from $22,000 (United States) to $32,000 (New Jersey). The income difference in post-tax-and-transfer median incomes is significantly less, however—closer to $12,000 ($23,000 versus $35,000) for the United States as a whole and $20,000 ($23,000 versus $39,000) for New Jersey residents. This reduces the U.S. value of vifrom .85 before taxes and transfers to .35 after taxes and transfers, and the New Jersey value of vifrom .98 before taxes and transfers to .62; see note 18.
20. The analysis here follows from adapting the model of reputation building in the entry-deterrence game by Fudenberg, Kreps, and Wilson (Kreps and Wilson 1982, and Fudenberg and Kreps 1987) to reputation building in the default-bailout game studied here. A formalization of this extension is presented in a technical appendix to this chapter, available from the author on request.
21. More formally, local tax financing will be preferred to the deficit-bailout strategy when the expectedbenefits of tax financing are greater than those from the deficit-bailout choice. From figure 2.1, tax financing promises area [A] for sure. If piis local government i’s assessment that the central government will be tough, then in the simple case with no shifting onto bondholders (s = 0) the expected benefit from the deficit-bailout strategy will be (1 -pi) · area [A+B+C] +pi· area [A-D]. Tax financing will be preferred when area [A] ≥(1 -pi) · area [A+B+C] +pi· area [A-D], or when pi≥area [B+C]/area [B+C+D]. Since area [B+C+D] measures the size of the bailout subsidy D, and since area [D] = D -area [B +C], tax financing will be preferred when pi≥1 -area [D]/D. Thus, for a given perceived level of central government toughness (pi), the deficit strategy is less likely the larger is area [D] relative to D.
22. Though the argument here is somewhat different, the conclusion that competition helps to harden a soft budget constraint is similar to that found in Dewartripont and Maskin (1995), Segal (1998), and Qian and Roland (1998).
23. Fully efficient pricing of local debt assumes that bondholders can accurately assess the risk of default, the probability of a central government bailout, and if there is no bailout, the probability that the courts will require repayment, and finally, the probabil-
ity that the local government can in fact repay. Perhaps the most difficult to assess is the fiscal capacity of the local government to repay. This requires knowledge of the local economy as well as the stock of all outstanding local government liabilities, not just the size of the current local borrowing being priced. Bond rating agencies and the under- writers of municipal debt seek to provide this important risk assessment service for investors.
24. See Inman (1983) for a summary of the variety of ways local governments can manip- ulate their budgets to disguise local borrowing. When cities use debt to pay a share Wof current expenditures—for example, through underfunded public employee pensions or rolled-over short-term debt—then the marginal cost of each unit of new public services will be (1 - W)MC. In this case, F = W = D/MC ·X.
25. As above (note 24) W = D/MC ·Xdefines the rate of subsidy from deficit financing.
After-tax and after-capitalization income for local taxpayers (y) then equals: y=I-(1 - W) · MC ·X- d·D, where Iis pretax income and dis the share of debt that is capitalized into lower market prices for taxable assets located within the city. Setting D = W· MC ·X and rearranging the local taxpayers’ budget constraint gives: y=I-[1 -(1 - d) ·W] · MC ·X. Now the implicit subsidy for the purchase of local public services becomes F =(1 - d) ·W. When there is full market capitalization then d =1 and F =0. Less than full capitalization implies F =(1 - d) ·W >0; d =0 implies a full subsidy from deficit financing or F = W.
26. It is possible that the information collected to price municipal debt efficiently could be used to price local land efficiently. The bond market internalizes the cost of gathering information by insisting that the purchaser of the local government debt buy all the debt for a given (unique) issue. This removes the free-rider incentive and thus encourages investment in information gathering. Obviously there can be no such requirement to
“buy all property” in a local land market. The question then remains whether the infor- mation revealed by the bond market is sufficient to price local land efficiently. There are two reasons to be doubtful. First, what the bond market reveals is only the interest rate and level of debt of each new issue; what land purchasers need to know are the interest rates and levels of debt of all outstanding obligations. Second, many important local deficits are never priced through the bond market—in particular, unfunded pension debt, inadequate maintenance of public capital, and the use of long-term debt to pay for current account spending. It is true that the investment bankers and rating agencies work hard to reveal that information for potential bondholders and each bond prospectus is freely available, but the information is only as current as the local government’s latest bond issue.
27. These incentives have long been appreciated by U.S. local governments. Hillhouse (1936) relates the experience of Philadelphia when today’s city was originally formed by the 1854 merger of eight previously independent local governments: “As soon as it was seen that consolidation was inevitable, the old districts immediately hastened to vote improvements and borrow money therefor(e), and to shift the responsibility to the larger corporate body. The new city thus found itself saddled with an debt of more than
$17,000,000, one-fourth of which had been created within thirty days prior to consolida- tion” (69).
28. See note 2. This inefficiency is in addition to any inefficiencies that such taxes might create in the location of business activity (Wildasin 1989).