The Fiscal Crisis Down Below

PALO ALTO – Sub-national governments – states, countries, cities, provinces, towns, and special districts – play different roles from country to country, but usually deliver important public services such as police and fire protection, transportation, education, health care, and welfare. In many countries, their fiscal position has collapsed under the combined weight of mismanagement and the global economic and financial crisis.

The relationship between sub-national and central governments includes the general division of responsibilities for providing and financing public services; national subsidies that at least partly pay for various services delivered locally; and tax collection.

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In the United States, the federal government has primary responsibility for defense, public old-age pensions (Social Security), and health care for the elderly (Medicare); sub-national governments are responsible for education and law enforcement. Health care for the poor (Medicaid) is a shared responsibility. Matching funds flow from the federal government to state and local governments by formulae delineating the shared responsibilities. Some of these formulae allow sub-national governments wide discretion; others do not.

The global economic and financial crisis has precipitated an immense expansion of central government spending, borrowing (and hence future taxing), lending, regulation, and mandates, some in “aid” to sub-national governments (about $200 billion in the US stimulus bill). A key question is whether central governments’ power worldwide will expand permanently – over not only the private economy, but also over sub-national governments.

There is remarkable variability in the role of sub-national governments relative to central governments. Prior to the current crisis, US government revenue was roughly 60% federal and 40% state and local. France was the most centralized of the major economies, with roughly a 80%-20% split between the national and sub-national governments, while the United Kingdom falls in between, at 75%-25%. China was the least centralized, at 30%-70%.   Argentina was the most balanced, at about 50%-50%.

Debates about government centralization run deep in the history and constitutions of most countries. The US Constitution knitted together the thirteen original colonies, and its Tenth Amendment reserves to the states all powers not expressly delegated to the federal government. Even today, tensions over further centralization (e.g., to supranational authority, as in Europe) and devolution (e.g., for Scotland, Québec, or Kurdistan) are intense.

There are several reasons to favor a healthy dose of decentralization. US Supreme Court Judge Louis Brandeis famously argued for “the states as laboratories.” A recent example in the US was welfare reform. When states got waivers for time limits and work or training requirements for welfare recipients, they were so successful that federal welfare reform followed.

Competition among localities – for example, between states for businesses and workers, and between school districts for students – can lead to more efficient and effective allocation of public resources. If people are able to migrate, they will move to jurisdictions with the mix of taxes and services (e.g., quality schools) that they prefer. As with competition in private markets, competition in government services leads to better outcomes.

Local authorities are closer to problems than national officials tucked away in a country’s capital. There are important differences among jurisdictions. Hospitals are more important for some areas, while schools are more important for others. Geographic cost-of-living differences are difficult to reflect in one-size-fits-all national programs.

Some functions are better suited for central-government financing. National defense is an obvious example, as are functions for which economies of scale are important. Where localities try to offload support for the poor onto other localities, the central government must step in and either fund such programs directly or set minimum standards.

In the US until the past three decades, local school districts were responsible for education. Various court rulings have determined that this process allowed richer districts to spend more than poorer ones and ordered states to equalize spending. States from California to Texas now routinely collect previously local property taxes to fund schools, and then redistribute them to local school districts. Many believe that the reduction of local control over the schools as a result of the elimination of local financing has been a major contributor to the poor performance of some American schools.

California is an example of long-run fiscal folly meeting short-run national and global economic crisis, resulting in chaos. For many decades, Californians had rapidly rising living standards, great public K-12 and higher education systems, and unprecedented upward mobility. But California’s unemployment rate, 12.3% in November 2009, was tied for the nation’s third highest. People and jobs are seeking better opportunities elsewhere. The state’s bond rating is dead last.

Excessive state spending, heavy regulation, and dangerously high taxes have helped create the state’s economic woes. The top personal income-tax rate (also levied on capital gains), the sales tax rate, the corporate tax rate, and the gas tax are all at or near the highest of any state.

The top 1% of the state’s income earners pay almost half the income taxes. Thus, the state’s coffers (and hence spending) overflow during booms, but then collapse, forcing emergency retrenchment, during busts. Ironically, California’s progressive tax and spending policies create such volatility that they destroy the state’s ability to fund everything, even basic services from education to health for its most vulnerable citizens.

Now facing another $20 billion deficit despite temporary tax hikes and spending cuts, California’s fiscal woes foreshadow those of many sub-national – or, indeed, national –governments globally. While all must first deal with the current emergency, sensible local fiscal, tax, and political reforms are vital to restore a balance of centralized and decentralized government.