Today, no program exists that explicitlycorrects for vertical fiscal imbalances. However, the whole system ofcategorical grants and conditional block grants from federal to state and localgovernments and from state to local governments can perhaps be viewed in partas correcting for vertical fiscal imbalances. While there are other motives forthese grants, such as persuading governments to adopt national policies andcorrecting for horizontal imbalances, their very existence derives fromvertical fiscal imbalances.
Horizontal fiscal imbalances arise whenstate or local governments differ in their ability to provide governmentservices. These differences occur because of different fiscal capacities andneeds. Horizontal fiscal imbalances are important at both the state and locallevels of government, but are especially prominent at the local level. Localgovernments are responsible for a large proportion of service provision, butthey have limited ability to raise revenue. The base of their primary revenuesource, the property tax, is inequitably distributed within states and acrossstates. Reliance on this revenue source results in large horizontal fiscalimbalances.34 The states thus provide a large proportion of local revenue in theform of grants-in-aid in order to correct for these imbalances. As wasdescribed in Section B, real per capita intergovernmental aid from state tolocal governments has increased significantly over time.
Just as for vertical fiscal imbalances,there is now no program that explicitly addresses horizontal fiscal imbalances.The General Revenue Sharing program discussed in the previous section and is nolonger in existence was also intended to address horizontal fiscal imbalances.As was described earlier, the formulas used to determine the level of transfershad equalizing components in them, such as tax effort, per capita income, urbanpopulation, and personal income tax revenues. Today, equalization is addressedin part by the system of categorical and conditional block grants. Many ofthese grants have equalizing components in that their allocation is based oncriteria such as per capita income and tax effort, but there is no systematicoverall scheme of equalization.
D. Tax Harmonization and TaxCollection
In the United States, the federal governmentand the states have considerable independent taxing powers. While the federalgovernment is the dominant player in raising revenues, the United StatesConstitution allows the states to levy any type of tax except import and exportduties and duties on tonnage. Thus, states raise a considerable proportion oftheir revenues through the use of personal and corporate income taxes, salestaxes, property taxes, and payroll taxes. There is, nonetheless, an enormousvariation among states in the types of taxes that they levy. For example, somestates have no income tax or sales tax and rely primarily on property taxes andpayroll taxes. Other states rely heavily on income and sales taxes for theirrevenues.
The primary sources of revenue for thefederal government are the personal income and payroll taxes. Taken together,these two taxes provide roughly 80 percent of federal revenues. Payroll taxesare used mainly to finance social insurance and hospital costs in the Medicareprogram.35 The next largest revenue source is the corporate income tax, whichcontributes about 12% of total federal revenues. Note that the federalgovernment does not levy a sales tax. By contrast, the primary tax revenuesources for state and local governments are retail sales and property taxes,contributing over 40 percent of their total revenues. Personal income taxesmake up about 15% of state and local revenues. In addition, transfers from thefederal government contribute roughly 20% of state and localrevenues.
The legal and constitutional right of thefederal and state governments to levy taxes independently means that the issueof tax harmonization is likely to be an important one for the United States.Without harmonization, administrative and compliance costs are higher when boththe federal and state/local levels of government levy taxes on the same base.These costs are compounded when each level provides different deductions,credits, and exemptions, thus introducing differences in tax bases. As well,issues of tax competition can arise among states when they levy taxes on mobilebases such as personal and corporate income. These types of problems can bealleviated or avoided by either assigning tax bases exclusively to one level ofgovernment or by developing tax harmonization and tax collectionsystems.
Despite the potential problems that resultwhen both the federal and state/local levels of government have access to awide range of tax instruments, there is no system of tax harmonization in placein the United States for any taxes. With regard to tax collection systems, theonly arrangements that exist are very minor and occur at the state/local level.In particular, in some states, the state government collects revenues fromsales and/or income taxes and remits part of the proceeds to localgovernments.
Since the federal government does not have abroad-based sales tax and the property tax is entirely left to the state/localgovernment, the issue of tax harmonization is particularly relevant in theUnited States only for the personal and corporate income taxes, although thecorporate income tax is a relatively minor tax at the state level. As describedabove, the federal and state/local governments levy personal and corporateincome taxes independently. Thus, there are likely to be large administrativeand compliance costs that would be avoided if there were a system of taxharmonization in place such as exists in most provinces in Canada.
With respect to sales taxes, the issue oftax harmonization will become important if ever the federal government decidesto adopt a broad-based sales tax such as a VAT. If this ever comes to be, itwould be desirable on both administrative and compliance grounds for there tobe some arrangement of coordinating sales taxes at both levels of government.However, negotiating the arrangement with 50 states with widely varying salestax systems would be a very difficult task.
Although payroll taxes are levied at bothlevels of government, the issue of tax harmonization is not as important as itis for, say, income taxes. The reasons for this are that payroll taxes arelevied at flat rates and on payroll as the tax base. Thus, administration andcompliance costs are low, so that administration and collection at one level ofgovernment is not as important an issue with the payroll tax.
There is a large body of theory dealing withthe optimal relationship among levels of government within a federation. As apractical matter, however, there is no definitive consensus on what thisoptimal relationship should be. Much depends on how best the federal system ina particular nation fits the underlying assumptions of the theory. Thus,whether economic efficiency is best served through a highly decentralized orhighly centralized system is a matter of debate. A factor that makes thisdebate a more difficult one to resolve in the United States is the widevariation that exists among states. The federal system in the United States iscomprised of one federal government, fifty states, and over 87,000 localgovernments. There are very large states and very small states. Some stateslevy income and sales taxes, while others do not. Some states leave theprovision of major expenditures to local governments, whereas others do not.Some states have generous programs for the sick, aged, and needy, whereasothers do not. Some states depend a great deal on transfers from the federalgovernment, whereas others do not. This variation among states is shaped byhistorical factors as well as the evolving preferences for the role ofgovernment within the economy. Consequently, rather than attempt to determineone way or the other whether the current system in the United States is anideal one, we will discuss some of the theoretical arguments of the federalismliterature in light of the experience in the United States.
1. Impacts on EconomicEfficiency
It is generally agreed that national publicgoods and services should be provided and financed by the federal government.National public goods and services are those whose benefits or costs accrue tocitizens across the country. The rule for assigning national public goods andservices to the federal government is indeed followed in the United States. Thefederal government is responsible for “national” areas such as nationaldefense, energy, the money supply, international commerce, and the postalservice. What is more debatable is whether subnational governments should beresponsible for providing and financing subnational public goods and services,i.e. those goods and services that mainly benefit citizens within a particularjurisdiction. A famous theory of fiscal federalism, known as the TieboutHypothesis36, argues in favour of decentralizedprovision of goods and services because competition among subnationalgovernments ensures that citizens of a particular jurisdiction receive thepublic goods and services that best represent their preferences. Decentralizedexpenditure provision and revenue raising also improves accountability byensuring that the level of government responsible for providing goods andservices is also responsible for financing them. Two key assumptions for theTiebout hypothesis to hold are that citizens must be mobile, so that they mayeasily relocate in response to differences in the provision and financing ofpublic goods and services, and that there are no spillovers acrossjurisdictions. The first assumption is likely to hold in the long-run in theUnited States due to the absence of language and cultural barriers and theabsence of restrictions in hiring citizens from other jurisdictions. In theshort-run, migrating across jurisdictions is costly in terms of having to findnew employment, sell one’s house, etc. Consequently, citizens are more likely to move in thelong-run to jurisdictions that have the mix of expenditure and taxation thatbest satisfies their preferences. The second assumption of no spillovers acrossjurisdictions is likely not to hold, but its degree of severity is open todebate. Many public goods and services can have benefits or costs that crossstate (or local) boundaries. Spillovers (or externalities) can take many forms.Highways, for example, can benefit citizens residing outside the state or localboundary. As well, education can benefit citizens of other jurisdictions eitherdirectly, if they attend a particular state university, for example, orindirectly, if they migrate to another jurisdiction, bringing the skillslearned with them. Externalities are also created when citizens move acrossjurisdictions to take advantage of generous health or welfare programs. Similararguments can be made on the taxation side. State and local governments maycompete for mobile individuals or businesses by offering lower tax rates. Theydo so without taking into account the effects of their tax incentives oncitizens in other jurisdictions. When externalities of this sort are present,there is a rationale for more central control of goods and service provisionand taxation.
The provision of subnational public goodsand services is relatively decentralized in the United States. State and localgovernments provide many goods and services and they have wide discretion onthe details of the various programs provided. Although the federal governmentstipulates conditions in many of its grant-in-aid programs to the state andlocal governments, the United States follows a general principal of statesovereignty in the provision of subnational goods and services. As a result,inefficiencies that may result from spillovers across jurisdictions may be leftuncorrected in the United States. On the other hand, efficiency may be enhancedfor those goods and services with benefits or costs accruing to citizens withina particular jurisdiction.
Turning to the raising of revenues, we sawin Section B that large vertical fiscal imbalances exist in the United Statesand, thus, revenue-raising is much more centralized in the United States thanexpenditure provision. This is true despite the fact that states have access tomost major tax sources. Whether this situation is more efficient than one wherestates have greater revenue-raising responsibilities is open to debate.Certainly, the fact that state and local governments are responsible forproviding various goods and services to their citizens but are not fullyresponsible for financing them detracts from accountability. It is also true,however, that administrative and compliance costs are lowered by assigninggreater taxing powers to the central government. Also important are the factsthat citizens and businesses are fairly mobile in the United States and thatthere are no tax harmonization agreements. These two facts imply that that taxcompetition among state and local governments is likely to be important in theUnited States. This is especially relevant for redistributive or ability-to-paytaxes. A state wishing to increase the amount of redistribution in its taxsystem would likely find those that contribute to the system migrating out ofthe state and those that could benefit from the system migrating from otherstates. As a result, it can be argued that for administrative, compliance, andtax competition reasons, efficiency is enhanced in the United States becausethe federal government has greater revenue-raising powers than lower-levelgovernments.
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