American Economic Association

Transcription

1 American Economic Association The Roles of Jurisdictional Competition and of Collective Choice Institutions in the Market for Local Public Goods Author(s): Dennis Epple and Allan Zelenitz Source: The American Economic Review, Vol. 71, No. 2, Papers and Proceedings of the Ninety- Third Annual Meeting of the American Economic Association (May, 1981), pp Published by: American Economic Association Stable URL: Accessed: 01/02/ :09 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review.

2 RESOURCE ALLOCATION IN THE LOCAL PUBLIC SECTOR The Roles of Jurisdictional Competition and of Collective Choice Institutions in the Market for Local Public Goods By DENNIS EPPLE AND ALLAN ZELENITZ* Having discovered and neatly portrayed the conditions for efficient provision of public goods, Paul Samuelson concluded that there was no viable mechanism for eliciting the information about preferences required to determine optimal public goods supply. Much subsequent theorizing about public finance decisions may be viewed as a quest for some demand-revealing mechanism which would refute Samuelson's assertion. Charles Tiebout, in particular, countered with the claim that a viable mechanism did exist for determining the optimal supply of local public goods. In his view, selfinterested individuals reveal their preferences for local public goods by their choice of jurisdiction. Tiebout reasoned that each individual "adopts," from the menu of local fiscal environments, that local community which most closely reflects his preferences. He further argued that the greater the number and variety of communities, the more efficient would the public goods provision be. Without empirical support, this ingenious idea lay dormant for several years. The question remained as to whether the mechanism described by Tiebout, even if it existed, operated so that local jurisdictions effectively elicited and satisfied preferences for local public goods. Fundamental to answering this question was the necessity of designing an experiment which would reveal the result of "voting with one's feet." No such experiment existed until Wallace Oates (1969) reasoned that operation of the Tiebout mechanism would result in the *Associate professor, Carnegie-Mellon University, and assistant professor, Tulane University, respectively. capitalization of differentials in fiscal variables into property values. His test findings indicated that indeed such capitalization was evident. At first, the results obtained by others who repeated and extended his experiment were generally consistent with his findings and hence his interpretation of the link between the Tiebout mechanism and the capitalization of fiscal variables. It was not long, however, before an alternative interpretation was suggested by Matthew Edel and Elliot Sclar, who argued that in the long run the Tiebout mechanism would result in no capitalization of differentials in taxes and public service levels. Their interpretation was precisely the opposite of that offered by Oates, and their empirical work -which indicated little evidence of capitalization-supported their interpretation. In retrospect, conflicting interpretations of the Tiebout hypothesis were almost inevitable given the absence of a formal model embodying the Tiebout mechanism. In an earlier paper with Michael Visscher, we argue that Tiebout's hypothesis is as follows: If individuals are able to choose from among a multiplicity of local jurisdictions, the result will be a Pareto-efficient provision of local public goods. We present two alternative models which differ in the technology for production of local public goods. One embodies the efficiency properties claimed by Tiebout, the other does not. Using these models we demonstrate that 1) Tax capitalization cannot be tested by the procedure proposed by Oates because the tax capitalization parameter is not econometrically identified-a possible reason for the contradictory empirical findings of Oates and of Edel and Sclar, and 2) A test of capitali- 87

3 88 AEA PAPERS AND PROCEEDINGS MAY1981 zation is feasible' but it is not a test of Pareto efficiency and hence not a test of the Tiebout hypothesis. The above line of research is the outgrowth of what we believe to be the central premise of Tiebout, that Pareto efficiency is achieved because self-interested individuals reveal their preferences for local public goods by their choice of jurisdiction of residence. An alternative approach in the quest for a demand-revealing process has been to attack this problem head-on, to focus upon the political institutions for collective decision making. Thus, jurisdictions may be regarded as behavioral entities which possibly weight the preferences of their citizens in selecting fiscal variables. The weighting process, most often conceived of as a voting mechanism, can then be judged with respect to the adequacy with which citizens' preferences are expressed in the actual fiscal decisions. The most widely known specification of governmental fiscal choice is the median voter model, which does connect the fiscal choices made by a jurisdiction's government and the desires of that jurisdiction's residents. William Niskanen's work on bureaucracy has stimulated interest in a broader investigation of governmental objectives, and formal models embodying a departure from the median voter framework are now being explored by Thomas Romer and Howard Rosenthal, Barbara Spencer, and others. The above models of governmental institutions and mechanisms of collective choice do not, however, explicitly recognize an important characteristic of local governments, that each is in proximity to similar jurisdictions. Thus, these models are not strictly models of local government decision making. To the contrary, all of these models focus on governments and collective entities that are conceptually isolated decision- 'Epple (1980) argues that a test of capitalization of fiscal variables is a joint test of the following hypotheses: 1) Residents and potential residents are informed about fiscal variables in alternative jurisdictions, and 2) Government restrictions (for example, zoning) do not cause individuals to consume more housing services than they would in the absence of restrictions. making units. Local governments play a prominent role in this line of research primarily because they are viewed as natural laboratories for testing theoretically derived hypotheses. It is at this interface with data for local governments that this second line of research touches on the line initiated by Tiebout. However, we view these alternative research approaches as deficient, since each tends to ignore the other. Although not explicit about the mechanism of intrajurisdictional choice, Tiebout casts doubt upon the notion that "...government's revenue-expenditure pattern... 'adapt[s] to' consumers' preferences" (p. 417). Similarly, research on collective decision making takes scant note of the potential impact of interjurisdictional competition on intrajurisdictional choice. The neoclassical theory of the firm provides an instructive reference. Individual firms pursue a self-interested profitmaximizing objective but competition among a large number of such firms results in efficient pricing and allocation. Does the analogy apply? Does competition among a large number of local governments assure efficient public goods provision even if governments of individual jurisdictions pursue objectives that are not necessarily public-regarding? If jurisdictional competition results in efficient provision of local public goods despite the pursuit of potentially perverse governmental objectives, can local jurisdictions provide a suitable environment for testing hypotheses about institutions of collective choice and governmental decision making? Tiebout's assertion regarding optimality has been attacked on two distinct fronts. First, there are those (see, for example, Truman Bewley and the references therein) who question the existence of the technological conditions necessary for Pareto efficiency, even assuming that local governments are public-regarding. Typical of this line of attack are the suggestions that the diversity of local governments may be insufficient to meet the residents' heterogeneous diversity of demands; or that the tax and spending mechanisms may cause some commodities' (for example, housing's) price

4 VOL. 71 NO. 2 RESOURCE ALLOCATION IN THE LOCAL PUBLIC SECTOR 89 to differ for consumers and producers; or that the production function for local services depends on the local jurisdiction's particular population (compare Oates, 1981). Thus, local governments may be unable to attain Pareto efficiency as envisioned by Tiebout, notwithstanding each of these government's desire to attain that end. Second, governments may have goals which are not completely public-regarding, governmental agents may make choices in a selfserving fashion. Even if Pareto efficiency could be assured, the electorate's welfare may not be maximized. Much recent work on the collective decision-making mechanism has focused upon this second source of inefficiency, different goals of citizens and their governmental agents. It is this second line which we investigate in our forthcoming paper. Our strategy is to specify a model with conditions that would appear to be ideal for the effective functioning of jurisdictional competition. We assume a metropolitan area inhabited by a population of identical individuals. The homogeneous land comprising the metropolitan area is divided into a parametrically determined number of equal-sized jurisdictions among which residents can move costlessly. Government services are produced with constant returns to scale. Since our goal is to study the workings of interjurisdictional competition, we assume that each jurisdiction has an entrenched government (i.e., a government not subject to electoral direction or control) that determines the tax rate on housing services and the level of government services in the jurisdiction. The government's power is limited to the choice of these two variables, and the government is required to raise taxes that are at least sufficient to pay government expenditures. To cast the question as starkly as possible, we begin by assuming that each government seeks to maximize profits. That is, each government chooses the tax rate and level of services to maximize tax revenues less government expenditures. Each government is assumed to pursue a Nash strategy. We then let the parametrically determined number of jurisdictions approach infinity and examine the properties of the equilibrium for this limiting case. An analogous procedure applied to profit-maximizing firms would result in the zero profit competitive equilibrium. In the jurisdictional competition case, we find to the contrary that government profit does not go to zero as the number of jurisdictions approaches infinity. Though the result was, to us, unexpected, the intuitive explanation is quite simple. Even if its share of the total land in the metropolitan area is small, a government can expropriate a portion of the rents on the land within its boundaries; land is not mobile and cannot be relocated to escape taxation. Though jurisdictional competition does not eliminate government profit, the total of such profit in an area is decreased by an increase in the number of jurisdictions. This result, too, is easily explained. For simplicity, consider the case in which all governments provide zero government services; all tax revenues are "profit." Given a downward-sloping housing demand function for the area as a whole and a limited number of jurisdictions, the demand function for each jurisdiction will also be downward sloping. This is because an increase in the gross-oftax housing price in one jurisdiction will induce residents to move from that jurisdiction, thus causing the price in all other jurisdictions to rise. As the number of jurisdictions increases, the elasticity of housing demand in any one jurisdiction increases. An increase in the housing price in a small jurisdiction, by inducing some residents to move, will only cause a small rise in housing prices elsewhere in the metropolitan area because a small jurisdiction will house a small proportion of the metropolitan area's population. In the limiting case, any one jurisdiction encompasses an infinitesimal fraction of the land in the metropolitan area, and the demand for housing in the jurisdiction is perfectly elastic. In setting a property tax rate, the government of the jurisdiction is fixing the difference between the gross-oftax and net-of-tax price of housing. A small jurisdiction faces a more elastic housing demand function than a large jurisdiction but the same housing supply elasticity as the

5 90 AEA PAPERS AND PROCEEDINGS MA Y 1981 large jurisdiction. Hence the government of a small jurisdiction has relatively limited ability to influence the gross-of-tax price and its choice of tax rate primarily affects the net-of-tax price. As a result, government profit per unit of land declines as the number of jurisdictions increases. Our paper also explores a second closely related question. Can governments of different jurisdictions pursue different objectives, yet coexist in equilibrium? For example, can one government pursue profit maximization, another expenditure maximization, and still another property value maximization? We find that such governments can coexist in equilibrium even in the limiting case in which the number of jurisdictions approaches infinity. Again, the reason is that governments are able to expropriate a portion of the rents on property within their jurisdictions. The amounts they expropriate may differ with objective functions, but jurisdictional competition cannot eliminate such differentials. The population is mobile but the land is not; many important results flow from this crucial fact. Our results show that the Tiebout hypothesis does not obviate the need to model intrajurisdictional governmental decision making. Our results also show that interjurisdictional competition can significantly affect the levels of taxes and services actually realized, whatever the governmental objective may be. Theoretical results based on a model of a jurisdiction considered in isolation may be significantly altered by considering the jurisdiction as one of many local governments residents may choose. If a model is to be tested using data for local jurisdictions in a metropolitan area, the interdependence among those jurisdictions cannot be ignored. The above results have convinced us that what is needed is a merging of these two lines of research. Models of the mechanisms of intrajurisdictional choice must be integrated with models of interjurisdictional competition if a satisfactory theory of local public goods markets is to be obtained. To the extent that local governments provide the basis for empirical tests of theories of governments, such a merger is also important for the more general study of public goods supply by all levels of government. There are three avenues by which the integration of models of inter- and intrajurisdictional choice can proceed. One strategy, employed in our paper with Visscher, is to assume the existence of equilibrium and to study the properties of the assumed equilibrium. Even where a proof of existence is absent, theorems of the following form can be instructive. If an equilibrium exists and assumptions X are satisfied, then the equilibrium must necessarily have properties Y. Conditions X characterize the environment and properties Y are the implications to be subjected to empirical investigation. This is less satisfying than the study of a model in which existence has been proved. However, where sufficient conditions for existence have not been established, the formal study of necessary conditions is much more fruitful than an entirely heuristic approach. Most examples of failure of existence of an equilibrium among local governments assume a heterogeneous population and heterogeneous jurisdictions. Such problems can be avoided by employing a model in which agents and/or jurisdictions are identical. While equilibrium in such a model is not guaranteed to exist or to be unique, many existence problems can be avoided. Such an approach also has the advantage of generating a model with symmetry properties that can be exploited for comparative static analysis. This approach is employed in our 1980 paper and in Paul Courant and Daniel Rubinfeld. In the former paper the results were, if anything, enhanced by the use of homogeneity assumptions. If jurisdictional competition does not eliminate monopoly power when residents are homogeneous, it can hardly be expected to be more efficacious if residents are heterogeneous. Of course, there are a host of issues for which heterogeniety along some dimension is crucial, but we suspect that there are a large number of interesting issues regarding governmental behavior and jurisdictional competition that can be studied in a model

6 VOL. 71 NO. 2 RESOURCE ALLOCA TION IN THE LOCAL PUBLIC SECTOR 91 in which strong homogeneity assumptions are employed.2 The third and most satisfactory approach is to explore the implications of models in which existence and possibly uniqueness has been proved. An important step in this direction has been made by Frank Westhoff. He proves existence of equilibrium in a model in which the median voter determines the tax rate and governmental service level within each jurisdiction and individuals are free to move among jurisdictions. Since, in his model, revenues are raised by a tax on endowments and there is no market for land, the model may be of limited use in deriving empirically testable propositions. The significance of the paper is that it sets forth a method of proof that may be applicable in models with greater empirical relevance. Epple, Filimon, and Romer, for instance, have succeeded in proving existence in a class of models in which a housing market exists and revenues are raised by a tax on housing service. Such models are instructive not only for their implications, but also because they clarify the requirements for existence. Hence, the issue of whether fiscal zoning or other ad hoc institutional factors are required to guaranty existence can be explored in a rigorous manner using such models. To conclude, let us reiterate. A deeper understanding of resource allocation in the local public sector is dependent upon research approaches which merge the role of collective choice institutions with that of jurisdictional competition. Theoretical work is needed that explores the existence and properties of equilibrium in models that offer the potential for empirical testing. Such models must reflect the role of housing markets and the fixity of jurisdictional boundaries as well as the choice mechanisms within jurisdictions that determine taxation and the provision of local public goods. 2Some of these have been tentatively explored in our working paper. REFERENCES T. Bewley, "A Critique of Tiebout's Theory of Local Public Expenditures," disc. paper, Northwestern Univ., Feb P. N. Courant and D. L. Rubinfeld, "On the Measurement of Benefits in the Urban Context: Some General Equilibrium Issues," J. Urban Econ., July 1978, 5, M. Edel and E. Sclar, "Taxes, Spending, and Property Values: Supply Adjustment in a Tiebout-Oates Model," J. Polit. Econ., Sept./Oct. 1974, 82, D. Epple, "What Do Tests of Tax Capitalization Test?," working paper, Carnegie- Mellon Univ., Aug , R. Filimon, and T. Romer, "Existence of Equilibrium Among Governments in a Metropolitan Area," working paper in preparation, Carnegie-Mellon Univ. and A. Zelenitz, "The Implications of Competition Among Jurisdictions: Does Tiebout Need Politics?," J. Polit. Econ., forthcoming. and,"the Relation Between Welfare Maximizing and Property-Value Maximizing Governments: The Effects of Jurisdictional Competition," working paper, Tulane Univ., Mar ,and M. Visscher, "A Search for Testable Implications of the Tiebout Hypothesis," J. Polit Econ., June 1978, 86, William A. Niskanen, Bueaucracy and Representative Government, Chicago 1971., "Bureaucrats and Politicians," J. Law Econ., Dec. 1975, 18, W. Oates, "The Effects of Property Taxes and Local Public Spending on Property Values: An Empirical Study of Tax Capitalization and the Tiebout Hypothesis," J. Polit. Econ., Nov./Dec. 1969, 77, , "On Local Finance and the Tiebout Model," Amer. Econ. Rev. Proc., May 1981, 71, T. Romer and H. Rosenthal, "Political Resource Allocation, Controlled Agendas, and the Status Quo," Public Choice, Summer 1978,33,

7 92 AEA PAPERS AND PROCEEDINGS MAY1981 B. Spencer, "Outside Information and the Degree of Monopoly Power of a Public Bureau," Southern Econ. J., July 1980, 47, C. Tiebout, "A Pure Theory Of Local Ex- penditures," J. Polit. Econ., Oct. 1956, 64, F. Westhoff, "Existence of Equilibria in I Economies with a Local Public Good," J. Econ. Theory, Feb. 1977, 14,