While
I’ve referenced Cultural Economics and I/O as my primary interests, my first
economic questions actually regarded political economy and public finance.
Perhaps unconsciously inspired by my Puerto Rican background, I’ve long been
intrigued by countries’ levels of debt and deficit, and how these two affect
(and are affected by) their economic and political performance. Puerto Rico
also inspires this post.
While
the economic and political history of Puerto Rico—and most importantly, how
these two have contributed to Puerto Rico’s current economic and fiscal
situation—are far too complicated to cover in just a few paragraphs (plus many
other, more informed and educated people have written about it in far better
ways than I can), I can venture to suggest several factors that I personally
consider critical to understanding Puerto Rico’s current standing.
Firstly,
Puerto Rico has been for the past five centuries under varying degrees of
colonial tutelage. Roughly the first four of those centuries was under what was
then the Spanish Empire, and the latest century under the United States (Puerto
Rico being officially an “organized, unincorporated territory” of this nation).
Under these circumstances, restrictions on trade, an overreliance on foreign
direct investment by the corresponding territorial power, the elimination of
favorable tax credits and benefits, among other factors, have left the island
in crisis since at least 2005 (the financial crisis of 2008-2009 and its impact
on the United States and the global economy only exacerbating this decline).
Low levels of successful domestic entrepreneurship, recessions, mounting debts
(reaching more than $70BB in debt markets in recent years, prompting the vicious
cycle of credit downgrades, which have led to higher interest rates, fewer
capacity to meet interest and debt payments, and so on so forth until the
island marches towards insolvency), rampant unemployment, and the disappearance
of a middle class are just some of the economic issues affecting the island.
Foreign firms remain some of the largest employers on the island other than the
bloated and inefficient local government, yet these firms reinvest few of their
revenues and income in the island’s economy, instead frequently packing up and
leaving thousands without jobs. Sluggish and polarized government, crumbling
infrastructure, social issues, an economy focused around consumption of foreign
goods instead of on savings and investment, the list goes on. For more economic
indicators and time series from the GDB, see here.
Yet
the Puerto Rican spirit has always been resilient, and you’d be hard-pressed to
find a population elsewhere in the world who (both for the better and for the
worse) is as passionate, opinionated and involved in the country’s direction
and the actions of its government. Thankfully, ideas are always the first step
out of crisis.
In
recent months and perhaps years, several potential grassroots solutions and
campaigns have been frequently cited by the general population. From cutting
legislators’ salaries and benefits (both as an incentive to alleviate gridlock
and perhaps as a reprimand for their poor performance), to greater
representation in the U.S. Congress (currently the 3.5 million American
citizens on the island are represented by just one, non-voting member of the
House; by comparison, the state of Connecticut, with only about 50,000 extra
inhabitants, is represented by five voting members of the House and two
Senators), to consolidation of municipalities into a smaller number of
administrative divisions, the number of suggestions seems endless. I will be
briefly touching upon the last of these suggestions: to
solve Puerto Rico’s fiscal crisis, a commonly cited potential grassroots
solution has been the elimination and consolidation of municipalities (from 78
down to 8 or a similarly small number).
Backing up
this suggestion was this type of comparison: megacities like New York’s nearly
500 square-mile span and 8 million inhabitants are managed by one mayor, while
Puerto Rico is divided into 78 different municipalities (some of which count
only about 1,800 inhabitants, and the largest of which is the capital San Juan,
with about 400,000). That represents 78 mayors, 78 municipal legislatures, one
governor, one island-wide legislature with 27 Senators and 51 Representatives,
and several handfuls of government agencies. While NYC also counts its city council,
borough councils and presidents, and its own set of government agencies, and
while we’re obviously considering different levels of government (city versus
state or nation), New York City’s government feels much less proportionally
bloated than that of Puerto Rico.
Seeing
this suggestion pop up on my social media accounts, however, led me to
question: Does centralization and delocalization improve management of public
finances? I was quickly reminded of one of my first, possibly naïve, research
endeavors in Economics, precisely on whether decentralization and localization actually improve overall the management of public finances. In short, I
investigated (more theoretically than empirically, though many empirical papers
have been conducted on this) whether localization may allow for smaller
deficits and debts due to better government responsiveness to needs, more
efficient, targeted and specific, less
wasteful programs, etc. For Puerto Rico, this would mean that 78 municipalities may actually be better than just 5, or 10.
As a much
more educated graduate now, I can see how it would be not so difficult to
conduct a study to investigate the relationship between different levels/ sizes
of governments and their management of public finances (as measured by the size
of their deficits and debts, their credit ratings, etc.), certainly controlling
for factors and variables that would affect the dependent variables (public
finance management). Among these factors, of course, is the type of expenditure
each level of government is responsible for. One could argue, for example, that
a small town government would better manage its finances since it can keep a
closer eye on how the money is spent, and it can do so by conducting very
targeted spending programs (whereas a large, national government carrying out
the same projects may need to allocate resources much less efficiently since it
has to design a broader program that is applicable to many different types of
small towns across the nation, and has much less information regarding the
specific needs of each of the localities that will receive the funding and how best
to utilize those funds; to that extent, a national government may be more
“wasteful” and may incur a larger number of inefficiencies that come with size,
complexity, and the need for applicability to a much larger set of people).
However, some may argue that given the national government’s vast resources,
its deficits may be proportionally much smaller than that of a small town: one
very large, one-off expenditure by a small city council may very well represent
an incredibly large percent of its budget and may cause it to incur what seems
like an incredibly large debt, which in the scope of the national government
would be like drops in the ocean. A valid study looking at different budget
institutions (particularly localization) and the public finance outcomes of
those institutions would need to adequately control for all these factors.
In short,
I question the wisdom that might suggest that the consolidation of Puerto
Rico’s municipalities into a smaller number of divisions would ultimately save
money and help in some part alleviate the island’s fiscal crisis. And I do this
of course not because I possess my own empirical evidence yet (and existing studies provide
somewhat inconclusive, if not conflicting suggestions), but because I can
theoretically suggest how it may actually be more efficient to decentralize and localize government expenditures: meaning devolve expenditure
decisions from national to local governments, while preserving the
revenue-collection capacity of the national government, and leaving in its hands
both the allocation of funds to each respective locality, and responsibility
for big-ticket, national items such as defense and security, national welfare
programs and inter-state infrastructure, etc.
Thus, fiscal and
policy decentralization may actually be an effective solution to Puerto Rico’s
fiscal problems. It’s potentially not that hard to imagine a system for a
country in crisis whereas the fiscal process is revamped: the national
government first collects revenues, then allocates a certain amount to national
items such as defense, public education, and debt reduction, reallocates the
rest to each individual locality based on a diversity of criteria, and these
localities in turn spend only what is allocated to them by the national
government and what they themselves collect (if revenue-collection is also
allowed at this local level). Allowing then citizens to vote on expenditures
through participatory budgeting (thus further devolving expenditure decisions
to smaller “localities” in the form of individual people) would accentuate the
representative and hopefully moderating effect on public finances of this
system. This may of course not be the most efficient process for a country
operating normally, but in critical circumstances may be a tool worth looking
at. Most Americans, for example, respond that they believe their city or town is headed in the right
direction while simultaneously responding that the nation as a whole is headed in the wrong direction. This speaks to the higher perceived effectiveness
of local as opposed to national governments in responding to constituent needs
and desires.
By decentralizing our budget
and promoting citizen-level collective action in budgetary policy at the local,
micro level (in other words,
participatory budgeting), we can cater budgets to more specific issues while
fostering discipline and responsibility in funding the programs in those
budgets. Clearly, public goods provision is easier at the local level, where
transaction costs are lower and regulation of free-riders is more effective.
Thus, “going local” can be good first steps toward more fiscally responsible
economic policies. In what follows I provide a theoretical (though admittedly
not particularly rigorous) argument as to why this may be potentially true.
This section I take from my own policy proposal written in the Spring 2013
edition of the Roosevelt Review of
Columbia University’s chapter of the Roosevelt Institute. The policy proposal
was titled “A New Budgetary Paradigm”, and included topics such as Ricardian
Equivalence and relaxing Laffer curve assumptions, which I plan to cover in
future posts of this blog. The policy proposal can be found here.
Decentralization
and Participatory Budgeting (excerpt
from “A New Budgetary Paradigm: Fiscal and Policy Decentralization,
Participatory Budgeting, and Redefined Tax Rate- Tax Revenue Relationships”)
Looking at a two-dimensional
policy space and plotting preferred policies on tax revenues versus the level
of spending, we can show that budget deficits are usually the preferred policy
outcome in our present system of formulating budgetary policy.
In this game where points A, B,
C, and D represent different policy-making groups or individuals, any area
where there is overlap between each player’s indifference curve is a possible
policy outcome. Thus, assuming that players prefer a policy outcome closer in
space to their own preferred policy, four distinct possible outcomes are clear.
Two of these outcomes represent a budget surplus: those formed by the agreement
between players A and B, and players A and C.
Indeed, because player A’s preferred policy is a high level of tax
revenue but a comparatively low level of spending, any agreement with this
player in this game will result in a budget surplus. Any agreement with player
D, on the other hand, will result in a budget deficit, because his preferred policy is a high level of spending
but a low level of revenue.
Of
course, this is a simplified model to explain the origins of different policy
outcomes under our present system. In it, we must assume that there is no
movement of the players’ preferred policies, and that they have perfect
information and control over tax revenue. Yet, we know that perfect control
over tax revenue is impossible, seeing as how government can only control the tax
rate. It is the tax revenue, then, that will be a function of the tax rate—a
function which can be described, among many other options, by relationships
such as the Laffer curve. Moreover, in our case of this game, we must
assume—and this seems a bold assumption—that player A does not exist. However,
in our real world that is actually not such an unrealistic assumption to make;
of all the players in our game, A is the least likely to exist in our world—few
policy-makers today call for the inefficient policy of high revenues but few
programs to spend that revenue on. Thus, our policy space ends up looking like
so:
where deficits are the policy
outcome according to player D’s preferences, despite two other players—B and
C—agreeing on the more fiscally responsible policy of the balanced budget. Therefore,
deficits are the usual outcome under our present system. As can be corroborated
with empirical data and a look at history over the past four decades, it is
clear that deficits have become our recent fiscal reality. This fact, however, does not necessarily have
to imply that they will also become our future
fiscal reality.
First of all, by looking once again at our policy-space,
it is clear that balanced budgets and surpluses are possible by allowing for
appropriate movement of our players’ preferred policies and indifference
curves. Thus, by allowing bargaining, cooperation and collective action in our
policy space, we can create overlap between our players’ indifference curves at
more fiscally responsible areas. Moreover, because bargaining is already a
strategy we employ today, another method to allow for even greater overlap in
these fiscally responsible areas is to naturally make the players’ preferred
policies and interests more similar. While living in a same locality does not
necessarily translate into equal interests, it is safe to assume that, at the
micro-level, neighbors and families have much more similar interests and
preferences than a large collection of citizens at a national stage. Thus, in
smaller, micro level organizations, regardless of the number of players—which
has potentially increased as we make collective action a broader, more
inclusive affair—and regardless of the size of their indifference curves,
interests may be far more similar and balanced budgets or surpluses much easier
to reach. Looking at our policy space:
Low
level of decentralization
High
level of decentralization
Perfect
decentralization (each individual has his own budget—there is no government)
Thus,
while it is no guarantee that a balanced budget or a surplus will be reached—in fact, it is just as
likely that it will move towards a deficit as to a surplus or a balanced budget
if the local community’s interests are as such—decentralization is nevertheless
a useful tool to make collective action much easier and, with more citizen
input, more fiscally responsible policies possible. If anything, it at least
increases the potential for cooperation, as evidenced by the larger overlap
between groups of players’ individual indifference curves when their interests
are more similar. With further provisions guaranteeing that the overlap of
interests will be on the surplus side of the policy space, this system may
theoretically guarantee consistent budget surpluses.
Indeed,
it has been a well-known, intuitive fact for decades that collective action is
much easier at the local level. Elinor Ostrom, the 2009 Nobel Laureate in
Economics, and other major thinkers in economic governance have proven that
resources can be very-well managed and regulated without the need for a large
government or regulatory body—instead, “communities of individuals have relied
on institutions resembling neither the state nor the market to govern some resource
systems with reasonable degrees of success over long periods of time”.[i]
With particular regards to fiscal and budgetary policy, this is in part because
decentralization counters diffusion of responsibility. Devolving fiscal
responsibilities to smaller, local organizations increases the extent to which
that same locality acknowledges its responsibility for its fiscal issues. For
example, while most of a government’s debt is publicly held, it would be hard
to believe that a head of a household feels as responsible for the national
debt as he or she does for his or her own family’s debt; it is simply common
sense that—if one is rational—one should feel much more personally responsible
with one’s own money and for one’s own debt than that which is shared and
diffused throughout many other citizens. In other words, barring extreme cases,
an individual household rarely lets itself accumulate as much debt as our
government does, because said household feels much more personally responsible
for any debt it accumulates—it will find it harder to free ride on the efforts
of others to pay it down (or simply stop accumulating it).
Thus, decentralization is a sure method to decrease
diffusion of responsibility, and make collective action with the aim of
reaching a balanced budget or surplus easier (by increasing the potential for
cooperation, evidenced with the larger overlap in possible policy outcomes in
our two-dimensional policy space). However, several critiques can be made
against decentralization. The first of these is that it might increase “bailout
beliefs”—the tendency to fall back on a higher, national level of government in
the case of failure.[ii] Thus, by granting more
power and responsibility over individual communities, we might increase their
incentives to simply spend much more than they can pay for, in the false belief
that the national government will eventually step in and bail them out. This
moral hazard can easily turn into a disastrous situation if every single
community falls into the temptation of these bailout beliefs—eventually, the
national government will find itself unable to save everyone who fails to meet
its fiscal responsibilities. To counter this, we can hold the larger, higher
level of government to a credible rule of not bailing out fiscally
irresponsible localities. While this is not efficient or desirable at the
individual level, it is at the collective one. In other words, while it would
not be beneficial for a locality that does
find itself in a fiscal dilemma, it would be beneficial to society as a
whole because it avoids the potential disaster of a nation-wide fiscal crisis
if all localities decide to fall back on these bailout beliefs.
Secondly, though the national government would retain
control over programs too expensive to devolve to local governments—and would
also retain control over responsibilities that are clearly the realm of the
national government, such as defense—decentralization does pose a difficult
complication in the issue of inequality. Indeed, one of the major arguments in
favor of a more centralized budget is the issue of redistribution:
higher-income areas can help support lower-income areas by making the federal
budget one large "pool" of revenue from which to draw resources to
redistribute to needier areas and necessary welfare services. If we
decentralize budgets, however, these lower-income communities will certainly be
impacted as they will see their resources and revenues—which they obtained
largely through redistribution from higher-income areas—significantly decreased.
In that case, an alternative policy would be to have a certain amount of each
locality’s revenue sent to a higher level of government (to a large extent what
the federal system does already). This level of government, in turn, would
redistribute these resources as needed—thus, some limited centralization to the
largest local community capable of redistributing the necessary funds and
resources. Nevertheless, to the extent that spending can be devolved and decentralized, it should.
Thirdly, another complication to a decentralization
argument is the issue of externalities.[iii]
To some extent, a centralized budget internalizes most externalities by having
weighed the costs and benefits of certain programs. However, by having many
more decentralized budgets we are allowing for many more externalities to occur
by excluding many communities from the budget-formulation process of each
individual community. For example, in our decentralized system, if a community
is willing and able to build a highly pollutant factory in its locality, it has
the right to do so regardless of the negative externalities of pollution to the
surrounding communities (who did not have a say in whether or not the factory
should be built). We would then be faced with the classic dilemma of who is responsible for offsetting the
negative externalities and, perhaps most importantly, the more philosophical
question of whether or not a community should have the right to build a
highly-pollutant factory knowing that its surrounding communities will be
negatively affected (even if it has the necessary funds, resources and
agreement). Perhaps under a centralized budget, the surrounding communities may
have been able to resist the construction of such a factory and avoid the
negative effects from such a program.
The
same goes for positive externalities: when a community decides to build a
high-tech research center with its own budget and funds, it is providing
positive externalities to all the communities that benefit from the research
and the discoveries done there. While seemingly less contentious than negative
externalities, positive externalities nevertheless bring out crucial questions
regarding the provision of public goods: If a community knows it won’t be
compensated for the programs it funds that provide positive externalities, is
there any incentive for it to continue such a program? Thus, if we decentralize
our budget, will we see a decline in these types of programs that require
incentives in order to be set in place? In the classic example of a lighthouse,
we know that there must usually be some third-party enforcer or neutral arbiter
in order to set forth the construction of said public good.[iv]
If budgets were decentralized, however, we could assume that no community would
build a lighthouse on a rocky shore, because each will be waiting for its
neighboring community to do so—knowing that if the neighbor builds the
lighthouse, its own community will obtain all the benefits without having to
pay any of the costs of construction or funding. Thus, some limited level of
centralization is also required for the provision of public goods.
Lastly,
many claim that decentralization might produce an inefficiently small
government. Alesina and Glaeser lay out the classical critique: “tax competition
between localities should lead to a race toward the bottom in terms of
provision of public goods leading to an inefficiently small size of
government.” [v] Indeed, while certain
communities may be willing to accept a relatively high tax rate in order to pay
for comprehensive services, many other communities might wish a lower tax rate
in exchange for lower spending. Thus, firms and employers might in turn wish to
relocate towards those communities where tax rates are lower, ironically
leaving those communities willing to have a large amount of revenue devoid of
such resources. Eventually, those communities who favor more spending might not
have the necessary funds (or jobs) to do so, while those communities who would
have the resources because of their low unemployment and large tax base, do not
have the will to spend at all. This argument, however, is not necessarily in
the mainstream when it comes to decentralization. Many others in fact claim the
opposite, in an argument very similar to our one regarding bailout beliefs:
decentralization might lead to an inefficiently large government, with reckless
spending from localities as they falsely believe that the national government
may be able to bail all of them out.[vi]
Thus, there really is no consensus regarding whether or not decentralization
might produce big or small government. What is important, nevertheless, is that
it produce fiscal discipline, and that many different policies can be
implemented to address this potential moral hazard or “race to the bottom”.
While these complications certainly place some
qualifications on our argument, they do not entirely discredit decentralization
as a possible solution to our fiscal crisis. For example, in Governing the Commons, Elinor Ostrom
presented what she called a “self-financed contract-enforcement game”.[vii]
In this one of many solutions to the problem she was studying—the tragedy of
the commons—she proposed that the players “themselves can make a binding
contract to commit themselves to a cooperative strategy that they themselves
will work out”. [viii] This contract “allows
the participants in the situation to exercise greater control over decisions
about who will be allowed to graze and what limits will be placed on the number
of animals… the self-interest of those who negotiated the contract will lead
them to monitor each other and to report observed infractions so that the
contract is enforced.” [ix]
While it might seem strange to apply Ostrom’s arguments about a common resource
to a national budget, the idea might not be that far-fetched. After all, it is
not that difficult to extend the classic example of over-grazing to our own
fiscal issues: the national budget becomes the common resource, all of the
citizens become the players, and over-grazing would be analogous to a budget
deficit. In order to avoid the over-grazing (the budget deficit) which could
lead in the long-run to a lack of the resource itself (a budget), we will need
to form some new contract by which all players can decide to regulate
themselves and use the resource (revenues and spending) more efficiently.
Up this point, most of the arguments presented have been
theoretical and based on economic models. Nevertheless, these ideas also have
political justifications and have been applied in real-world scenarios.
Especially during the 1990’s, the World Bank published extensive analysis of
the issue of fiscal and political decentralization. In the East Asia and the
Pacific Region, the World Bank conducted research that demonstrated that direct
democracy in decentralized resource allocation results in a higher level of
citizen satisfaction with the allocation process itself (though not necessarily
the outcome)[x]. With regard to budget
deficits themselves, in “Budget Institutions and Fiscal Performance in Latin
America”, Alesina, Hausmann, Hommes and Stein proposed that fiscal institutions
with “ex-ante constraints” on deficits—such as balanced budget rules—are
associated with a higher level of fiscal discipline.[xi]
This has been corroborated in the U.S. by Bohn and Inman in “Balanced Budget
Rules and Public Debts: Evidence from the US States”. [xii] Extending this fact to our decentralization
argument, I propose that explicit rules are not strictly necessary; as Elinor
Ostrom pointed out, self-enforcing contracts can be enough to provide for
efficient results. These self-enforcing contracts, in turn, are only possible
in highly decentralized, local communities where interaction and familiarity
ensure a smaller willingness to fall back and free ride on others who know you.
Moreover, it is important to remember that strict rules are a very limiting
factor in the case of shocks. While we argue for a fiscally responsible budget,
this argument does not always necessarily imply a balanced budget or surplus.
Indeed, in Keynesian orthodoxy, during times of recession a deficit may very
well be the appropriate economic policy to implement. However, keeping those
assumptions in mind, in that case it might still be better to have a deficit at
the local, decentralized level, where spending can be used in the most
community-specific and appropriate way possible to stimulate recovery.
Leaving aside
momentarily the economic arguments in favor and against decentralization, there
is one important, political dimension to this proposal. Indeed, a prime
question in political science has always been how to improve the congruence
between citizens’ preferences and policy outcomes. [xiii]
One clear solution to increasing this congruence should be decentralization.
Indeed, in our majoritarian, representative system, it is difficult to
determine whether voters’ choices are truly represented or have any influence
on policy. Thus, with such an important issue as tax policy, it might be best
to redirect decisions so that it is highly more representative and influenced
by the voters and firms themselves. Moreover, as Bingham Powell, Jr. made
clear, our present system assumes that all we can know about citizens’
preferences is revealed through their vote choices. The problem is, however,
that they can only choose from among the alternatives that are presented to
them, not from what might actually be their own preferences.[xiv]
Therefore, collective action and more personal input at the local level might increase
the positive, social and economic impact of government services in each
locality, because it was the citizens themselves who made those preferences
clear, and not distant representatives.
Thus, having considered both the economic and political
arguments in favor and against of decentralization, we might feel safe
concluding that it might be a good strategy to solve our fiscal crisis. While
clearly no theory is a guarantee of success, making tax policy a truly
cooperative endeavor—decentralizing it and including actual people and
interests in the process, where everyone gets complete, close-to-perfect
information—should provide for a much more efficient use of funds and spending.
Thus, a more responsible and efficient budgetary policy will imply decentralizing
the budget to some extent—to the level where people have similar interests and
priorities, and where agreements are possible that put these interests and
priorities to best use. Moreover, in these communities of similar interests, an
agreement on expectations, priorities and funding of governance might get rid
of the negative incentive effects of raising tax rates.
[i] Elinor Ostrom, Governing the Commons:
The Evolution of Institutions for Collective Action (Cambridge: Cambridge
University Press, 1990).
[ii] Timothy Frye, “Coalitions and Federalism”
(lecture, Columbia University, New York, NY, November 15, 2012).
[iii] Kenneth A. Shepsle and Mark S. Bonchek,
“Public Goods, Externalities, and the Commons,” in Analyzing Politics:
Rationality, Behavior, and Institutions (New York: W.W. Norton & Company,
1996), 278.
[iv] Ibid, 264.
[v] Alberto Alesina and Edward Glaeser, Fighting
Poverty in the US and Europe: A World of Difference (Oxford: Oxford
University Press, 2004), 88.
[vi] Ibid.
[vii] Ostrom, Governing the Commons, 18.
[viii] Ibid, 15.
[ix] Ibid, 17.
[x] Andrew Beath, Fotini Christia, and Ruben
Enikolopov, “Direct Democracy and Resource Allocation: Experimental Evidence
from Afghanistan,” Policy Research Working Paper 6133 (The World Bank, 2012).
[xi] Alberto Alesina, Ricardo Hausmann,
Rudolf Hommes, and Ernesto Stein, “Budget Institutions and Fiscal Performance
in Latin America,” Working Paper Series 394 (Inter-American Development Bank,
1999).
[xii] Henning Bohn and Robert P. Inman,
“Balanced Budget Rules and Public Deficits: Evidence from the U.S. States,”
Working Paper No. w5533 (National Bureau of Economic Research, 1996).
[xiii] G. Bingham Powell, Elections as
Instruments of Democracy: Majoritarian and Proportional Visions (New Haven:
Yale University Press, 2000).
[xiv] Ibid, 16.
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