The State of our Economy, the State of our Congress

Other than the obvious economic repercussions, public finance also impacts and informs the political environment of a nation. In one of my first tentative steps into empirical research, I tried to investigate whether economic factors impact partisanship and gridlock in the United States Congress.

The idea was straightforward: regress different measures of polarization and partisanship on different economic measures, controlling for such factors as time trends, whether elections were held on a given year, whether the Democratic Party was the majority in Congress for that session, and even the number of women in Congress, among others. The polarization measures were the percent of party unity votes in that Congress (a party unity vote defined as one where more than 50% of one party votes against 50% of the opposite party), the percent of moderates in that Congress, the difference between the means of the two parties on a liberal-conservative dimension, the percentage of overlapping members on a liberal-conservative dimension (where zero overlap means the most “liberal” Republican is still more conservative than the most “conservative” Democrat), and both the percentage of Democrat and Republican moderates.

The economic metrics used were the usual suspects: growth, unemployment, and inflation. I also included the deficit (or surplus), and the level of debt in the economy. I also included first-differenced variables, such as the change in the unemployment rate from one year to the next, etc. Data ranged from the beginning of the Great Depression to the end of 2013.

Of course, the first difficulty was typical of working with time series: the frequency and span of measurements frequently did not match or correspond. While annualized measures of unemployment, growth, and debt data could be easily obtained from existing observations, Congressional data is on a per-congress basis: meaning measured every two years and spanning those two years of each given Congress. An obvious—though not particularly ideal solution—was simply using the Congressional partisanship or polarization measures for both years of the given Congress. Thus, for the 107^th Congress (January 2001- January 2003), measures of polarization were assumed to be the same for both 2001 and 2002. This is most appropriate assuming little turnover or change in the members of Congress for the years that make up a Congress.

At the time of carrying out this research, my knowledge and application of time series methods in Economics were both rather limited. As such, my results were quite inconclusive. In particular, since conducting my research, I have grown much more informed as to selecting an appropriate ARIMA model, choosing the model that best fits with Akaike’s or Bayesian Information Criteria, and most importantly, using a VAR model instead and—even more critically—potentially a VEC (Vector-Error-Correction) Model when dealing with multiple, potentially related variables as both independent and dependent measures.

For my original research, my main results supported a weak effect: economic measures would have the type of effect on Congress that we would want to see, in that lower levels of growth, higher unemployment, and generally extreme levels of inflation (both low and high) decreased the level of polarization and partisanship in Congress. Yet, all of these effects were comparatively weak both in terms of the magnitude of the coefficients and the degree of significance. Yet, one effect conclusively stood out as significant across all models and large in magnitude: the level of national debt. In short, the larger our debt gets, the more polarized and partisan our Congress, even after controlling for time effects and other potential controls.

However, knowing the other shortcomings of my research, and now more informed of time series methods, if I were to conduct this research again I would certainly suspect potential cointegration of some of my variables, in particular those that showed my strongest results. As such, I would conduct tests for cointegration and run a VEC model for debt and polarization methods. Most critically, by doing so I would want to rule out a spurious regression between these variables. For example, a peculiar result of my research was that the number of women in Congress seemed to increase polarization in Congress. It is likely, however, that this result was not properly capturing underlying time trends and other factors—after all, both the number of women in Congress and our national debt have risen steadily over time; a model would have to be very carefully specified to control for all these effects. Otherwise, a case would have to be made for the polarizing effect of women in Congress, which seems more a relic of earlier centuries.

Of course, the question is then: were my original results due to a spurious regression? It’s highly possible. The alternative would be that further, better-informed tests and VAR models would reveal cointegration of debt and polarization. In that case, there would be a long-run relationship between the national debt and the level of polarization where, if a large increase in the rate of national debt growth occurs, polarization would decrease to bring back the variables to their long-run equilibrium. This would imply then, that at moments of rapidly climbing debt, Congress would actually unite to resolve the issue, which is precisely what we as citizens would expect and prefer. Alternatively, at times where the debt is increasing less rapidly, members of Congress may give themselves the luxury of focusing on more partisan, less immediately pressing issues.

The accuracy of this statement, however, is still left up to consideration. Are the state of our economy and the state of our Congress jointly determined? What is the specification of this structural VAR, and its economic implications? How can it inform possible reforms to the way our Congress operates under different economic scenarios?

Public Finance: Relaxing Laffer Curve Assumptions and Revising Tax Rate- Tax Revenue Relationships

As a freshman taking Principles of Economics with Prof. Sunil Gulati, I was intrigued by one of the many theoretical concepts of public finance: the Laffer Curve. On the surface, this curve describing the relationship between tax rates and tax revenues is built on sound assumptions and reasoning. After all, the tax rate-tax revenue relationship can clearly be defined as a function (though most realistically, a multivariable one), and as such there should be a tax rate that maximizes that function (tax revenues). The problem is, however, that tax revenues should be precisely a multivariate function: studying the relationship between tax rates and tax revenues and—most critically—claiming a relationship like the one defined in the Laffer curve can be highly misleading when not controlling for the appropriate variables, or not allowing for different versions of this curve depending on the controls.

The Laffer curve Arthur Laffer curve described may be correct in theory—but it may be so only for a very limited and unrealistic set of assumptions, or values of the other variables under consideration. Much research has already been done on the Laffer curve, and this concept has indeed generally been met with skepticism by empirical studies. After all, one can begin dismantling its many assumptions simply by considering the predicted tax revenues at the tax rates of 0% and 100%. At 0%, the claim that tax revenues will also be zero is most appropriate, even using the simple tax revenue function implied by the Laffer Curve (tax revenues are simply tax rate multiplied by the tax base), since of course anything multiplied by zero will also be zero. Not much imagination, however, is required to think of potential reasons why tax revenues would not be zero at a 100% tax rate. Most critically, would all taxable economic activity (in short, the tax base) actually drop down to zero? We can think of many physiological, social, legal and material reasons, among many others, for why individuals would still work at a 100% tax rate, most important of them being the instinctual need for survival (assuming of course that economic activity would be well-regulated so as to make tax evasion highly difficult for all individuals, if not impossible).

Based on these thoughts, my idea was: how can we relax the Laffer curve assumptions by considering the different types of political and social systems under which people live and engage in economic activity? At its core, the Laffer curve attempts to make a claim about individuals’ motivations to work and remain in the tax base at every given tax rate. What if those motivations were varied based on the social and political scale? For example, under varying degrees of economic and social liberty we could expect varying degrees of commitment to work. Under a hypothetical (though in our world, perhaps not even much so), highly totalitarian system, we could imagine a dystopia of a 100% tax rate where everyone is required to work. In that case, the motivation to work is purely external, but nevertheless perfect. Tax revenues in that case would clearly not be zero (though a complication would of course be how far away from zero those revenues would be: would people give the minimum effort in this kind of system?).

Thus, a truly rigorous examination of the function that describes the relationship between tax rates and tax revenues (abstracting and simplifying from the highly complex and marginal nature of modern-day tax codes) would give way to at least three considerations: individuals’ motivations to work (meaning a simple yes or no decision to enter the labor force), the effort applied to one’s work once one is actually working, and finally the “tax evader” decision: whether or not one will be in the tax base. Laffer made the leap from tax rate to this final consideration: the relationship between tax rate and tax evasion. And at the least, he made the simplifying assumption that a 100% tax rate would automatically mean a “no” to the decision to join the labor force.

The idea, however, is that under different political, economic or social systems, individuals may have varying external and internal public motivations that will compel them to: work, apply a certain level of effort in that work which will translate to a taxable, economic output, and finally submit that output to actually be taxed (meaning, not be a tax evader). Moreover, the classic Laffer curve is myopic in that it considers only one part of the taxpayer- government relationship: it considers how the taxpayer will make her labor and tax responsibility decisions based only on the tax rate she observes when filing her taxes each year. Yet, it does not consider that, underlying that transaction is the promise of a further, later transaction: that of government spending or government transfers that the taxpayer will directly or indirectly benefit from. Thus, it fails to consider the simple fact that, yes, higher taxes makes a taxpayer unhappy, but that tax rate should in theory (and this requires several assumptions of our own) imply a larger government budget and, in turn, a larger array of government services that should, in the net, benefit the taxpayer. Be it as indirect as paying the government debt (an action that is intangible and less direct) or as direct as building a new railway that will connect the taxpayer’s town to a major hub of economic activity, the promise of public services (particularly under different economic, social, and political systems) should also be considered when trying to formulate the different possible shapes of the tax rate- tax revenue relationship. Moreover, the political and social system also plays a role in this factor, through the issue of information: we might expect that in more democratic, open and less corrupt political systems, information as to how tax revenues are being spent by the government would be more readily available, allowing the taxpayer to make a more informed decision as to this portion of the taxation transaction Thus, in a society where the government regularly shares information on its budget, or where the taxpayer regularly informs the government as to her preferences regarding that budget—be it through participatory budgeting or some other mechanism—the willingness of the taxpayer to work, make effort, and pay taxes may be very different from one in which the government is very closed and taxpayers are not informed as to how their money is being spent. In the former, more open society, we might expect taxpayers to be more willing to pay higher taxes; in the latter, this asymmetric or incomplete information (from both sides: taxpayers either not having the chance to share their interests or the government not disclosing expenditures), might make taxpayers hesitant to accept lower disposable incomes.

Of course, this all sounds great in theory. It is easy to criticize the Laffer curve for its shortcomings and limiting assumptions. Yet, empirically testing for the real shape(s) of the tax rate-tax revenue relationship is considerably more difficult than one’s own theorizing and postulations. Most importantly, attempting to test “motivation to work and pay taxes” under different tax rates in different sociopolitical and economic systems essentially boils down to testing whether there is a statistically significant difference between the elasticity of labor supply in the different systems under consideration. In short, is the elasticity of labor supply different in the United States (an arguably more democratic, capitalistic and individualistic society and political system with ample economic liberties) from the elasticity of labor supply in an equally democratic, but more socially-leaning nation such as France? Or a very different nation (politically, socially, and economically) like North Korea? And, in turn, does that translate to different levels of tax revenues in those countries in the scenario where tax rates are close to or at 100%?

Hopefully someday, a rigorous examination of this question can be conducted that (whether it is easy or not) will help guide the leaders of different nations faced with very different social, political, and economic systems (and in turn, the very different public motivations of its citizens) to a sound decision regarding their tax rates.

After all, nations of different sociopolitical and economic systems have for decades been applying the same, almost cookie-cutter prescriptions formulated under specific, oftentimes limiting and inapplicable assumptions without regard to how tax codes should actually look in the kinds of societies they consist of. These, at times, have led to disastrous budgetary, political, and social results. 

Maybe with a closer examination of these issues, nations whose services and public motivations of its citizens require higher tax rates will stop living in the fallacy that lowering tax rates is a perpetually self-financing source of economic stimulus, and will implement the tax codes that adequately respond to the needs and demands of their citizens. Likewise for those with potentially different tax rate prescriptions. 

Different theoretical curves describing the tax rate-tax revenue relationship under different sociopolitical and economic systems

Public Finance: Ricardian Equivalence

Among the most well-known of the classical economists is David Ricardo. Known particularly for the concept of comparative advantage and how it—and not absolute advantage or any other measure—should be the basis for trade between individuals or nations (making trade no longer a zero-sum game), Ricardo is also well-known for laying out the theory behind what is known as Ricardian Equivalence. While he doubted the real-world existence of this proposition (and Robert Barro’s subsequent work in the 1970’s seemingly finding evidence for it is still frequently discussed), Ricardian Equivalence essentially states that taxpayers are rational and infinitely (or close to infinitely) forward-looking. Thus, they internalize the government’s budget constraint, such that they understand that a decrease in tax rates today must imply an increase in tax rates in the future. Instead of spending their tax cut and increasing Consumption (which might be the desire of government officials engaging in expansionary fiscal policy), they will save that money knowing that they will be taxed at a higher rate later. In short, this implies a relative ineffectiveness of fiscal policy (whether expansionary or contractionary) on Consumption and thus on GDP and economic growth.

This proposition assumes of course that there is no dominant wealth effect (thus, that a tax cut today would not be more than compensated for by the larger wealth of subsequent generations, making a tax cut in essence self-financing), that taxpayers are rational, and that they are very-forward looking. Those are of course strong assumptions; we know there are a myriad of biases, egocentric and temporal errors, myopia and temporal discounting, among other decision-making factors that make taxpayers (and economic agents in general) particularly “irrational” actors. On top of that, of course, much has happened between the time of Smith, Ricardo, Mill, Malthus, etc., and economic thought has evolved correspondingly. Heckscher and Ohlin, for example, have built upon the theory of comparative advantage to include factors of production and in turn help explain sources of comparative advantage. 

In a world where public finance has been a central topic of political discourse all around the world, it is essential that economics reach comprehensive and accurate responses to a large number of questions: What is the role of public debt on economic growth and taxpayer behavior? Does deficit spending (with the explicit purpose of stimulating the economy) actually work? Is Ricardian equivalence empirically observed? If so, is its effect different between expansionary or contractionary fiscal policy? How forward-looking are taxpayers? Are tax cuts self-financing? Is there a wealth effect? Do the answers to these questions vary based on demographic makeup, political leanings, or social inclinations of the population under study? And finally, based on the answers to these questions, what is the appropriate tax and fiscal policy to ensure the proper balance between economic growth, the social and political goals of each population, and the proper management of the nation’s resources and what is in essence each generation’s intertemporal responsibility: leave behind a better and more prosperous society (for all) than the one they were born into?

Public Finance: Decentralization and Localization, Participatory Budgeting

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.

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[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.