The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword
• Geoffrey Brennan
• Preface
• Acknowledgments
• The Power to Tax
• 1.: Taxation In Constitutional Perspective
• 1.1.: The Notion of a “constitution”
• 1.2.: The Logic of a Constitution
• 1.3.: The Means of Constitutional Constraint
• 1.4.: The Wicksellian Ideal and Majoritarian Reality
• 1.5.: The Power to Tax
• 1.6.: The Enforceability of Constitutional Contract
• 1.7.: Normative Implications
• 2.: Natural Government a Model of Leviathan
• 2.1.: Leviathan As Actuality and As Contingency
• 2.2.: Monopoly Government and Popular Sovereignty
• 2.3.: The Model of “leviathan”: Revenue Maximization
• 2.4.: The Model of Leviathan As Monolith
• 2.5.: The Constitutional Criteria
• 3.: Constraints On Base and Rate Structure *
• 3.1.: Government As Revenue Maximizer Subject to Constitutional Tax Constraints
• 3.2.: Tax-base and Tax-rate Constraints In a Simple Model
• 3.3.: One Among Many
• 3.4.: Tax Limits and Tax Reform
• Appendix: Progression In the Multiperson Setting
• 4.: The Taxation of Commodities
• 4.1.: The Conventional Wisdom
• 4.2.: Constitutional Tax Choice
• 4.3.: Alternative Forms of Commodity Tax: the Choice of Base
• 4.4.: Uniformity of Rates Over Commodities
• 4.5.: Uniformity of Rates Over Individuals
• 4.6.: Discrimination By Means of the Rate Structure
• 4.7.: Summary
• Appendix
• 5.: Taxation Through Time Income Taxes, Capital Taxes, and Public Debt
• 5.1.: Income Taxes, Capital Taxes, and Public Debt In Orthodox Public Finance
• 5.2.: The Timing of Rate Announcement
• 5.3.: Income and Capital Taxes Under Perpetual Leviathan
• 5.4: Leviathan’s Time Preference
• 5.5.: The Time Preference of the Taxpayer-citizen With Respect to Public Spending
• 5.6.: The Power to Borrow
• 5.7.: Conclusions
• 6.: Money Creation and Taxation
• 6.1.: The Power to Create Money
• 6.2.: Inflation and the Taxation of Money Balances: a “land” Analogy
• 6.3.: Inflation and the Taxation of Money Balances
• 6.4.: Inflationary Expectations Under Leviathan
• 6.5.: Inflation, Wealth Taxation, and the Durability of Money
• 6.6.: The Orthodox Discussion of Inflation As a Tax
• 6.7.: The Monetary Constitution
• 6.8.: Inflation and Income Tax Revenue
• 6.9.: Monetary Rules and Tax Rules
• 7.: The Disposition of Public Revenues *
• 7.1.: The Model
• 7.2.: Public-goods Supply Under a Pure Surplus Maximizer: Geometric Analysis
• 7.3.: The Surplus Maximizer: Algebraic Treatment
• 7.4.: The Nonsurplus Maximizer
• 7.5.: Toward a Tax Policy
• 8.: The Domain of Politics
• 8.1.: Procedural Constraints On Political Decision Making
• 8.2.: The Rule of Law: General Rules
• 8.3.: The Domain of Public Expenditures
• 8.4.: Government By Coercion
• 9.: Open Economy, Federalism, and Taxing Authority
• 9.1.: Toward a Tax Constitution For Leviathan In an Open Economy With Trade But Without Migration
• 9.2.: Tax Rules In an Open Economy With Trade and Migration
• 9.3.: Federalism As a Component of a Fiscal Constitution
• 9.4.: An Alternative Theory of Government Grants
• 9.5.: A Tax Constitution For a Federal State
• 9.6.: Conclusions
• 10.: Toward Authentic Tax Reform Prospects and Prescriptions
• 10.1.: Taxation In Constitutional Perspective
• 10.2.: Tax Reform As Tax Limits
• 10.3.: Tax-rate Limits: the Logic of Proposition 13
• 10.4.: Tax-base Constraints
• 10.5.: Aggregate Revenue and Outlay Limits: Ratio-type Proposals For Constitutional Constraint
• 10.6.: Procedural Limits: Qualified Majorities and Budget Balance
• 10.7.: Toward Authentic Tax Reform
• Epilogue

9.3.

Federalism as a Component of a Fiscal Constitution

The analysis of Section 9.2 provides a useful introduction to that of federalism. In the earlier analysis, we adopted a model that contained a large number of political jurisdictions, each one of which defined the “range of publicness” for the goods and services to be supplied governmentally, but all of which were contained within a suprajurisdictional economy, characterized by open migration and free trade among persons in all the governmental units. Here we introduce a different model. We define the inclusive jurisdictional-political boundary to be coincident in both membership and territory with that of the economy. In this respect, we are back to the implicit closed-economy-closed-polity models of earlier chapters. There are no “independent nations” to be considered; there is only one political community. We want, however, to examine the prospect of using federalization of the political structure as an indirect means of imposing constraints on the potential fiscal exploitation of Leviathan. It may be possible that an explicit constitutional decision to decentralize and hence to disperse political authority may effectively substitute for overt fiscal limits. In conducting this discussion, we wish to contrast both the approach and the results with the reigning orthodoxy in the economic theory of fiscal federalism. We begin, therefore, with a brief descriptive statement of the main elements of that theory.

The conventional theory of fiscal federalism. In what might be called the conventional or orthodox “economic theory” of federalism, the various functions of government are assigned to different levels (central, state or provincial, local) in accordance with the spatial properties of the public-goods externalities embodied in the carrying out of these functions.4 In terms of the efficiency norm of the economist, this theory places or specifies for any particular public good or service a lower bound on the size of the political (or administrative) jurisdiction that should be assigned powers to finance and supply that good or service. In this framework, assignments to jurisdictions of smaller size (below such a boundary limit) would generate interunit spillovers. Efficiency in the overall organization of public-goods financing and supply, therefore, seems to dictate “merger” into “optimal-sized” units.

Note, however, that this argument does not establish any case for federalism, per se, because there are no logical grounds against assigning functions to jurisdictions larger or more extensive than the lower bound determined by the appropriate ranges of publicness. There would seem to be no reason why strictly localized public goods should not be provided by supralocal governmental units, which might, of course, decentralize administratively as the relevant externality limits dictate. In other words, the conventional theory offers no basis for deriving an upper bound on the size of political jurisdictions. There is no analysis that demonstrates the superiority of a genuinely federal political structure over a unitary structure, with the latter administratively decentralized.

This result is not, in itself, surprising when we recognize that the “economic theory” of federalism is no different from standard normative economics in its implicit assumptions about politics. The normative advice proffered by the theory is presumably directed toward the benevolent despotism that will implement the efficiency criteria. No support can be generated for a politically divided governmental structure until the prospects for nonidealized despotism are acknowledged. Once government comes to be modeled either as a complex interaction process akin to that analyzed in standard public choice or, as in this book, in terms of Leviathan-like behavior, an argument for a genuinely federal structure can be developed. Further, the normative theory that emerges can be as “economic” as the conventional one. The individual, at the initial stage of constitutional deliberation, may find it “efficient” to decentralize and to disperse the effective taxing power as between the central and the subordinate units of government.

The central government and protective-state functions. Let us continue to model government in Leviathan terms. Whether central, provincial, or local, we assume that government will try to maximize net surplus within the set of internal and external constraints that it confronts. The question to be examined is whether or not explicit constitutional decentralization and dispersal of fiscal authority can provide effective substitutes, in whole or in part, for direct controls over the taxing power.

We must first take account of the initial leap out of Hobbesian anarchy, the primal establishment of government as the enforcer of individual rights and contracts, sometimes called the minimal or the protective state.5 The protective functions will almost necessarily be assigned to the governmental unit that is coincident in area and membership with the area of the potential economic interdependence. Political subdivision into fully sovereign national units will create prospects for internal conflict, quite apart from internal barriers to trade and migration.6 If protective-state functions are assigned to the central government, with no constraints on the taxing power, the individual will predict Leviathan provision of protective-state services (internal security, enforcement of rights and contracts, and external defense) but that taxes will be imposed so as to maximize the net surplus over and above the costs of supplying such services. Since the size of the potential tax base (income and wealth in the economy) is clearly dependent on the size and quality of the protective-state services offered, government may well be in the position discussed in Chapter 7. (See, particularly, Figure 7.2 and related discussion.) At the constitutional stage, the individual will clearly seek to restrict the central government’s power to tax while leaving it with sufficient authority to finance the desired level of protective-state services. This objective may be accomplished by assigning to the central government a relatively narrow revenue potential through an appropriate base-rate restriction, one that directly relates revenue potential to the services provided.7

Productive-state functions: “national” public goods, costless migration, no locational rents. Our concern is not primarily with the financing of protective-state functions assignable to the central government. It is, instead, centered on the possible extension of central government competence beyond such limits with the corresponding extension of taxing power. For purposes of analysis in this and succeeding subsections, we assume that the central government carries out its protective-state functions satisfactorily. It guarantees rights of property and contract, protects against external threats, and ensures free internal trade and migration within its boundaries. It finances these activities by some appropriately limited taxing power, one that restricts the central government’s possible exploitation of taxpayers within relatively narrow bounds.

We shall develop our argument in a series of models, arrayed in some rough order of increasing complexity (and realism). In the first three models discussed below, we shall make the extreme assumption that migration is costless. There are no moving costs, and no one has personal preferences as to location within the inclusive territory. Further, there are no locational rents to be earned anywhere in the economy.

In the first case, let us assume now that there is a single public good potentially desired by citizens, a good that is technologically nonexcludable throughout the whole “national” territory. Further, we assume complete nonrivalry in consumption. The good is ideally Samuelsonian. (No such good may exist, but the polar case is useful for expository purposes.)

From the precepts of the orthodox theory of fiscal federalism, the financing and provision of such a “national” public good under these conditions should be assigned to the central government rather than to subordinate units of less-than-optimal size for the function. In the latter assignment, interunit spillovers emerge to generate inefficiency, and total supply of the good will tend to be suboptimal. What emerges from the Leviathan perspective?

Assignment of the “national” public good to central government fiscal authority will require constitutional constraints to ensure both that revenues will be expended on provision of the good and that there will be limits on total revenue collections. Some such constraints could surely be constructed, in accordance with the norms emergent from the analyses of earlier chapters, and as we have already assumed to be present with respect to protective-state services. Nonetheless, as the analyses have also suggested, the constraints that might be imposed will accomplish these purposes only within certain tolerance limits and cannot be expected to ensure “efficiency” in any narrowly defined sense. Government could, in other words, be expected to secure some net surplus, a surplus that represents net efficiency loss to taxpayers.

The problem to be posed is one in comparative institutional analysis. It would be possible, at the constitutional stage, to assign the financing and provision of the “national” public good to subordinate units rather than to the central government, despite the “national” range of both nonexcludability and nonrivalry. The predicted results of such a federal assignment may then be compared with centralized assignment.

Under the extreme conditions postulated, the equilibrium solution under the federal assignment will be zero taxation along with zero provision of the public good. Any attempt on the part of any single subordinate unit of government, under Leviathan motivation, to levy taxes, even for the provision of the good, will result in total and immediate outmigration to the remaining jurisdictions in the economy. There will be no tax or fiscal exploitation in this solution. But the net efficiency loss will be measured by the potential difference between the benefits of the public good and its costs. There is no way of determining a priori whether these efficiency losses will be greater than, equal to, or less than those that are to be expected under centralized assignment. For our purposes, it suffices to demonstrate that the federal assignment may involve lower efficiency loss than the equivalent assignment of the function to the central government authority. The mobility constraint that prohibits local governments from exploiting citizens is tantamount to a constitutional rule that restricts the domain of public spending in such a way as to prohibit provision of the public good.

Productive-state functions: costless migration, no locational rents, complete “national” jointness efficiency but with provincial excludability. The efficiency argument for federal assignment increases dramatically if we drop the nonexcludability assumption from the model considered above while leaving all other assumptions of the model invariant. Let us continue to assume that the “range of publicness” defined in terms of costs of provision over numbers is genuinely “national.” We assume now, however, that subordinate units of government may, without undue cost, effectively exclude noncitizens from enjoying the public-goods benefits from localized provision.

In this model, by contrast with that examined above, any single unit of government can tax-finance and supply the public good without motivating mass outmigration from its boundaries to other units within the inclusive territory. To the extent that taxes are imposed so as to leave citizens with more surplus than they could obtain in competing jurisdictions, individuals will be motivated to remain in the fiscally responsive jurisdiction.

The equilibrium solution in this model will involve the concentration of all members of the inclusive jurisdiction into only one of the subordinate governmental units. This concentration will be necessary to exploit fully the jointness efficiency aspects of the public good. The single government that remains fiscally viable, however, will, in the extreme conditions postulated, be unable to secure any net fiscal surplus. Taxes will be levied on citizens strictly in terms of their relative public-goods evaluations; all taxes will tend to approximate Lindahl prices. Any attempted departure from this pattern of taxation will immediately set up the potentiality for a competing government to offer better terms to everyone; immediate mass outmigration from the unit that tries to undertake any fiscal exploitation will result.

In this model, therefore, there is a clear efficiency gain in adopting the federal rather than the centralized assignment for the public good, even though the range of publicness defined in the jointness sense remains “national.” There are no efficiency losses in the federal solution, whereas, as earlier indicated, there may be efficiency losses in the centralized solution stemming from the failure of taxing constraints to eliminate all Leviathan surplus prospects. Note that the federal assignment secures the reduction of predicted efficiency loss to zero without the introduction of any overt fiscal constraints on the authority of the local governmental units. The fiscal discipline that is forced upon these units in the solution emerges from the mobility of resources across subordinate governmental boundaries within the inclusive territorial jurisdiction. These units of government cannot spend revenues for other purposes than public-goods provision, and they cannot tax in any arbitrary way so that net surplus may be generated.

Production-state functions: costless migration, no locational rents, localized public goods. If we now modify the model by relaxing the assumption concerning the range of publicness, and allow for local-governmental limits on the jointness efficiency in public-goods provision, we are back in the idealized Tiebout world discussed earlier in this chapter. Elaboration at this point is unnecessary. The equilibrium solution differs from that immediately above in that, with localized public goods, population will not be concentrated in single units but will instead be dispersed among separate units, with each unit producing an efficient level of public goods, and with each unit imposing essentially Lindahl tax prices. As in the earlier case, the solution will be fully efficient. A federal assignment is dictated, both from our Leviathan set of assumptions about government and from the set of assumptions that characterize the orthodox theory of fiscal federalism.

Locational value, costs of mobility, and localized Leviathans. The models introduced to this point in our discussion of federalism are grossly unrealistic in their assumptions about locational value and costs of mobility. They should be considered to be preliminary to more realistic models that incorporate locational preferences of taxpayers, locational rents earned by economic resources, and positive costs of moving as between locations. Once any or all of these elements are allowed for in the distribution of people and resources throughout the territory of an economy, the efficacy of the indirect constraint in reducing or eliminating fiscal exploitation by subnational units of government is decreased. If a person, for any reason, simply prefers to live in X rather than in Y, within an inclusive jurisdiction containing both X and Y, he becomes vulnerable to some fiscal exploitation by the government of X, even if it remains in “competition” for people and resources with the government of Y.

The existence of locational value implies that local governments should not be allowed unconstrained taxing power, as might have been implied by some of the extreme models when this value was assumed away. Acknowledgment of the existence of positive locational value does not, however, directionally modify the argument for federal assignment of functions sketched out in the simpler models given above. To the extent that the indirect mobility constraint is operative at all, subordinate governments will be limited in their fiscal powers in comparison with centralized government powers.

Toward an “optimal” federal structure. The argument for a constitutional-stage federal assignment of functions, with accompanying taxing powers, under certain conditions may be accepted, and the suggested modification of the “range of publicness” mappings implicit in orthodox analysis may be rejected. But we have not, to this point, offered a definitive set of suggestions concerning “optimality” in the design of a federalized structure itself, given our Leviathan assumptions about political process. How small or how large should competing subordinate units of government be? How many subordinate units should be contained within the inclusive protective-state jurisdiction?

There are at least four elements that need to be considered as relevant to any answer to this question: costs of mobility, potentiality for collusion, ranges of publicness, and economies of scale in administrative organization.

The costs of moving presumably increase with geographical distance. “Costs of moving” include here not only actual costs of shifting among locations, but, also, subjective or psychological costs involved in shifts among locations along scales of preference. (A person may be relatively indifferent as between Broward and Dade County in Florida. She may place a high value on Florida over any other state.) Empirical evidence confirms the simple analytical results here; persons tend to shift among jurisdictions more readily if these jurisdictions are geographically close one to another. From this fact it follows that the potential for fiscal exploitation varies inversely with the number of competing governmental units in the inclusive territory. This element, taken alone, implies the efficacy of a large number of subordinate governmental units.

A second element also points toward the desirability of a multiplicity of jurisdictions. For reasons equivalent to those familiar in oligopoly theory, the potentiality for collusion among separate units varies inversely with the number of units. If there are only a small number of nominally competitive governments, collusion among them with respect to their mutual exercise of their assigned taxing powers may be easy to organize and to enforce. On the other hand, the costs of organizing and enforcing collusive agreements increase disproportionately as the number of competitors increases.

The “range of publicness” or “economies of scale in consumption” element offsets the first two elements, at least to some degree and for some functions. As the orthodox analysis suggests, the equivalence mappings between the size of political jurisdictions and the range of publicness is of relevance, if not necessarily of dominating importance. It is worth noting as an analytic footnote in this connection that it is the nonexcludability characteristic of public goods rather than the economies of scale in consumption as such that is the more crucial limit on the capacities of decentralization.

A final element involves the costs of administration and organization, which tend to point in the direction of a smaller number of units and toward a combination of functional authorities within single units. There is economic content in the familiar argument for fiscal consolidation among localized jurisdictions. What is often neglected in discussions of consolidation, however, is the offsetting potential for fiscal exploitation, a potential that only emerges when something other than the benevolent despotism model of government informs the analysis.

A normative theory of the “optimal” federal structure would have to incorporate each of the elements noted, along with other relevant considerations, among which would be the locational fixity of productive resources, the homogeneity of the population, and the predicted efficacy of explicit constitutional constraints on central-government and local-government taxing powers. Our purpose here is not to offer such a “theory,” even in the form of a few highly abstracted models. Our purpose is the much more limited one of suggesting a rationale for introducing a dispersal of fiscal authority among differing levels of government as a means of controlling Leviathan’s overall fiscal appetites.

[4. ] For a clear example, see Albert Breton, “A Theory of Government Grants,” Canadian Journal of Economics and Political Science, 31 (May 1965), 175-87. But also see Gordon Tullock, “Federalism: Problems of Scale,” Public Choice, 6 (Spring 1969), 19-29; Mancur Olson, “The Principle of ‘Fiscal Equivalence,’ “ American Economic Review, 59 (May 1969), 479-87; Albert Breton and Anthony Scott, The Economic Constitution of Federal States (Toronto: University of Toronto Press, 1978); Richard A. Musgrave, “Approaches to a Fiscal Theory of Political Federalism,” in National Bureau of Economic Research, Public Finances: Needs, Sources, and Utilization (Princeton: Princeton University Press, 1961), pp. 97-122; and Charles M. Tiebout, “An Economic Theory of Fiscal Decentralization,” in Public Finances: Needs, Sources, and Utilization, pp. 79-96.

[5. ] For further discussion, see James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975). Also, see Robert Nozick, Anarchy, State, and Utopia (New York: Basic Books, 1974).

[6. ] Historically, of course, federalized political structures have emerged from some coordination between previously independent units rather than from the deliberative dispersal of political power at a constitutional stage of decision. For our purposes, however, the conceptualization of the latter model of origination of federalisms is more helpful analytically.

[7. ] Earl Thompson has implied that protective-state services are directly related to “coveted wealth.” From his argument a case can be made for allowing a central government to tax nonhuman wealth, presumably with designated rate limits. See Earl Thompson, “Taxation and National Defense,” Journal of Political Economy, 82 (July-August 1974), 755-82. Thompson derives his theory from the predicate that governments are totally efficient and entirely constrained to produce results desired by the electorate. Our alternative model of public choice generates a quite different normative evaluation of the wealth tax. (See Chapter 5.)