Front Page Titles (by Subject) 9.4.: An Alternative Theory of Government Grants - The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution)
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9.4.: An Alternative Theory of Government Grants - James M. Buchanan, The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution) 
The Collected Works of James M. Buchanan, Vol. 9 The Power to Tax: Analytical Foundations of a Fiscal Constitution, Foreword by Geoffrey Brennan (Indianapolis: Liberty Fund, 2000).
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Foreword and coauthor note © 2000 Liberty Fund, Inc. © 1980 Cambridge University Press.
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An Alternative Theory of Government Grants
The orthodox theory of fiscal federalism includes as one of its parts a theory of intergovernmental grants. The traditional justification for such grants can take three forms: first, certain functions of government allocated to lower levels may generate interjurisdictional spillovers, which can be internalized only by payments between jurisdictions, or appropriate transfers from higher levels of government; second, economies of scale in the administration of taxation may be obtained if central (or higher-level) governments are responsible both for revenue raising and for disbursing funds to lower-level jurisdictions for expenditure; or third, interregional disparities in income (or possibly population) may be seen to require interregional redistribution on more-or-less standard “equity” grounds, by higher-level governments.
As elsewhere in this book, we set aside this third possible justification as lying outside the domain of the current discussion. The other two arguments are, however, of a type that would make them relevant to the constitutional calculus of the typical voter-taxpayer as we have posited it. In principle, they are arguments that ought to bear weight, but like other aspects of the economic theory of federalism, they presume a model of government as the benevolent despot—far removed from our own.
The Leviathan model does, however, readily enough generate a theory of “government grants,” with both positive and normative aspects. Within a constitutionally designed federal structure, we would predict that there would be constant pressures by competitive lower-level governments to secure institutional rearrangements that would moderate competitive pressures. One obvious such arrangement would be one that established a uniform tax system across all jurisdictions: this would remove one major element of the competitive government process. And the logical body to administer any such agreement is the higher level of government. In return for an appropriate share of the additional revenue, the central government would act as an enforcer of the agreement between lower-level governments, doling out financial penalties to those jurisdictions which attempted to breach the agreement. Appropriate “fiscal effort” would become an important criterion for determining the share of total revenue that went to each lower-level government: if some state-province levied a low rate of tax in relation to some revenue instrument over which it retained jurisdiction, other states would need to be able to penalize it by means of its grant appropriation by the central government.
With revenue-raising powers thus reassigned to the central government, we would expect both some pro rata return of revenues to state governments and some remaining “special” grants to particular states. The reason for these latter “redistributions” in this model lies in the presence of differential locational rents among states. Those states where locational rents are high, and which could therefore charge higher taxes in the genuinely competitive setting, would no doubt expect a larger share of total revenues per capita in the cartelized case where the central government organizes revenue collection. Correspondingly, in those states where locational rents are lowest, we would expect states to obtain a lower per capita share of total revenue. Additionally, since any lower-level government unit can effectively break the cartel by remitting taxes and attempting to attract extra residents-taxpayers thereby, one might expect that some proportion of the additional tax proceeds from cartelization would be shared on a more-or-less equal-share basis. In this sense, we ought to expect small states to obtain a larger per capita share than large states. There are, then, clear empirical implications here that could be tested to determine the extent to which this explanation of revenue sharing and the structure of grants is an acceptable one. In this connection, there is one observation that deserves mention. With conventional explanations-justifications of intergovernmental grants, one would expect that a considerable amount of intergovernmental transfer could and would occur bilaterally between governments at the same level: interjurisdictional spillovers, for example, would seem to be most appropriately handled in this way. With our alternative theory of the central government as monitor of a cartel among lower levels of government, simple bilateral negotiation between particular jurisdictions would be almost useless since it increases monopoly power only modestly, and we would expect it to be a rare phenomenon. In practice, of course, it is: in very few federations do we observe any significant transfer of funds between jurisdictions at the same level—virtually everything is channeled through the higher level of government.
The normative implications of our alternative theory are clear. Revenue sharing is undesirable, because it subverts the primary purpose of federalism, which is to create competition between jurisdictions. Each jurisdiction must have responsibility for raising its own revenue and should be precluded from entering into explicit agreements with other jurisdictions on the determination of uniform rates. This conclusion is, of course, congruent with the one that emerges from more familiar models of public choice; in a setting where electoral choices are constraining, it is desirable to have expenditure and revenue decisions determined at the same jurisdictional level. The Leviathan construction, however, arrives at similar conclusions from a quite different route.