EXECUTIVE SUMMARY
INTRODUCTION
This paper discusses how a decentralised system of government may act as a constraint on the size and growth of the public sector by fostering greater competition among governments and how it may be used to generate outcomes that more clearly reflect the demands of the general public. It also examines to what extent such a system has acted as a constraint, both in Australia and for other federal states. The paper also considers ways in which Australia's federal system can be adapted to make it more effective as a constraining influence.
A FEDERAL SYSTEM OF GOVERNMENT AS A CONSTRAINT ON THE SIZE OF THE PUBLIC SECTOR
To examine the advantages a federal system of government has to offer, we have considered a federal system in the context of a Leviathan (monopoly) model of government behaviour. While it is not suggested that governments behave in this fashion, the model does recognise that government tends to move towards monopolistic behaviour. As such, the model offers a useful tool to study the constitutional constraints necessary to impose on even a benevolent government to increase the likelihood it will act in the best interest of society.
A constitutionally imposed federal system of government is one means of limiting government's monopoly power. Federalism introduces a degree of competition into the public sector. Mobile citizens will be able to seek out their preferred tax-service bundle. Local jurisdictions forced to compete among themselves for the residency of mobile citizens are limited in their ability to exploit their citizens.
The effectiveness of federalism as a constraint on a Leviathan government is determined by three factors. First, the number of competing jurisdictions determines the range of choices available to citizens. The greater the choice available, the less likely a citizen will be subject to fiscal exploitation. Second, the mobility of citizens is influenced by the cost of moving, in all its aspects. The lower the cost of moving, the greater the competitive pressure on governments. Finally, governments may be able to circumvent the competitive pressures of federalism by collusive action. Cartel-like agreements on tax-service packages will limit the choice of citizens. This collusive action is likely to take the form of local jurisdictions ceding taxing powers to the central government in exchange for inter-governmental grants.
EMPIRICAL TESTS
The evidence of the impact of a federal structure on the behaviour of government is limited and contradictory. International evidence offers no clear picture regarding the effect of decentralisation of government expenditures. There is, however, evidence that inter-governmental grants contribute to greater public sector size. The greater body of United States evidence is more supportive of the decentralisation hypothesis. Four of the five studies discussed present evidence suggesting that a federal structure serves to limit the size and growth of government. Again, the evidence concerning intergovernmental grants is generally consistent with the hypothesis that governments attempt to circumvent the constraints of a federal structure.
THE EVIDENCE FOR AUSTRALIA
Australia, like many of the major industrialised economies, has experienced dramatic growth in the size of its public sector over the last few decades. During this same period, there has been little change in the level ot decentralisation of the public sector, however measured. There has, however, been an increase in the States' reliance on intergovernmental grants relative to own-source revenues. Evidence suggests that this has been a major contributing factor to the growth in Australia's public sector.
That decentralisation happens to play no role in explaining public sector size and growth in Australia is inconsistent with evidence for the United States. Possible explanations for this include: (1) the relatively small number of lower-level governments in Australia, limiting consumer choice and facilitating collusive action by governments; (2) the limited mobility of citizens due to the size of Australia's States, the high level of urbanisation, and the isolation of its major urban areas; and (3) the economic insignificance of local government units.
THE DEATH OF DEATH DUTIES: EVIDENCE OF TI EH OUT-STYLE MIGRATION
Evidence of Tiebout-style fiscal-induced migration is relatively scarce. Evidence for the United States suggests that fiscal factors do play a role in intra-urban population movements. In Australia, the migration trends among the six States following Queensland's abolition of death duties are consistent with the Tiebout hypothesis. Trends over the period 1977-82, the period during which death duties were phased out in all States, were significantly different than that for the prior and subsequent periods.
STRENGTHENING AUSTRALIA'S FEDERAL SYSTEM: POLICY PRESCRIPTIONS AND SUMMARY
The evidence presented for Australia, the United States, and an international sample of countries supports the argument that fiscal decentralisation and fiscal independence have constraining influences on the size of government. With the exception of Australia, increasing decentralisation of expenditures limits both the size and growth of the public sector. Less concentration of expenditure authority at the central government level reduces the monopoly power of government and increases the competitive pressures on lower-level governments by allowing for a greater variety of program types and delivery mechanisms from which consumer-voters may choose.
Increased fiscal independence also limits the size and growth of government. Intergovernmental grants serve to break the bond between taxing and expenditure and weaken the fiscal discipline imposed by a federal system. Recipient governments no longer bear the responsibility of raising revenue to finance desired expenditures and no longer need fully justify new expenditure programs. A program of intergovernmental grants allows competitive governments to act as a tax cartel, levying a constant tax rate across all jurisdictions -- the effect being to limit the choice of consumer-voters.
Evidence is also offered that suggests that consumer-voters do respond to differences in tax/service bundles across communities. In Australia, the case of Queensland's abolition of death duties in 1977 offers evidence of this. In the two or three years subsequent to the Queensland government's action, the State experienced increased immigration from all of the other States. In particular, this migration was comprised of persons 50 years of age and older, but there also was immigration from groups across the age spectrum. The pattern and timing of migration is strongly consistent with the fiscal-induced migration hypothesis.
In light of the theory and evidence presented, five policy prescriptions are put forth, designed to strengthen the Australian federal system. Briefly, these recommendations are:
- A reduction in Commonwealth Revenue Assistance Grants;
- A reduction in the role of special purpose grants;
- Partial Commonwealth withdrawal from personal income taxation;
- Provision for State retail sales tax; and
- State transfer of expenditure functions to local governments.
These recommendations argue for greater fiscal responsibility on the part of the Australian States with regard to both revenue raising and expenditures. They also argue for increasing competition among governments by passing down to the State and local governments greater responsibility for both taxation and expenditure functions. Because of the institutional factors, the potential for competition at the State level is limited. If there is to be greater inter-governmental competition, it would best take place at the intra-urban level, among local governments. For this reason, we recommend that local governments be given greater authority over a wider range of expenditure functions, especially schools.
The five policy prescriptions call for major restructuring of the Australian federal system. The proposals are not fully detailed; but rather offer brief sketches of possible changes. Details would have to be negotiated by the various affected parties. The ultimate goal of the policy prescriptions is to enhance the level of competition and the range of effective choices in the Australian federal system.
1 INTRODUCTION
If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary.
The Federalist
As politicians and bureaucrats are not angels, but human beings with human weaknesses, controls on government are necessary. The American Founding Fathers, mistrusting government, created three branches within one government, each serving to check and balance the powers of the others. This paper is not concerned with checks and balances within one government, but with the checks and balances created by a system of individual, competing governments -- federalism. We examine the constraints that a federal constitution can impose on the actions of less than angelic governments. We discuss the ability of a system of competitive governments to better control and direct governments' taxing and spending outcomes.
Economists have long held up the competitive market system as an ideal for the organisation of private sector activity. Competition, it is argued, leads to the most efficient allocation of society's resources, and to the mix of output which provides consumers the highest level of satisfaction. Competition offers the consumer the widest possible range of product choice at the lowest possible prices. If consumers demand a good or service, that good or service will be provided so long as it is profitable for some producer to do so. The competitive market does not rely on the benevolent motivations of economic agents to achieve these ends. Adam Smith noted:
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self interest ..." (1)
In a non-competitive market, the constraints on private action which would channel outcomes promoting the public good are less in evidence. Competitive pressures alone no longer determine the allocation of resources, mix of output, and prices. Monopolists can influence their determination, and since the result is not dictated by the preferences of the general public it is not likely to coincide with them.
Government -- the public sector -- has tended to be organised along non-competitive lines. A single, monopoly, government unit is the most common form of public sector organisation. If the agents of government could be relied upon to be benevolent and altruistic, seeking to further the social interest, then their monopoly position would not harm society's well-being. (2) The interests of the government agents and of society at large would be one and the same and the general public need not fear the acts of its government.
If, however, government agents are not totally benevolent and totally altruistic, and are instead the egoists economic theory assumes them to be in their private-sector dealings, then the interests of government need not coincide with the social interest. The acts of egoist government agents may be directed by the same motivations that direct their private-sector dealings -- the advancement of their own private interest with no regard, or diminished regard, to their impact on the well-being of society. In such cases, society may best be served by constraining government agents in their actions to insure that the agents' interests more closely correspond to the interests of society.
In the past few years, Australia has taken steps to increase the exposure of its economy to competitive market forces. Most notably, it has opened the door to its domestic financial markets, permitting foreign banks to compete. It has also moved to open the domestic airlines industry to greater competition, beginning with the repeal of the Two Airline Policy effective from 1990. The first tentative moves towards abolishing the monopolies in the agricultural marketing and distribution industries have been made. Micro-economic reform is being implemented, or considered, in many other areas of the economy. Even deregulation of that most sacred of cows, the labour market, is being seriously discussed.
Many see these actions as essential if Australia intends to compete effectively in the increasingly competitive and integrated world economy. Increased competition will force Australian industries to improve their productivity and adopt up-to-date technology and marketing methods. Others argue that even if Australia could maintain its traditional life-style sheltered behind protectionist barriers, the monopolistic nature of much of Australia's domestic industries imposes unnecessary costs on Australian consumers. Even within wholely domestic industries, increased competition will improve the quality, price, and selection of products available to the consumer.
The rapid post-war growth in the public sector, in Australia as well as most other major Western industrialised nations, has led economists to begin to examine the benefits of increasing the exposure of the public sector to increased competition as a means of imposing desirable constraints on the actions of the public sector. (3) The concern of this paper is with one possible constraint, a constitutionally-imposed federal system of government. A decentralised system of government -- that is, a system of multi-layered government -- can introduce competitive influences which may constrain the tendency of the public sector to grow bigger than citizen-voters want. A system of competitive governments may discipline the actions of government, better controlling and directing its spending and taxing.
Australia already has a constitutionally established federal system of government, comprising the Commonwealth, the six States and two Territories, and the hundreds of local governments. The current structure and method of operation, however, fails fully to exploit the possible advantages of a federal system. Revenue and expenditure functions are near enough monopolised by the Commonwealth and State governments respectively, with local governments playing only a peripheral role.
The system offers little scope for competitive interaction. The outcome of this is that consumer-voters face an unresponsive public sector and restricted choice among publicly-provided goods and services. Rather than serving to create a marketplace for publicly-provided goods among which the consumer-voter may choose, and in choosing impose a discipline on exploitative governments, the federal system has tended to enhance the monopoly powers of governments.
This paper discusses how a decentralised system of government may act as a constraint on the size and growth of the public sector by fostering greater competition among governments and how it may be used to generate outcomes that more clearly reflect the demands of the general public. It also examines to what extent it has acted as a constraint, both in Australia and for other federal states. The paper also considers ways in which Australia's federal system can be adapted to make it more effective as a constraining influence.
2 A FEDERAL SYSTEM OF GOVERNMENT AS A
CONSTRAINT ON THE SIZE OF THE PUBLIC SECTOR:
THE BRENNAN AND BUCHANAN THEORY
A LEVIATHAN THEORY OF GOVERNMENT
Let us begin our consideration of the benefits of a federal system oi government by thinking about a model of government behaviour. The model will yield predictions about the actions of government agents both in an unconstrained (unitary system of government) case and in a constrained (federal system of government) case. It is also possible to determine what characteristics a federal system should possess if the actions of government agents are to be directed towards socially-preferred outcomes.
The "public choice" model examines the determination of collective, i.e. public, decisions by applying the rational, self-interested, utility-maximising assumptions commonly applied to private economic agents to agents in the public sector. (4) This model assumes actors in the public sector -- politicians, bureaucrats, and special interest groups -- seek to use the powers of government to further their own sectional interests. Advancement of these interests may run counter to the general social welfare. Questions of efficiency and of equity are irrelevant, although policy prescriptions may be argued for in those terms. The public choice model predicts that outcomes of governmental processes will not coincide with the public interest.
The electoral process, in the public choice model, may act as a constraint on government, but it is doubtful how effective it is. It can to some extent be exploited by government. Furthermore, the actions of some government agents are not subject to the disciplines of the political marketplace. For example, the actions of tenured bureaucrats will not be effectively constrained by the electoral process.
In this paper I shall adopt the worst-case scenario of government unconstrained by the electoral process. The "Leviathan" model of government offered by Brennan and Buchanan is an extreme version of the "Public Choice" model. In its simplest form, Brennan and Buchanan's Leviathan government is assumed to be a monopoly government with the objective of revenue-maximisation. Government is not inherently benevolent, but rather is indifferent and possibly even malevolent, and is not effectively constrained by democratic processes. Although it is not suggested that government necessarily acts in this manner, it is justified by arguing that "... there are inherent tendencies in the structure of government to push it toward that sort of behaviour implied in the monopolistic model, tendencies that may emerge in settings where constraints are wholly absent". (5)
Use of this model allows us to examine the effectiveness of the constraints that society might wish to impose upon a currently benevolent government to insure that the government's interest continues to correspond with society's. We might believe that, in general, our politicians and bureaucrats have our best interests at heart. But we would surely rest easier if we knew that, in fact, the constraints on their actions and the incentives they faced ensured that by serving their own interests they also served ours.
The Leviathan model assumes that government's objective is the maximisation of revenue available for its discretionary use. In the extreme case, if there are no constraints on how government spends its revenues, then government's agents could treat collected revenues as their own. Imagine the lord of the manor in feudal times: taxes collected from the vassals were the lord's to do with as he wished. Nowadays, the powers of the lord are not so absolute; government does face some constraints on the way it employs its revenues. The model assumes that these constraints take the form of requiring government to provide some minimum level of public goods and services of benefit to the general public. Beyond this, government's revenues may be used for the benefit -- even if not the direct, financial benefit -- of the politicians and bureaucrats.
Government programs will be administered so as to minimise the proportion of the program's budget actually received by the intended beneficiaries, with the remainder -- the surplus -- used to further the interest of the administrators. For example, Brennan and Buchanan suggest that politicians and bureaucrats directed to make monetary payments to qualifying members of the community (i.e. the poor) will not find it in their interest to do so. Rather, they will seek to minimise the revenues directed to the poor with the surplus secured by the politicians and bureaucrats through expansion of the administering bureaucracy. (6) Maximising the surplus available for the discretionary use of the government agents requires revenue maximisation on the part of government. (7)
The ability of the Leviathan government to maximise revenue is assumed to be limited only by the constitutional constraints on its actions. These fall into three categories:
- constraints on allowable tax bases (e.g. limiting government to taxes on wages and salaries, or forbidding deficit financing);
- constraints on the structure of the tax rates imposed on allowed tax bases (e.g. permitting progressive taxes only); and
- constraints on government's monopoly position (e.g. imposing a federal rather than unitary system of government).
In the first two cases, the constraints directly affect the maximum revenue government can collect. In the third case, the constraint affects both revenue collected and, perhaps more importantly, the proportion of revenue that must be spent on general-benefit goods and services. That is, it imposes limits on government's discretionary use of its revenue.
The first two categories of constitutional constraints are not trivial, but the focus of this paper is on the third. The topics to be addressed include the role that a federal system of government, and the competitive pressures it introduces, can play both in constraining the size and growth of government and in increasing its responsiveness to general public demands.
FEDERALISM AS A CONSTRAINT UPON LEVIATHAN
The possible economic advantages of a federal system of government were discussed by Charles Tiebout in a 1956 paper, "A Pure Theory of Local Government Expenditures". Tiebout considered a system of local jurisdictions whose governments provided goods and services. The benefits were received, and taxes to support each government paid, only by residents in the jurisdiction. If citizens were able and willing to move from one jurisdiction to another, then, Tiebout argued, the jurisdictions would compete among themselves for the residency of the citizens.
The various jurisdictions would each offer bundles of government-provided goods and services, considered to be of value to current and prospective citizens, at the lowest possible tax price. The communities that were most responsive to citizen demands would experience immigration and growth, while those that failed to satisfy citizen demands would experience emigration decline. (8) With a sufficiently large number of jurisdictions, the range of preferences held by citizens (i.e. high tax/high service, low tax/low service, high level of education services/low quality roads, etc.) could be satisfied. Essentially, Tiebout's federal system of government serves as a competitive marketplace for goods and services provided by local government, analogous to the competitive marketplace for private goods, where the consumer shops among competing sellers and chooses the one that offers the product/price combination he or she likes best. (9)
A vitally important feature of Tiebout's model is the mobility of the citizens. It is assumed that citizens are free to move among the various jurisdictions to the one that suits them best and that the costs of doing so are insignificant. That is, there are no location advantages, such as employment or climate, that would lead citizens to require, or prefer, residence in one jurisdiction over another, and moving costs are zero. It is this mobility that forces jurisdictions to take notice of citizen preferences or face depopulation through emigration. Since the only sources of revenue available to a government are, ultimately, the income and wealth of its citizens, governments must seek to avoid losing their citizenry. Failure to do so means economic demise.
The Tiebout model shows the benefit of federalism as a constraint on Leviathan. Ignoring, for the moment, the central government, a mobile citizenry in a federal system of competing sub-national jurisdictions will serve to limit (a) the revenues collected by the local governments, and (b) the proportion of revenue that is devoted to the purposes of government agents rather than spent on goods and services of general benefit.
To see this, consider two jurisdictions where the governments offer the same level and range of goods and services. Citizens of both jurisdictions have identical incomes and tastes. If the proportion of the first government's revenues spent on general benefit goods and services is less than that for the second, it must raise a larger amount of revenue from its citizenry than does the second government. Citizens living in the first jurisdiction will observe that the cost of the government goods and services they receive is greater than if they resided in jurisdiction two. There, they would receive the same level of goods and services, at a lower tax price. Technically, their "fiscal residual" -- the difference between the tax price they pay and the value of the publicly-provided goods and services they receive -- in jurisdiction two would be greater than in jurisdiction one. If citizens were completely and freely mobile, citizens of jurisdiction one would "vote with their feet" and migrate to jurisdiction two.
Government one would be faced with two choices. It could reduce the revenues collected while increasing the proportion of revenue that went to general-benefit goods and services. In this way, it would better or exceed the performance of jurisdiction two. The second choice would be ceasing to exist.
In a system of many local jurisdictions, no government would be able to exploit its citizenry: that is, to do other than maximise their fiscal residual. Any attempt to exploit would cause instantaneous and complete (with zero moving costs) migration to another jurisdiction, one with a non-exploitive government. Though the tax/service bundles offered by governments might differ, no government would be able to exact a surplus from its citizenry. Each would be forced to provide its bundle of services at the lowest tax price possible or face fiscal extinction. Thus, though the level of taxation and expenditures might differ across jurisdictions, this would reflect differences in tastes. Importantly, the share of revenue spent on goods and services would be constant across all jurisdictions and would be the minimum necessary to finance the goods and services.
CAVEATS
The advantage of a federal state over a unitary state is the potential for competition for residents among governments at the same level of the federal hierarchy. To the extent that this competition is allowed to and is capable of flourishing, revenue constraints are imposed on government and its Leviathan characteristics held in check. Tiebout emphasised two reasons why this fiscal competition may be muted -- limited choice of tax/service bundles, and restricted mobility -- while Brennan and Buchanan added a third, inter-governmental collusion. Let us consider each in turn.
(a) Number of Communities
Tiebout assumed a large number of local jurisdictions offering competing tax/service bundles. If, however, the number of jurisdictions is limited, then the range of tax/service bundle choices will also be limited. Some or many citizens will then not find their ideal tax/service bundle; they will choose the jurisdiction that comes closest.
The limited range of tax/service bundles creates an opportunity for fiscal exploitation by government. For example, assume the fiscal residual a citizen would receive from the tax/service bundle in jurisdiction A is $3,000, while the fiscal residual that would be received from the tax/service bundle in the citizen's next-preferred jurisdiction B is $2,000. In this case, the government of A could exact a surplus of $1,000 from the citizen without fear of emigration to B.
Furthermore, the fewer jurisdictions, the greater the possibility of interjurisdictional collusion for the purpose of fiscal exploitation. This matter is discussed below.
(b) Mobility
As previously argued, the effectiveness of federalism as a constraint on government's monopoly power depends on the mobility of the citizenry. If citizens stay put, the competitive pressures on government to maximise the percentage of collected revenues spent on general benefit goods and services are lessened, and the efficiency of federalism as a means of limiting the fiscal exploitation on the part of government is reduced. Reasons for not moving include: a limited range of jurisdictions to choose from; high moving costs; locational rents earned by economic resources (e.g. gold-mine engineering skills are worth more in Kalgoorlie than Adelaide); or simple locational preferences (e.g. preferring the beaches of Perth to those of Melbourne, or wanting to be near one's mother in Woy Woy).
If governments need not fear that their citizens will emigrate, constraints on their economic behaviour are loosened. Economic exploitation of citizens is possible, and generates a surplus for discretionary use by government agents. Governments will be able to generate a surplus equal to the difference between the value citizens place on living in their current jurisdiction and the value they would place on living in the next best alternative jurisdiction. For example, assume our gold mining engineer receives locational rents for her talents of $10,000 per year from living in Kalgoorlie rather than Adelaide, the next best alternative. The Kalgoorlie government could exact a surplus of up to this amount from her without risking her decamping to Adelaide. If our lover of beaches valued the differential in beach quality between Perth and Melbourne at $3,000, then the extent of fiscal exploitation the Perth government could undertake would equal $3,000 without threat to its economic viability. (10)
To the extent that the mobility of the citizenry is limited, for whatever reason, the constraining influence of a federal system of government is weakened and the monopoly powers of government are correspondingly strengthened. Governments will be able to exact whatever locational rents citizens receive from their choice of jurisdiction.
(c) Intergovernmental Collusion
Though Brennan and Buchanan argue that a federal system of government offers the potential of a constrained Leviathan, they recognised that governments would seek ways to circumvent the fiscal discipline imposed by competitive federalism. They argued that
[W]ithin a constitutionally designed federal structure, one would predict that there would be constant pressure by competitive lower-level governments to secure institutional rearrangements that would moderate competitive pressures. (11)
Such arrangements might take the form of lower-level governments agreeing on a common tax rate and tax base. This approach might be unstable as there is no effective enforcement mechanism. An alternative and more stable cartel might involve the central government's levying a uniform tax across all jurisdictions, sharing the revenues with the lower-level governments.
As already argued, competition among lower-level governments will drive taxes down to the level at which taxes paid by the citizenry equal the benefits received from the government goods and services provided. If, however, the lower-level governments collude with the central government to form a tax cartel, they will be able to exact a surplus for discretionary use. This tax cartel would involve lower-level governments ceding taxing powers to the central government that were previously exclusive to the lower level or shared by all governments.
The central government, now in a monopoly position with respect to the relevant tax base, can levy the revenue-maximising tax rate. It can collect more than the sum of revenues that could be collected by the individual lower-level governments. The central revenue would then be shared, with each lower-level government receiving at least what it would have collected under the competitive regime. The additional revenue would be shared among the central government and the lower-level governments. The lower-level governments' total share would be received in the form of inter-governmental grants.
The impact of this intergovernmental collusion on public sector size is felt in a number of ways. First, formation of the tax cartel enables governments to avoid the revenue constraints of a federal system of government with mobile citizens. By passing the revenue-raising responsibilities up the federal hierarchy to the central government (the one government in a federal system which faces no competition for citizens) lower-level governments are able to limit the impact of a mobile citizenry. (12) Citizens can no longer choose from among a range of tax/service bundles.
Second, competition among the lower-level governments on the expenditure side is also constrained, since a government faces a weakened threat of economic insolvency if it offers an unattractive package of goods and services. Regardless of the package offered and the number of citizens expressing a preference in favor of or against it, the revenue base of the government is assured through the tax-cartel agreement (at least until the agreement is re-negotiated). Thus citizens are much less able to impose their will on governments through the threat of emigration.
Third, grants from the centre tend to weaken the discipline imposed on lower-level governments that would otherwise have to finance expenditures from their own taxes. They blur the local taxpayers' perception of the true cost of local-government-provided goods and services. This is often called the "fiscal illusion" hypothesis. (13)
The separation of tax and spending powers serves to disguise the true cost of public services, creating the illusion that government is smaller than it actually is. The complex and indirect structure of taxes and expenditures results in an underestimation of the costs of locally-provided goods, resulting in an increased demand for local government output. Grants from higher levels of government are perceived by the residents to be partially paid for by residents of other localities (despite the fact that the recipients, in turn, will be paying for part of similar grants to other localities). In other words, the grants received are not perceived to be paid for out of the higher taxes levied by the grantor government. Therefore, the grants have both an income and a price effect on the local demand for public goods. The resulting size of the local public sector will be larger than would occur under a system of fiscally-independent localities.
Finally, when taxing powers are concentrated in the hands of the central government, the range over which it can apply its monopoly power is expanded. The greater the range of economic activity over which the central government has taxing powers, the more potent its taxing powers are likely to be.
If taxing powers over economic activities are divided between the central government and the lower-level governments, taxes levied by the central government may be avoided by changes in the economic activities the taxpayer undertakes. For example, if labor income is a central government tax base while consumption expenditures are a lower-level government tax base, then income taxes levied at the revenue-maximising rate by the central government may be partially avoided if the taxpayer consumes more leisure and fewer other goods and services. If the central government had taxing powers over both tax bases then taxes could be levied on goods complementary to leisure, thereby offseting the effect of tax-avoiding changes in economic activity on the part of the taxpayer. (14) The potency of the central government's revenue-maximising powers is likely to increase disproportionately with increases in the tax bases available to it.
3 EMPIRICAL TESTS OF THE
BRENNAN/BUCHANAN HYPOTHESIS
Evidence of the impact of a federal system of government on the size of the public sector is relatively scarce outside the United States. In this section, we consider what constitutes a federal structure, and how the various relationships might be quantified. We then examine the available evidence.
DEFINING FEDERALISM
In considering the impact of federalism on the behaviour of the public sector, it is necessary to clarify what is meant by a federal structure of government. The Australian Constitution clearly establishes two levels of government, the Commonwealth and the States, each with both independent and coordinate functions. While the Commonwealth/State system is legally a federal structure, in some respects it fails to qualify economically. In some areas, the States act merely as agents for the Commonwealth, policy decisions being made at the Commonwealth level with administrative control delegated to the States. An obvious and extreme example is the provision of higher education services. Though constitutionally an independent function of the States, in practice higher education programs are the exclusive domain of the Commonwealth government.
In contrast, local governments have no legal standing under the Australian Constitution: they are creations of the State constitutions. Though they are creations of the States, economically they operate with a reasonable degree of independence from the States. Australian local governments are considerably more "revenue independent" of the States than the States themselves are of the Commonwealth. (15)
It is therefore necessary to distinguish between a decentralised federal structure and a deconcentrated federal structure. Under a decentralised structure, the decentralised units possess truly independent decision-making power, whether constitutionally guaranteed or not, and the provision of services reflects the demands of the residents of the decentralised units. Under a deconcentrated structure, however, the units possess no independent decision-making power. Service levels are determined at the central government level and need not reflect the demand of residents of the units.
To serve as a constraint on Leviathan-like behaviour, the appropriate structure must be a decentralised federal system. Lower-level governments must be independent of the central government. To create a market for local public goods, the level of services provided must reflect local demand. While constitutional guarantees are secondary to the workings of such a system, their existence can only serve to strengthen the competitive nature of a decentralised system.
MEASURING DECENTRALISATION
The principal hypothesis to be examined is that "total government intrusion into the economy should be smaller, ceteris paribus, the greater the extent to which taxes and expenditures are decentralised". (16) In the various attempted empirical tests of the Leviathan hypothesis, "government intrusion" has been measured as government's share of total economic output. This has been defined in one of two ways: either as total government tax receipts as a percentage of gross domestic product (abbreviated as "TXP"), or as total government outlays as a percentage of GDP ("SIZE").
The disadvantage of TXP is that it ignores debt-financed government spending. For OECD countries, government borrowing as a percentage of GDP averaged 1.4 per cent for the period 1960-1984. In Australia, the government deficit has averaged 3.5 per cent of GDP for the period 1950-84. As total expenditures must be balanced by total finances, the use of SIZE avoids this problem. SIZE more closely measures government's resource absorption and hence provides a more complete measure of public sector size.
Public sector decentralisation can be measured as expenditures (or revenues) of the lower-level governments as a percentage of total public sector expenditures (or revenues): "DEC1". This definition assumes that grants to lower-level governments are completely fungible -- that they are not effectively tied to specific expenditure programs. Such grants may represent the payoff from collusive arrangements between the grantor and lower-level governments (lower-level governments would presumably prefer their payoff in the form of untied grants so as to maximise their discretionary power).
An alternative definition would assume that grants are not fungible and that lower-level governments are serving essentially as the agents of the grantor government in administering the grant-targeted programs. Grants would be more a reflection of the grantor government's paternalistic desire to ensure some minimum service levels rather than a payoff from a collusive agreement. In this case, the extent of decentralisation would best be measured as lower-level government outlays financed by own-source revenue as a percentage of total government outlays: "DEC2". This would more accurately reflect the lower-level governments' fiscal independence of the grantor government.
Finally, it might be recognised that some grants (unconditional grants) are not tied to specific programs and are therefore fully fungible while others (specific purpose grants) are so tied and therefore are much less fungible. In this case, decentralisation would be measured as lower-level government outlays financed by own-source revenues plus unconditional grants, all as a percentage of total government outlays: "DEC3".
For some studies for the United States, non-fiscal measures of decentralisation were used. In one case, decentralisation was measured by the total number of competing local governmental units: "LOC1". This definition may, however, overstate the extent of competition, because it assumes that all units have a similar influence on public sector size. Given the wide range of powers held and functions performed by local government units, this is probably unrealistic. An alternative measure is the number of general-purpose local governments: "LOC2". LOC2 excludes the many single-purpose governments such as school, water, and sewer districts which may overlap the boundaries of the general-purpose governments. Many of these single-purpose units have no authority to levy taxes and have no full-time employees. Specifically, LOC2 is defined as population per general-purpose government. The greater the population per unit, the more limited is the range of residence choice and the less fiscal competition one is likely to observe.
To circumvent the discipline of a truly decentralised federal structure, governments may seek to collude regarding tax and expenditure policy. Governments may try to reach agreements with regard to tax bases and/or tax rates. Uniformity of tax policies weakens the discipline that may be imposed on governments by a mobile citizenry by limiting the range of available alternatives.
If governments seek to form a tax cartel to circumvent the discipline imposed by a federal system, a likely by-product will be inter-governmental grants. Under a tax cartel, lower-level governments would become more fiscally dependent upon the grantor government. One measure of the extent of fiscal dependence is intergovernmental grants as a percentage of total lower-level governments' finances: "FDEP1". This definition assumes that all grants represent payoffs to the lower-level governments for their agreement to the tax cartel and cession of their taxing powers to the grantor government.
An alternative definition recognises the difference between unconditional grants and specific purpose grants. Local governments entering into a cartel arrangement would be reluctant to give up the freedom of untied revenues collected from local taxes in return for grants tied to specific programs. Specific purpose grants may be interpreted as reflections of the grantor government's paternalistic interest in service levels of local government programs, as previously argued. Unconditional grants are more likely to reflect tax cartel payoffs. Following this line of argument, fiscal dependence would be measured as unconditional grants as a percentage of total lower-level governments' finances: "FDEP2". Contrariwise, the ratio of specific purpose grants to total lower-level governments' finances ("SPG") may measure the grantor government's paternalistic pressures.
The author prefers the use of FDEP1. In any tax cartel arrangement, the ultimate payoff is likely to be a compromise between the recipient governments' desire for the freedom of unconditional grants, and the grantor government's desire to exert control via specific-purpose grants.
EMPIRICAL EVIDENCE -- INTERNATIONAL
In general, what empirical evidence there is -- it is summarised in Table 3.1 -- is not conclusive either for or against the Brennan and Buchanan position. In an early test of their fiscal decentralisation hypothesis, Oates observed no strong relationship between centralisation and public sector size for a sample of 43 countries. Increased centralisation led neither to increased nor decreased public sector revenues. Oates concluded that "... the extent of centralisation in the public sector appears to have little effect on the size of government". (17)
Table 3.1 Decentralisation and Public Sector Size: Results of Various studies
| Author | Sample | Public Sector Size Variable | Decentralisation Variable | Intergovernment Grants Variable | Conclusion |
| Oates (1985) | 43 countries a | TXP | DEC1 | FDEP1 | not supportive |
| 48 US.States a | TXP | DEC1 c LOC1 | FDEP1 FDEP1 | not supportive not supportive | |
| Saunders (1986) | 22 OECD countries a | SIZE | FED b | n/a | supportive |
| Nelson (1987) | 48 US States a | TXP | DEC1 d LOC2 | FDEP1 FDEP1 | not supportive supportive |
| Nelson (1986) | 48 US States a | TXP | LOC2 | n/a | supportive |
| Marlow (1988) | United States e 1946-1985 | SIZE | DEC1 | n/a | supportive |
| Grossman (1989) | United States e 1946-1986 | SIZE | DEC1 | FDEP1 | supportive |
Notes:
a Cross-sectional studies
b Dummy variable 1 = federal state; 0 = otherwise
c Estimated for both revenues and expenditures
d In one case adjusted for state expenditure responsibilities
e Time-series study
n/a = not applicable
An intriguing finding which Oates does not discuss is the positive relationship between public sector size and intergovernmental grants. Brennan and Buchanan's intergovernmental collusion hypothesis would predict that increases in the extent of transfers between governments would lead to increases in public sector size. Intergovernmental grants are one means by which governments can avoid the fiscal discipline of federalism. The positive relationship Oates reported between grants and public sector size offers some support for the Leviathan view of government.
Saunders's study of the factors influencing public sector size in OECD countries provides evidence that supports the Brennan and Buchanan decentralisation hypothesis. Saunders examined the historical, cultural, political and institutional determinants of public sector size and growth. He found that, other things being equal, federal states have a public sector size approximately 7 per cent smaller as a percentage of GDP than do non-federal countries. (18)
EMPIRICAL EVIDENCE -- UNITED STATES
The most extensive empirical testing of the Brennan and Buchanan fiscal decentralisation hypothesis has been undertaken for the United States. Again, the evidence is mixed.
In addition to his study for the international sample, Oates also tested the impact of fiscal decentralisation on public sector size for the 48 contiguous states of the US. As with the international sample, Oates was testing Brennan and Buchanan's fiscal decentralisation hypothesis, ignoring the intergovernmental collusion caveat. He found only a weak negative relationship between his two fiscal centralisation variables and public sector size. The same weak relationship was also observed between the non-fiscal index of decentralisation and public sector size. As with his international sample, Oates concluded that there was no evidence to support "the view that decentralisation constrains the size of the public sector". (19)
But Oates's results for the United States do indicate a positive relationship between public sector size and intergovernmental grants, just as he found for his international sample. This finding is consistent with Brennan and Buchanan's intergovernmental collusion caveat. I have explored this relationship elsewhere. (20)
Suggesting that Oates's measures of decentralisation were inappropriate, (21) Nelson retested the decentralisation hypothesis using more sophisticated measures of decentralisation. His reported results provide support for the decentralisation hypothesis: non-fiscal centralisation has a consistent and positive impact on public sector size as measured by the tax variable TPX. Unlike Oates's findings, however, Nelson's do not support the intergovernmental grants hypothesis. Increased intergovernmental grants do not appear to either increase or decrease public sector size.
In an earlier paper, Nelson examined the impact of constitutional constraints on revenue base and tax rate structure and the degree of decentralisation on public sector size. As in his comment on Oates's paper, he found that increased non-fiscal centralisation has a strong positive impact on public sector size, no matter how defined, consistent with the Leviathan hypothesis. The results for his fiscal centralisation variable are, however, less supportive of the hypothesis. Thus, again, the evidence is mixed as to the Leviathan hypothesis. However, the importance of choice, as measured by nonfiscal decentralisation, comes through. (22)
Marlow questioned the findings of Oates and Nelson on two grounds. First, he argued that they tested the fiscal decentralisation hypothesis for only a part of public sector activity (state and local as opposed to federal, state, and local). By ignoring the federal government, they excluded a major component of public sector activity, in recent years more than half. Marlow concluded that their methods "provide, at best, weak tests of the decentralisation -- total government size hypothesis". (23) He also suggested that Oates and Nelson underestimated the total impact of government by measuring centralisation using TXP rather than SIZE.
Correcting for these errors, Marlow found that decreased centralisation of government expenditures had a significant and negative impact on government size, consistent with the Brennan and Buchanan hypothesis. Increased fiscal decentralisation reduced both the absolute size of the public sector and its rate of increase.
Finally, as I have argued elsewhere, the papers by Gates, Nelson, and Marlow emphasise the issue of fiscal decentralisation -- public sector size to the exclusion of Brennan and Buchanan's inter-governmental collusion hypothesis. (24) Although Oates and Nelson include an intergovernmental grants variable in their analysis of the United States data, it is little discussed and they do not refer to the collusion issue. Furthermore, and contrary to expectations, in Nelson's study the grants variable appears unrelated to public sector size. This may be because, as Marlow noted, Oates and Nelson were testing the decentralisation hypothesis on the size of state and local governments, a subset of total public sector activity. Marlow, though not specifically addressing the collusion issue, treats grants as an expenditure of the granting government, rather than of the government that receives and finally spends them. He thus partially controls for the impact of government collusion on total public sector size.
I extended Marlow's analysis to consider the impact of intergovernmental collusion. The results were consistent with Marlow's, but also indicated that the fiscal discipline imposed by decentralisation of taxing and spending powers can be circumvented by collusive agreements among lower-level governments and the central government. Increased federal grants had a strong positive impact on public sector size and growth.
4 THE EVIDENCE FOR AUSTRALIA
Australia has not been spared the past few decades' experience of rapid public sector growth. In this section, we examine the record of public sector growth in Australia and the evidence of the effect on this growth of centralisation of expenditures at the Commonwealth level and Commonwealth intergovernmental grants.
GROWTH IN THE AUSTRALIAN PUBLIC SECTOR, 1950-1984
The Australian public sector (measured as SIZE, total public sector outlays as a percentage of GDP) has grown from 28.2 per cent in 1950 to 41.5 per cent in 1984 (see Figure 4.1), equivalent to an annual rate of 1.1 per cent. After a sharp jump and then a decline between 1950 and 1954, the Korean War years, SIZE experienced a slow but steady growth, from 27.4 per cent in 1954 to 31.3 per cent in 1969. Between 1969 and 1974, public sector size was a relatively stable 31 per cent of GDP. This stability was interrupted by a sharp jump to 36.5 per cent in 1974, the last year of the Whitlam government. For the remainder of the 1970s there was a relative stability in SIZE. Finally, the early 1980s were years of vigorous expansion, SIZE increased from 37.0 per cent in 1980 to 41.5 per cent in 1984.
Figure 4.1 Public Sector Size in Australia, 1950-84
Source: Norton and Kennedy (1986)
Over the same period, there has been either a slight increase or a slow decline, depending on the definition of decentralisation adopted, in the importance of the State and local sector (see Figure 4.2). State and local government outlays as a percentage of total government expenditures (DEC1) increased from 42.7 per cent in 1950 to 47.0 per cent in 1984. At the same time, State and local outlays financed by own-source revenues as a percentage of total government expenditures (DEC2) declined from 28.7 per cent to 24.0 per cent. For most of the 35-year period, DEC1 and DEC2 followed much the same pattern. Commonwealth grants and States' own-source revenues tended to fluctuate in a countervailing pattern. In 1970, this ended and own-source revenues began to decline in relative importance. Between 1970 and 1984, DEC1 increased from 38.5 per cent to 47.0 per cent, while the increase in DEC2 was only from 21.6 per cent to 24.0 per cent.
Figure 4.2 Decentralisation in Australia, 1950-84
Source: Norton and Kennedy (1986)
The hypothesis that greater fiscal decentralisation would constrain the growth of the public sector, would suggest that this increase in the State and local sector, as measured by DEC1 (or the decline as measured by DEC2), would be inversely correlated with the growth of total public sector size. If the State and local sector becomes economically more relevant, the competition among lower-level governments minimises the fiscal exploitation of resident taxpayers.
Throughout this period, intergovernmental grants have been a major source of State and local finances. Historically, most Commonwealth grants have been unconditional: until 1973, unconditional grants accounted for more than 70 per cent of the total. Starting in 1974, the role of specific-purpose grants grew dramatically until by 1976 they constituted 50 per cent of all grants. This reflected policy decisions of the Whitlam government. Since 1976, specific-purpose grants have slowly declined in relative importance, to 42 per cent of all grants in 1984.
Though specific-purpose grants are theoretically tied to specific expenditure programs, the recipient State governments have seldom effectively been required to match the funds from other resources. (25) There has been little to prevent "grants displacement"; that is, the use of specific-purpose grants to replace own-source-financed expenditures. The freed own-source revenues can then be employed for any expenditure program. As the matching provisions imposed on specific-purpose grants have, generally, been non-binding, all grants are treated here as unconditional.
Grants as a percentage of total State and local finances (FDEP1) have increased from 46.5 per cent in 1950 to 51.3 per cent in 1984 (see Figure 4.3). This relatively small change for the total period masks more dramatic changes within sub-periods. Between 1952 and 1960, the relative importance of grants declined steadily to approximately 34 per cent of total State and local finances. Figure 4.2 shows that own-source revenues increased to fill this gap in State finances. Over the next ten years, FDEP1 changed little, increasing to only 35.8 per cent. The period 1970 to 1976 was one of rapid growth in FDEP1. By 1976, it had reached 50.0 per cent. Over the remaining years until 1984, FDEP1 remained stable. During this period, growth in own-source revenues failed to match that for intergovernmental grants; hence the widening gap between DEC1 and DEC2. This implies an increasing degree of fiscal dependence of the States on the Commonwealth.
Figure 4.3 Intergovernmental Grants In Australia, 1950-84
Source: Norton and Kennedy (1986)
This increased relative importance of grants suggests a weakening of the fiscal discipline faced by governments. Relaxed constraints on revenue would be expected to lead to expanded activity by government. As government became less constrained by fiscal competition, its overall size would be expected to increase.
Statistical Evidence of the Impact of Centralised Expenditures and Intergovernmental Grants on Public Sector Size
The present author has tested the Brennan/Buchanan hypotheses using time-series data for Australia. (26) No support was found for Brennan and Buchanan's decentralisation hypothesis: estimates of the impact of both DEC1 and DEC2, measured in both absolute value and as growth rates, on SIZE found no significant relationship. These results suggest that increased fiscal decentralisation does not generate the Tiebout-style competition among State and local governments as envisioned by Brennan and Buchanan. They are dramatically different from findings reported for the United States, where DEC1 was found to have a strong negative impact on public sector size. (27)
With regard to intergovernmental grants, the FDEP1 variable had the expected strong, positive impact on public sector size. This is strong evidence for the intergovernmental collusion hypothesis. The evidence suggests that grants do enhance the governments' (Commonwealth and State) monopoly power. By weakening the tax competition among governments, grants lessen the budgetary constraints they face. This separation of taxing and spending responsibilities disguises the true cost of public services. This encourages "fiscal irresponsibility" and permits expansion of the public sector. Furthermore, the uniformity of taxes created by such collusion limits the range of choices available to the citizenry and thereby neutralises the discipline imposed on governments by a mobile population. This finding is consistent with the evidence for the United States. (28)
Thus, in the context of the existing Australian public sector, efforts to shift economic power from the Commonwealth to the State and local governments would not reduce the size or slow the growth of the public sector through Tiebout-style competition. However, it would have these effects due to a reduction in the monopoly power of the governments as revenue raisers, and by imposing greater fiscal discipline on all governments.
Why the Inconsistent Results?
In light of this contradictory evidence regarding the impact of fiscal decentralisation on public sector size for the United States and for Australia, it is worth considering what differences exist between the two countries that might explain the results observed. In chapter 2, we discussed the important assumptions underlying the basic Tiebout model upon which the Brennan and Buchanan hypothesis was built. Tiebout noted two caveats to his model: (a) choice as represented by the number of competing jurisdictions, and (b) the mobility of citizen-voters. We consider the importance of these two factors in explaining the contradictory results for Australia relative to those for the United States. We also consider a third factor affecting Australia, the economic role played by local governments.
(a) Number of Lower-Level Governments
The Brennan and Buchanan fiscal decentralisation hypothesis argues that competition for the patronage of voters, and the tax base they represent, serves to constrain the revenue-maximising instincts of the governments. But for competition to exist, there must be a range of viable choices open to the voter. The importance of choice is evidenced in two studies by Nelson, who reported a strong and positive relationship between public sector size and population per multi-function government. (29) That is, the more decentralised the population, the smaller the public sector. One expects that the greater the range of viable locational choices, the more decentralised would be the population.
In Australia, the range of choices, relative to that in the United States, is small. At the State level, Australia has only six States plus the Northern Territory and the Australian Capital Territory versus the fifty States and the District of Columbia in the United States. At the local level, Australia had 840 local government authorities in 1983. This compares with more than 22,000 multi-function governments in the United States in 1982. (30) Furthermore, population per multi-function local government in Australia is twice that for the United States. Thus, the range of choice and the scope for competition is much greater in the United States than in Australia.
More importantly, the small number of lower-level governments in Australia enhances the ability of the governments to form collusive agreements both with the Commonwealth government and among themselves. The difficulty in reaching and policing a collusive agreement is likely to be much less in Australia than in the United States because fewer parties are involved. This is even more so due to the peripheral nature of local governments in Australia. The insignificance of the decentralisation variables seems to support this argument. Even if the States were completely fiscally independent of the Commonwealth, the small number of States in Australia makes collusion among the States easier and more likely than in the United States.
(b) Mobility of the Citizenry
The fact that Australia is geographically the size of the continental United States but with less than 5 per cent the number of lower-level governments implies that the average size of the geographical area served by a governmental unit is relatively large. In addition, Australia is a highly urbanised country with 61 per cent of its population in 1984 living in the immediate metropolitan areas of the six capital cities and the capital of the Northern Territory. An additional 9 per cent live in the six other major cities of 100,000 or more persons. (31) This concentration of population combined with the relative geographic isolation of the major metropolitan areas (32) does little to enhance the mobility of the citizenry, but rather increases the locational rents that the governments can exact. Though there may be scope for Tiebout-style competition at the local level, this is likely to be marginal due to the relative economic insignificance of local governments as previously noted.
(c) The Economic Insignificance of Local Governments
Although a sufficient number of local government units may exist to foster competition, their economic importance is slight. In 1984, local government expenditures accounted for approximately 11 per cent of total State and local expenditures. As a percentage of total government outlays, local government expenditures accounted for approximately 6 per cent. In the United States, the corresponding figures are approximately 60 and 25 per cent respectively. The economic insignificance of local governments is mirrored in the limited range and relative unimportance of functions for which local governments have responsibility. Functions that are major determinants in voters' location decisions -- for example, education -- are local functions in the United States but State functions in Australia. (33)
This factor may actually serve to enhance the ability of local governments to reach intergovernmental collusive agreements. Thus, though there may be a sufficiently large number of local governments to encourage effective fiscal competition, their economic insignificance is lively to make their impact only marginal.
The combination of these factors serves to limit the fiscal discipline imposed by decentralisation of government taxing and spending powers. At the same time, they enhance the ability of lower-level governments to collude amongst themselves and to exploit their locational advantages.
5 THE DEATH OF DEATH DUTIES:
EVIDENCE OF TIEBOUT-STYLE MIGRATION
The evidence cited so far is consistent with the Tiebout hypothesis of competition among sub-federal jurisdictions, but it is not direct evidence that such competition actually occurs. It does no more than suggest that citizens shop among the available jurisdictions and that the jurisdictions, recognising this, attempt to offer attractive tax/service bundles as a lure to current and prospective residents.
The ability of citizens actually to respond to variations in tax/service bundles is limited by various economic and non-economic factors. As already noted, citizens may receive locational rents, either because their skills earn them more where they live than they would elsewhere or for non-pecuniary reasons -- such as beaches. To move in response to variations in available tax/service bundles may involve forgoing some of these rents. It would involve direct moving costs. Thus, the decision to move reflects a weighing of the increased benefits received from residence in the jurisdiction with the most preferred tax/service bundle against the cost incurred in making the move.
Furthermore, many moves may be unrelated to short-term variations in economic relativities, but instead may occur in response to changing preferences over an individual's life. That is, even if fiscal relativities remained constant over time, so that from a Tiebout hypothesis perspective the system is in equilibrium, interstate migration may still occur. For example, during one's working years, one's preferences may be for residence in an urban centre with its greater employment prospects and higher average income level. Upon retirement, residence in a rural setting, with its slower lifestyle and lower cost of living, may be preferred.
Direct evidence of fiscally-induced migration is relatively scarce, whether for the United States or for Australia. One study by Aronson and Schwartz (1973) offers evidence for the United States. The abolition of death duties by Queensland in 1977 and the following, though not necessarily resulting, interstate migration towards Queensland is often cited as evidence of fiscally-induced migration in Australia.
ARONSON AND SCHWARTZ
Aronson and Schwartz examined population shifts among the towns in the Harrisburg, Pennsylvania urbanised area for the periods 1950-60 and 1960-70. The area was small (only 78 square miles in 1970), and they thought it unlikely that employment or commuting considerations were significant factors in choice of residence. They attempted to determine if the observed migration patterns during these periods could be predicted by a Tiebout-style model of fiscally-induced migration.
The authors estimated the imputed fiscal transfer (IFT) an individual (rich or poor) could expect to receive in each of the twenty-six localities in the urban area. IFT is defined as the difference between per capita expenditures of the community and taxes an individual would pay if residing in that community. (34) So long as the towns levy their taxes on a reasonably broad base, individuals with above average income will have a negative IFT, while individuals with below average income will have a positive IFT.
Figure 5.1 illustrates this. The horizontal axis measures individuals' income, while the vertical axis measures expenditures per capita and taxes. It is assumed that expenditures are for pure local public goods (pure in the sense that all residents of the providing jurisdiction receive an equal share of the goods). Line AA represents expenditures received by income level, which by assumption is constant across all incomes. If some broad-based tax, such as a property tax, is levied and an individual's property value is assumed to increase directly with the individual's income, then taxes paid at each level of income is given by BB. An individual's IFT would be measured by the vertical distance between AA and BB, at that individual's level of income. For individuals with income above Y*, where AA intersects BB, the IFT is less than zero; for individuals with income below Y*, the IFT is greater than zero; and for individuals with income of Y*, IFT is zero.
Figure 5.1 Estimating Imputed Fiscal Transfers
It was assumed that an individual would want to live in the community which maximised his expected IFT. By examining their potential IFT for each of the twenty-six towns, individuals could determine, based on their income, which town offered them the maximum IFT. Aronson and Schwartz determined the IFTs for rich and poor individuals to determine the likely direction of migration among the towns of the Harrisburg area.
They used this model to predict how the population in the Harrisburg area would redistribute itself over the two time periods. The model was correct in 70 per cent of the 54 predictions for 1950-60 and 89 per cent of those for 1960-70. Statistically, there was less than a 1 per cent chance that the number of successful predictions was due to chance. Aronson and Schwartz therefore concluded that fiscal factors are significant in determining the direction of migration.
QUEENSLAND DEATH DUTIES
In Australia, fiscally-induced migration is likely to be uncommon. While intra-urban area migration may be feasible for most Australian cities, the relative unimportance of the economic services provided by the local governments is not likely to induce significant migration. Per capita local expenditures in 1983-84 averaged only $291 (varying between a high of $359 in Queensland and a low of $204 in South Australia), less than 3 per cent of per capita household income. Furthermore, the geographic isolation of urban areas and the relatively large size of the States makes both intra- and interstate migration costly and introduces the employment location problem.
An often-cited exception to this assessment is Queensland's 1977 abolition of death duties on estates passing to either a spouse or a child. Queensland's action had a "snowball" effect on the other five States and on the Commonwealth government. In quick succession, New South Wales, Victoria, and South Australia abolished duties on estates passing to a spouse, with Western Australia and Tasmania following suit in 1978. The Commonwealth government abolished its death duties in 1979. Duties on estates passing to a child were maintained by the five States until 1980, when South Australia and Western Australia followed Queensland's example. Next to follow were New South Wales and Tasmania in 1982. Victoria completed the demise of death duties in 1983. (35)
The domino effect on death duties in the other five States and the Commonwealth government was not the only possible consequence of Queensland's act. A Tiebout-style model of fiscally-induced migration would predict a movement of population towards Queensland; in particular, a redistribution of the elderly population in favour of Queensland. The elderly are no longer constrained in their choice of residence by employment considerations -- i.e., the locational rent of their current place of residence is less than for working-aged individuals -- and thus are more mobile than the average Australian. Furthermore, with exemptions from death duties as low as only $12,000 in some States, "... the State death duties were important and weighed heavily on even modest estates ..." (36) Thus, moving to a State that did not tax estates passed on to heirs offered even moderate-income families the potential of significant savings on death duties. The present value of the savings realised by avoiding death duties may have been enough to more than cover moving costs plus any location rents.
The existing evidence of interstate population migration is consistent with the Tiebout hypothesis. Hugo examined the pattern of Australian migration for the period 1976 to 1981 and found a strong trend in interstate migration towards Queensland. (37) Over the five-year period, Queensland had a net increase in population from interstate migration of 74,293 persons. Of that, approximately half occurred during the last year. The only other State to show a net increase was Western Australia with 10,356 persons, net, moving to that State.
Although annual data on place of residence by age group were not available, the 1976 and 1981 Censuses allowed Hugo to estimate the intercensal flows of persons by age. His evidence indicates that Queensland was the only State to have a net gain of persons fifty years of age and over due to internal migration during this period. The influx of persons to Queensland was, however, not limited to the elderly. Hugo noted that, although elderly migrants were a significant minority, the pattern was repeated across the age spectrum, with the other dominant group being young families.
While this pattern of interstate migration is consistent with what the Tiebout hypothesis would predict would occur after the abolition of the death duties, there are alternative explanations. Queensland, because of its warm climate and attractive beaches, has long represented a retirement alternative for individuals from the southern States with their colder winters. While this lure of warm winters and lovely beaches may explain much of the attraction Queensland holds for many migrants, it is necessary to ask whether the 1976-81 experience reported by Hugo was uncommon or just a reflection of traditional patterns?
The evidence reported in Figures 5.2-5.7 suggests that the abolition of death duties in 1977 is a significant factor in explaining migration patterns in subsequent years for each of the six States. Each of the figures measures the increase (or decrease) in the State's population resulting from interstate migration for each of the years 1972 to 1985. While interstate migration is highly variable from year to year, there is for each of the States a fairly consistent difference between the 1977-1982 period and the preceding five-year period and subsequent three-year period.
Figure 5.2: Interstate Migration -- New South Wales
Figure 5.3: Interstate Migration -- Victoria
Figure 5.4: Interstate Migration -- Queensland
Figure 5.5: Interstate Migration -- South Australia
Figure 5.6: Interstate Migration -- Western Australia
Figure 5.7: Interstate Migration -- Tasmania
Looking first at Figure 5.4 for Queensland, it is obvious that migration into Queensland from the other five States began a dramatic climb starting from 1978. By 1980, migration into Queensland was exceeding 20,000 persons per year. The peak was reached in 1981 with more than 40,000 migrants to the state. By 1983, migration levels had fallen back to approximately 10,000 per year, more closely in line with the pre-1977 levels. This "spike" in Queensland's migration record coincides with the abolition of death duties (allowing a year or so lag to allow households to respond).
The patterns for Victoria, South Australia, and Tasmania (see Figures 5.3, 5.5, and 5.7, respectively) reveal just the opposite pattern. Each of these States had a downward spike reaching its nadir in 1980 or 1981. Victoria had shown steady emigration for the full period. From 1977, after recovering from an earlier (1975) severe spell of emigration -- possibly the aftermath of Whitlam's 25 per cent across-the-board tariff cuts of 1973 and/or the commodity boom of 1974-75 -- Victoria's emigration increased on the order of 60 per cent. In 1977, approximately 10,000 persons left the State; by 1981 the figure was 16,000 persons. Over the next two years, Victoria rebounded to its 1972 level of 4,500 emigrants per year.
South Australia also reveals a trough during the 1979-81 years (see Figure 5.5). In this case, however, this represents the end of a long downward slide which began with a peak in 1974. The spike in 1974 coincides with the large migration out of the Northern Territory in the wake of Cyclone Tracy in December, 1974. (38) Like Victoria, SA was likely to have been adversely affected by the tariff cuts and commodity boom of the early 1970s and the pre-1976 emigration may be explained by resulting labour market realignment. Emigration reached its peak in 1980 with more than 5,000 persons leaving SA. Migration showed only a marginal recovery during the next two years.
Tasmania's migration pattern is again similar (see Figure 5.7). Emigration did not begin to increase until 1979, though prior years were all ones of emigration. Between 1979 and 1981, the number of persons leaving Tasmania more than doubled and significant recovery did not occur until 1983.
Western Australia (Figure 5.6) was the only State other than Queensland to consistently gain population from the other states. Following a sharp jump in immigration in 1973-75, possibly a result of the tariff cut, Western Australia's inflow experienced a slowing which continued until 1981. (39) Immigration during the years 1978 to 1980 averaged only 1,300 persons per year in comparison to an average 3,900 persons per year for the full 14-year period. Finally, New South Wales (Figure 5.2) appears to be the one exception to the expected pattern. For the full 14-year period, NSW lost population to the other States. Average emigration was 11,500 persons per annum. However, contrary to expectations, 1978 and 1979 were years of well below average emigration; approximately 230 persons per year left NSW. It was not until 1980 and 1981 that significant emigration began again. Approximately 6,000 persons left NSW in 1980 and an exceptionally high 21,000 departed in 1981. Thus, if NSW was affected by Queensland's actions, this appears to have been significantly delayed and to some extent offset by other factors.
The present author has elsewhere found further evidence to support the fiscal migration hypothesis. Those States that levied death duties on estates passing to a child in years when Queensland did not do so, experienced either a slowdown in immigration from other States or an increase in emigration to other States. In the first three years after abolishing its death duty, Queensland's population growth rate due to interstate migration was approximately 25 per cent faster than before, while the other five states experienced growth rates due to interstate migration that were approximately 10 per cent slower on average. (40)
6 STRENGTHENING AUSTRALIA'S FEDERAL SYSTEM:
POLICY PRESCRIPTIONS AND SUMMARY
With the rapid growth of the public sector over the past three decades, economists have begun to turn their attention to ways of constraining the undesirable tendencies of government. This essay has examined one means of doing so: by creating greater competitive pressures on governments to better respond to the wants and needs of their constituents. This competitive pressure can be brought to bear by a federal system of government comprised of independent governments, each responsible for raising their own revenues to finance their outlays.
A federal system of fiscally independent governments offers mobile consumer-voters a range of choices as to the tax/service bundles offered by governments. Governments that seek to exploit their constituents and exact revenue for discretionary use will find their constituents migrating to competing jurisdictions offering more attractive tax/service bundles. As with a competitive market for private goods, a competitive market for public goods will provide the consumer-voter his most preferred mix of public goods at the lowest tax price.
The evidence cited in the preceding sections strongly suggests that government, both in Australia and in other countries, exhibits some of the characteristics of a Leviathan-like revenue-maximiser. The evidence also suggests that a decentralised -- federal -- system of government acts as a partial restraint on the Leviathan nature of government. But the evidence also strongly implies that governments have sought ways of circumventing this competitive pressure. One means that appears to have been effective is the formation of a revenue cartel. Through this revenue cartel, the states, in collusion with the Commonwealth government, have been able to avoid the responsibility of raising the revenue to fund their own outlays. This has led to a weakening of the constraints on government's overall revenue-raising ability. The small number of States in Australia has eased this process.
In this section, we consider policy prescriptions for Australia. The suggestions are merely an outline of reforms consistent with the desired ends; a detailed program of reforms is beyond the scope of this paper.
The policy suggestions made are designed to help break the revenue cartel that is the Australian federal fiscal system. The suggestions seek to reimpose -- upon the States -- fiscal responsibility. (41) To do this requires relaxing the stranglehold the Commonwealth government currently exercises on revenue-raising powers, and the virtual monopoly of the State governments on major service programs. In all, the purpose is to inject more competition into the public sector and to reestablish the link between government outlays and revenue collection. The policy recommendations are designed to serve two purposes:
- to reduce the dependence of State governments on Commonwealth largesse by passing down to the States greater, and truly independent, revenue-raising powers; and
- to increase competitive pressures on State and local governments by passing down greater expenditure authority.
Some of the policy prescriptions made are not new. In some cases, the same suggestions, such as amending Section 90 of the Constitution and the introduction of state personal income taxation, have been made numerous times before. (42) Others are relatively new proposals for Australia. The institutional restructuring required to implement some policy proposals may be severe, but the recommendations here have been limited to those involving minimal institutional restructuring; though even in these cases, the restructuring may appear extensive.
Achieving greater fiscal independence for the State governments will involve significant reductions in transfers from the Commonwealth. To meet this goal, the following prescriptions are offered.
(1) Reduction in Commonwealth Revenue Assistance Grants
Commonwealth grants to the States should be made only for the purpose of equalising for tax base deficiencies. (43) By applying a given rate of tax to the appropriate base, each State should be capable of raising revenue equal to the statewide revenue per capita. To the extent a State falls short of this level, it would be provided equalising grants sufficient to bring it up to the State average. At a minimum, States should be equally well placed to fund a uniform level of basic services, and ideally, States should have equal tax base per capita to draw upon. This reduction in grants would be offset by a partial withdrawal by the Commonwealth from income and sales taxation, giving the States access to these bases.
Obviously, the ability of a State to meet this uniform level of basic services even after tax base equalisation is dependent upon differences among the States in the cost of providing these services. However, we do not suggest the Commonwealth attempt to equalise for cost differentials. This position is taken for two reasons. First, apparent cost differentials may merely reflect State policy decisions rather than true cost differentials. For example, two States may each operate local commuter rail systems but at different costs per passenger mile (or whatever other standard one wishes to apply). The cost differential may reflect true differences in the cost of providing the service arising from, for example, differences in terrain; or it may represent policy decisions: for example, manning levels may have been set in response to union featherbedding pressures, or the choice of capital equipment -- electric versus diesel -- may have been made with an eye to supporting a local industry. Grants to compensate for cost differences arising from policy decisions can encourage the continuance of inefficient methods of service provision.
We propose not that governments be prevented from making decisions to support local industries or unions, but that if they should do so, the cost incurred be borne by the local taxpayers and not exported, through cost equalisation grants, to taxpayers in other States who have had no say in the decision.
Second, equalising for cost differentials may encourage continued residence in high cost areas by removing the disincentive to do so. If individuals receive private benefits from residing in a high-cost area, then it is they who should pay the cost of making this choice, not the public at large. If, however, it is in the national interest to further the development of certain high-cost areas of Australia, this should be explicitly stated and the necessary support provided. Grants to further this national goal should, however, be made directly to the affected parties and not to the State government in question.
(2) Commonwealth Withdrawal from Special Purpose Grants
Under Section 96 of the Constitution, the Commonwealth is empowered to make conditional grants to the States. This power has been thoroughly exercised, with approximately $8,500 million in specific purpose grants made in 1986. Major expenditure items include universities and Colleges of Advanced Education, schools, roads, housing, and local government tax-sharing. Constitutionally, these are areas of State responsibility. (44)
In principle, special purpose grants have a role to play in the funding of publicly-provided goods with spillover benefits (i.e., where the benefits from the good "spill over" onto other localities). But one of their by-products is that the Commonwealth government is able to extend its paternalistic influence into areas previously beyond its control. For the States, it has meant loss of control of expenditures and of the ability to respond to the special needs and wants of their constituents.
This is most clearly seen in the case of the current debate over the future structure and role of the tertiary education system. The debate has been undertaken almost to the exclusion of any input from the nominally governing bodies, the State governments. The Commonwealth has put forth dramatic proposals for the restructuring of the tertiary system. These suggestions have shown little regard for any local and/or regional needs or goals the States might have for their institutions. The current debate is clearly an application of the maxim, "he who pays the piper calls the tune".
To re-establish State independence in setting expenditure priorities, we suggest the Commonwealth remove itself from functions that are appropriately and constitutionally the States' domain. To this end, the Commonwealth should significantly reduce its program of special purpose grants.
This is not to deny that Commonwealth special purpose grants to the States can sometimes further national or regional interests. These interests, as well as States' interests, would be better served, however, if the Commonwealth took direct responsibility for the relevant function, if the national interest were the overriding interest, or more precisely targeted the group to be benefited. For example, the Commonwealth might have a clear interest in seeing that access to tertiary level education is available to students of lower socio-economic groups. This policy need not require total funding of universities et al. by the Commonwealth, but instead, could be implemented by grants (i.e. scholarships) made directly to members of the target groups or grants made to the States specifically for this purpose, rather than more generally for funding tertiary institutions. In general, special purpose grants need to be better directed to the specific program of interest, with their conditions narrowly defined to that aspect of the program that has spillover effects or that is of national interest. Broad-brush grants allow Commonwealth intrusion in areas solely of State interest.
The ultimate consideration is that the States should have final say in the range and structure of the expenditure programs they administer. Commonwealth special purpose grants and their attending conditions impose a uniformity across the States. A narrowing and restructuring of these grants will allow nation-wide interests to be addressed while at the same time allowing the States to better respond to the particular needs and wants of their constituents -- which are not necessarily the same in all States.
(3) Partial Commonwealth Withdrawal from Personal Income Taxation
A reduction in Commonwealth grants to the States would leave the States financially strapped and would require either that greater burdens be placed on existing State tax bases or that new tax bases be exploited. The major State tax, the employer payroll tax (accounting for 28 per cent of total taxes collected in 1986-87), prima facie discourages employment, which argues more for limiting its exploitation than for extending it. (45) Thus, new tax bases must be made available to the States.
The most obvious candidate is personal income. States were offered, under Eraser's "New Federalism" policy, the opportunity to levy surcharges (or provide rebates) on Commonwealth income tax collections, but were reluctant to do so. The high personal income tax burden imposed by the Commonwealth made States scared to add to it. The Wran government's "double taxation" campaign when the Fraser government first advanced the surcharge initiative only served to heighten States' reluctance to impose income tax surcharges.
If the Commonwealth withdrew its grants, as proposed in propositions (1) and (2), there would be sufficient surplus in the Commonwealth's budget to allow for income tax cuts to make room for State entrance into the income tax field. For purposes of illustration, it is worth considering an income tax for grants tradeoff proposal advocated by Walsh. (46)
Walsh estimated that a 10 per cent income tax levied by Victoria would generate revenue equal to its share of projected 1987-88 (Commonwealth) general revenue funds. Owing to lower per capita income in the other five States, this tax rate would have not have generated sufficient funds fully to replace the lost grants. These shortfalls could have been met from Commonwealth equalisation grants. Overall, Commonwealth general revenue grants could have been cut from a projected $13,500 million to $2,300 million. To make room for the 10 per cent State income tax, the Commonwealth would have had to cut its proposed income tax rates by approximately 10 percentage points each. If special purpose grants were scaled back as recommended above, this would allow even greater cuts in Commonwealth tax rates.
Thus, it is possible for the Commonwealth to scale back its level of assistance to the States without any significant adverse impact on either the Commonwealth budget or the States' ability to meet their existing expenditure commitments. The details of the implementation of States' income taxes and integration with the Commonwealth system, while considerable, need not be insurmountable. Issues such as whether to adopt a uniform Income Tax Assessment Act, (47) the setting and changing of Commonwealth and State tax rates, and the collecting and disbursing of revenue would be subject to negotiation among the affected governments. The important consideration would be freedom of the States in determining the answers to these questions, whether that be in coordination with the other States and the Commonwealth or independent of the other parties.
Finally, it should be noted that whatever room the Commonwealth should make for State income taxation need not be filled by the States. On the other hand, it may be more than filled. The determination of the State income tax to be imposed would be an issue to be decided at the individual State level. The level of State income taxation would have to be set in conjunction with decisions on the range and magnitude of expenditure programs a State wished to undertake. We do not mean to imply that all States would impose the same tax rates on the same tax base.
The purpose of returning income-taxing powers to the State is to introduce greater tax competition into the Australian system. Imposed uniformity with respect to base and rates would offer little improvement over the current system. It is the potential for variations across the States that creates the choice necessary in a Tiebout-style federal system and creates the incentives for governments to improve their service to their constituents.
(4) Provision for State Retail Sales Tax
To complement the Commonwealth's partial withdrawal from personal income taxation, it is proposed that Section 90 of the Constitution be amended to permit States to levy a retail sales tax. (48) Rates of taxation would be determined individually by the States.
This proposal has the advantage of providing States with a substitute or complement to the personal income tax. Although Brennan and Buchanan recommend limiting the range of tax bases available to government, this is a policy decision to be made by a State's consumer-voters. Whether a sales tax would be used in conjunction with, or as a substitute for, the personal income tax would be determined by each individual State. State voters may prefer limitations on rates, rather than on bases.
Increased financial independence of the States may do much to weaken the revenue cartel. It may also expand the range of policy options on tax/service bundles available to State governments. However, its ability to expand the range of effective choices available to the individual consumer-voter may be limited. This has much to do with the institutional structure of the Australian system: the limited number of States and the geographical isolation of the major population centres. If a greater range of effective choice is to be made available, then it can best occur at the local government level. The greatest potential for significant fiscal competition among governments exists in major population centres. The number of local government authorities within the six capital cities ranges from seven in Mobart to fifty-six in Melbourne. However, the existing economic insignificance of local governments makes useful competition unlikely. Not many people decide where to live on the merits of parks, libraries, and garbage collection. To encourage this greater competition and choice, the following policy proposal is offered.
(5) Transfer of State Expenditure Functions to Local Governments
We suggest that States devolve responsibility for certain expenditure categories to local governments. In particular, it is suggested that local governments be granted control over schools. For many households, the location and quality of schools plays a major role in deciding where to live. Granting local governments responsibility for local schools creates the potential for significanl differentiation of local governments on the basis of tax/service bundles offered. For example, communities wishing to attract young families with children would offer high quality education services, while communities more geared to the elderly would emphasise an alternative mix of services.
This proposal has the drawback that access to quality schools may be location-determined if funding is locally raised. That is, community A will be resistant to school-aged children from community B attending schools in A if A finances its schools from local revenues. To avoid this problem, we suggest schools be State-funded through a system of vouchers provided to families with school-aged children. These vouchers would be redeemable at any school and their value could be tied to a family's income status. This system would permit localities the freedom to operate the type of school system they deem appropriate while enabling a family to choose that school which provides the educational services and environment most in tune with the family's preferences.
To fund other services (police and fire services are the two prime candidates in mind) devolved to local governments, local governments could be given the option to piggyback on the States' retail sales tax. Local governments would be permitted to levy a set rate, over and above the State rate, on the States' tax base. The maximum rate a local government would be permitted to levy would depend on the expenditure responsibility devolved to the local governments. Revenue collected in a locality would be shared accordingly with the locality. This would minimise administrative and compliance costs.
APPENDIX
Grossman (1988) tested two hypotheses:
- That decreased fiscal decentralisation contributes to increased public sector size; and
- That increased intergovernmental collusion, as measured by intergovernmental grants, also contributes to growth in the public sector.
To test these hypotheses, the following equations were estimated:
SIZE = a0 + a1DEC + a2FDEPl + a3X + et (1)
where SIZE, DEC (equation (1) was estimated for both DEC1 and DEC2), and FDEP1 are as defined in Chapter 4, and:
X = control variables; and
e = a random disturbance term.
Two control variables were considered. Y is real (1981 dollars) disposable income per capita. Y controls for the Wagner's Law influence on demand for public sector goods and services. P, population in millions, acts as a scale variable.
All data were drawn from either Norton and Kennedy (1986) or Butlin (1977).
Table A.I reports the regression results. (Estimates of the equation using growth rates were also obtained. Results were consistent with those reported.) Equation (1.1) reports the results for the simple regression of SIZE on DEC2, a simple test of the decentralisation hypothesis. Only results for DEC2 are reported here; results for regressions using DEC1 were similar. Equation (1.2) includes the two control variables but not FDEP1. Both equations were subject to significant serial-correlation (at the 95 percent level of significance) and the results reported for these equations are for the equations adjusted using the Cochrane-Orcutt technique.
The results reported for equations (1.1) and (1.2) offer no support for Brennan and Buchanan's decentralisation hypothesis. The coefficients for DEC2 are positive, contrary to expectations, and not significantly different from zero. The results suggest that increased fiscal decentralisation does not generate the Tiebout-style competition among state and local governments that Brennan and Buchanan envisaged. These results are dramatically different from those reported for the United States by Marlow (1988) and Grossman (1989), who found DEC2 to have a negative and significant impact on public sector size in each of their corresponding equations.
Of the control variables, only P is significant. The positive coefficient suggests that government goods and services suffer from congestion problems or diseconomies of scale. The negative, though insignificant, coefficient for the PY variables suggests that public sector size is an income-inferior good. (The estimated coefficients for the control variables are likely to be imprecise due to a high degree of multicollinearity between the variables.)
Equations (1.3) and (1.4) report results for the regressions including FDEP1. Again, both equations were subject to significant serial-correlation and the results reported are for the Cochrane-Orcutt technique-corrected regression.
With the inclusion of FDEP1, the explanatory power of the equations is increased. Inclusion of FDEP1 does nothing, however, to improve the explanatory power of DEC2. The coefficients of DEC2 are still positive and continue insignificant, providing further support for the conclusion that Tiebout-style competition is nonexistent at the state and local levels in Australia. The positive coefficients for FDEP1, however, provide strong evidence in support of the intergovernmental collusion hypothesis. The evidence suggests that grants do enhance the Commonwealth's monopoly power while also encouraging fiscal irresponsibility at the state and local levels. This finding is supportive of those reported by the present author for the United States. Thus, efforts to shift economic power from the Commonwealth to the state and local governments would not reduce the size or slow the growth of the public sector through Tiebout-style competition. However, it would have these effects due to a reduction in the monopoly power of the Commonwealth government as revenue-raiser and by imposing greater fiscal discipline on state and local governments.
The signs and significance of the coefficients for the control variables are unaffected by the inclusion of FDEP1.
Table A.1: Regression results for tests of the Fiscal
Decentralisation and Intergovernmental Collusion Hypotheses
| Variable | Estimated Coefficients | |||
| (1.1) | (1.2) | (1.3) | (1.4) | |
| DEC | 0.114 (0.94) | 0.102 (0.81) | 0.039 (0.33) | 0.034 (0.28) |
| GRT | ... ... | ... ... | 0.313* (2.67) | 0.294* (3.20) |
| PY | ... ... | -0.001 (0.88) | ... ... | -0.002* (1.24) |
| P | ... ... | 2.381* (2.88) | ... ... | 2.229* (3.25) |
| CONT | 30.772* (5.82) | 8.031 (1.14) | 18.207* (3.00) | 0.562* (0.09) |
| R2 | 0.845 | 0.873 | 0.866 | 0.902 |
| D.W. | 1.635 | 1.473 | 1.728 | 1.722 |
| RHO | 0.955 | 0.799 | 0.903 | 0.653 |
* Significant at the 95 per cent level, two-tailed test.
Notes: All regressions corrected for serial-correlation using the Cochrane-Orcutt technique. Absolute value of t-statistic in parentheses.
ENDNOTES
1. The Wealth of Nations, page 14.
2. It is possible that individuals may not agree on which groups deserve government benevolence. Furthermore, the political system may push altruistic governments into undertaking unaltruistic actions.
3. The primary focus of economists has been in trying to determine the causes of this expansion. A number of theories have been advanced. See Buchanan, "Why Does Government Grow?", and Mueller, "The Growth of Government: A Public Choice Perspective" for a survey of the theories.
4. The field of "Public Choice" economics concerns the study of non-market decision-making; the application of economic methods to politics. Early works in the field include Black, The Theory of Committees and Elections; Buchanan and Tullock, The Calculus of Consent; and Downs, An Economic Theory of Democracy. An excellent review of the literature is found in Mueller, Public Choice.
5. Brennan and Buchanan, The Power to Tax, page 16. The concept of Leviathan government was first introduced by Thomas Hobbes (1588-1679) in his Leviathan (1651). To Hobbes, "Leviathan" or unconstrained government was the only alternative to anarchy.
6. Op. cit. page 28.
7. A simple representation of the model assumes that government seeks to maximise the surplus, S, available for discretionary use by the government's decision-makers. Government is, however, assumed to be constrained to expending a set proportion, a, of revenues, R, on public goods and services of benefit to the general public, G. That is:
(1) G = aR
where 0 < a < 1. The surplus is given by
(2) S = R - G
which can be rewritten as S = (l - a)R. Assuming a is constant, then maximisation of S requires maximisation of revenue, R. If a is not constant -- the more relevant assumption in the context of a federal system of government, the focus of this paper -- then S can be increased by either increasing R or reducing a.
8. This assumes that governments can cease to exist due to lack of economic viability, and that there is an effective means of forming new governments.
9. In addition, a federal system of government may enhance the ballot box pressures already inherent in a two-party political system. For example, popular changes adopted in one jurisdiction may spill over to another, not due to migration, but rather due to perceived political pressures. The sitting party in the second jurisdiction may feel compelled to adopt the policy of the first jurisdiction to forestall its opposition from using the policy as an issue in a subsequent election.
10. These are restricted and artificial examples, of course. Suppose the mining engineer loves the beach to the extent of $3000? That will reduce her exploitability: the Kalgoorlie government cannot extract more than $7000 surplus from her before she heads for the coast.
11. The Power to Tax, page 182.
12. The central government may, however, face competition from the lower-level governments over tax bases. Flowers ("Shared Tax Sources in a Leviathan Model of Federalism") makes an argument for separation of taxing powers by different levels of government. Competing, but different-level, revenue-maximising governments sharing a tax base will lead to combined tax rates on the backward-bending portion of the Laffer curve: i.e. tax rates so high that further increases would reduce revenue while "tax cuts" would increase revenue.
13. For a more thorough discussion of the concept of fiscal illusion, see Buchanan and Wagner, Democracy in Deficit, and Oates, 'On the Nature and Measurement of Fiscal Illusion: A Survey".
14. Consolidation of taxing powers is not necessary. Coordination by the two levels of government could serve the same purpose. For example, central taxes on income could be complemented by lower-level taxes on leisure products, thereby closing off the taxpayers' substitution possibilities.
15. In 1984, own-source revenues comprised 71.7 per cent of total revenues of local governments. The comparable figure for State governments was 44.5 per cent.
16. Brennan and Buchanan, The Power to Tax, page 15.
17. Gates, "Searching for Leviathan", page 754.
18. Explaining International Differences in Public Expenditure: An Empirical Study. Saunders used a dummy variable "TED". For states with a federal structure FED = 1. For all other states, FED = 0. Saunders does not indicate how he defines a federal state.
19. Oates, op. cit., page 753.
20. Grossman, "Fiscal Decentralization and Government Size: An Extension".
21. Nelson, "Searching for Leviathan: Comment and Extension", page 198.
22. Nelson, "An Empirical Analysis of State and Local Tax Structure in the Context of the Leviathan Model of Government".
23. "Fiscal Decentralization and Government Size", page 264, emphasis in original.
24. Grossman, "Fiscal Decentralization and Government Size: An Extension".
25. Tertiary education grants prior to 1974, the Hospital cost-sharing grants between 1975 and 1981 (for all States except South Australia and Tasmania), and the Commonwealth/State Housing Agreement grants are three notable exceptions.
26. Grossman, Fiscal Decentralization and Public Sector Size in Australia. The basic approach developed by Marlow ("Fiscal Decentralization and Government Size") and Grossman ("Fiscal Decentralization and Government Size: An Extension") was followed. See the Appendix for a more thorough discussion of the empirical results.
27. See pages 25-25 above.
28. Grossman, "Fiscal Decentralization and Government Size: An Extension".
29. "An Empirical Analysis of State and Local Tax Structure in the Context of the Leviathan Model of Government"; "Searching for Leviathan: Comment and Extension".
30. Australian Bureau of Statistics; U.S. Department of Commerce.
31. Between 1950 and 1984, the share of Australia's total population residing in the six capital cities plus Canberra, Gold Coast and Townsville -- the only cities with 1984 population in excess of 100,000 persons for which consistent historical series were available -- increased from 51.5 per cent to 64.9 per cent. Figures are from unpublished data from the Australian Bureau of Statistics.
32. The two closest State capitals, Hobart and Melbourne, are more than 600 kilometres apart. The average distance between State capital cities is 1,700 kilometres (based on most direct air route).
33. Evidence for the United States suggests that, ceteris paribus, the greater education expenditures per pupil, the greater the demand for housing in a community: see Gates, "The Effects of Property Taxes and Local Public Spending on Property Values", and Edel and Sclar, "Taxes, Spending, and Property Values: Supply Adjustments in a Tiebout-Oates Model".
34. Education expenditures would be the largest single component of local government expenditures. The measure of taxes paid was based on real estate property taxes, which were the principal source of revenue for the local governments.
35. The response of the five States may not have been in reaction to fears of their population's emigrating to Queensland, but rather in reaction to internal pressures. State governments may have feared death duties becoming an important issue at their next election. (This point was brought to my attention by Cliff Walsh.) The quick response of most States with regard to death duties on estates passing to a spouse would suggest this is a likely explanation.
A cursory review of State elections between 1975 and 1983 does not, however, offer strong support for this thesis in regard to death duties on estates passing to a child. If this issue exerted internal pressures on State political parties, it was uneven across states and generally slow to exert itself. Four of the ruling governments survived one election between 1977 and the years they abolished all death duties. Only in South Australia did the first election subsequent to 1977 bring about a change of government.
This ballot-box-pressure argument may be more applicable to the Commonwealth, since it need not fear emigration of its elderly citizens. Repeal of the death duty was an issue in both the 1975 and 1977 federal elections. However, how important a campaign issue it was is hard to judge. The Whitlam government was turned out in 1975 even though it pledged to abolish death duties, while the Eraser government, offering a similar promise in 1977, was re-elected.
36. Pedrick, "Oh! To Die Down Under!", page 120.
37. Hugo, "Interstate Migration in Australia, 1976-81".
38. Cyclone Tracy destroyed approximately 80 percent of the domestic building stock in Darwin. In the wake of the cyclone, approximately 35,000 persons, 75 percent of the total population, were evacuated from Darwin, many to other states (see Darwin Disaster: Cyclone Tracy, Report by Director General, National Disaster Organisation on the Darwin Relief Operation, 25 December 1974-3 January 1975), Many of the transported residents were classified as residents of their state of refuge for 1974. Data for the subsequent years do not show a substantial increase in migrations to the Northern Territory as refugees returned to Darwin.
39. The migration data do not suggest that Western Australia immigration flows increased significantly following Cyclone Tracy.
40. Grossman, "Fiscal Competition among the States in Australia: The Demise of Death Duties".
41. The recommendations also have the advantage of imposing greater fiscal responsibility on the Commonwealth government, by introducing competition between the States and the Commonwealth over tax bases and by more clearly delineating Commonwealth/State responsibilities.
42. See for example Walsh, "Reforming Federal Financial Relations: Some Radical (or are They Conservative?) Proposals", and "The Distribution of Taxing Powers Between Levels of Government: The Possibility of State Income Taxation Reconsidered".
43. Some dispute even the necessity for tax base equalisation grants (see e.g. Courchene, Equalization Payments: Past, Present and Future).
44. This is particularly true with regard to local governments. Local governments have no basis in the Australian Constitution, but rather are creatures of the State constitutions. They exist by the consent and at the grace of the State governments.
45. Evidence of the incentive effects of the payroll tax is scarce. One study examined the inter-industry effects of replacing the payroll tax with an income tax surcharge, and concluded that this would lead to the creation of an extra 175,000 jobs (based on 1977-78 data): Chapman, R. and Vincent D., "Payroll Taxes in Australia".
46. Walsh, "The Distribution of Taxing Powers Between Levels of Government: The Possibility of State Income Taxation Reconsidered".
47. An important question would be whether the States and the Commonwealth adopted a uniform tax base. There are persuasive arguments both for and against this idea.
48. Amendment of Section 90 is not strictly necessary: a change in the High Court's interpretation of Section 90 coulci also validate State retail taxes.
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