A New Approach to Evaluating the Welfare Effects of Decentralized Policies

Abstract

Local policies result in benefit-spillovers, mobility, capitalization, fiscal competition, and interjurisdictional fiscal externalities that are not internalized by the government enacting the policy. The inefficiencies of these forces are well-known, but the prior literature is missing three things: a comprehensive treatment of all the relevant spillovers, a careful method of quantifying the extent of the spillovers, and a determination of the federal subsidy/tax necessary to eliminate the inefficiencies of decentralization.  We quantify these spillovers through a new metric, the "marginal corrective transfer'' (MCT)---the intergovernmental grant necessary to induce a locality to internalize all interjurisdictional externalities. The MCT can be compared across policies, and thus explicitly ranks policies on the extent of the inefficiencies from decentralization.  An empirical recipe book is provided to estimate the MCT using various approaches, including a sufficient statistics methodology relying on capitalization.  Empirically, we show local human capital policies should be subsidized by the federal government while race-to-the-bottom policies should be taxed. 

Keywords: marginal value of public funds, fiscal competition, fiscal externalities, welfare, spillovers, mobility, capitalization, grants, fiscal federalism. JEL: H22, H25, H77, I20, L10, L50, D50, R50, benefit-cost analysis

JEL Classification: H22, H25, L10, L50, D50