We propose a theory of tax centralization in politico-economic equilibrium. Taxation has dynamic general equilibrium implications which are internalized at the federal, but not at the regional level. The political support for taxation therefore differs across levels of government. Complementarities on the spending side decouple the equilibrium composition of spending and taxation and create a role for inter governmental grants. The model provides an explanation for the centralization of revenue, introduction of grants, and expansion of federal income taxation in the U.S. around the time of the New Deal. Quantitatively, it accounts for approximately 30% of the federal revenue share’s doubling in the 1930s, and for the long-term increase in federal grants.
University of Copenhagen, Department of Economics Discussion Paper 17-18, July 2017, with Martin Gonzalez-Eiras. PDF.
We propose a theory of tax centralization and intergovernmental grants in politico-economic equilibrium. The cost of taxation differs across levels of government because voters internalize general equilibrium effects at the central but not at the local level. The equilibrium degree of tax centralization is determinate even if expenditure-related motives for centralization considered in the fiscal federalism literature are absent. If central and local spending are complements, intergovernmental grants are determinate as well. Our theory helps to explain the centralization of revenue, introduction of grants, and expansion of federal income taxation in the U.S. around the time of the New Deal. Quantitatively, the model can account for the postwar trend in federal grants, and a third of the dramatic increase in the size of the federal government in the 1930s.
On VoxEU, Steven Durlauf offers an excellent overview over Kenneth Arrow’s work. Durlauf emphasizes five areas of research:
- The impossibility theorem, in the tradition of Condorcet.
- General equilibrium theory and the welfare theorems, in the tradition of Walras.
- Decision-making under uncertainty, the Arrow-Pratt measures of risk aversion and contingent commodities.
- Imperfect information, in the context of medical care and as a source of statistical discrimination.
- Economics of knowledge, anticipating the endogenous growth literature.
Like Faust, limitless curiosity and passion for knowledge meant that Arrow strove without relenting; but unlike Faust, Arrow needed no redemption. His intellectual integrity was pristine and unparalleled at every stage of his life. His character was as admirable and admired as his intellect. Arrow’s personal and scholarly example continues to inspire, nurture, and challenge.
On his blog A Fine Theorem, Kevin Bryan discusses the history of economic thought leading from the classical economists and Walras to Arrow and Debreu.
My read of the literature on GE following Arrow is as follows. First, the theory of general equilibrium is an incredible proof that markets can, in theory and in certain cases, work as efficiently as an all-powerful planner. That said, the three other hopes of general equilibrium theory since the days of Walras are, in fact, disproven by the work of Arrow and its followers. Market forces will not necessarily lead us toward these socially optimal equilibrium prices. Walrasian demand does not have empirical content derived from basic ordinal utility maximization. We cannot rigorously perform comparative statics on general equilibrium economic statistics without assumptions that go beyond simple utility maximization. From my read of Walras and the early general equilibrium theorists, all three of those results would be a real shock.
VoxEU, October 11, 2016, with Martin Gonzalez-Eiras. HTML.
- The US fiscal system underwent a radical transformation around the time of the Great Depression.
- Perceived cost differences of revenue collection across levels of government, due to general equilibrium effects, can partly explain the rise of tax centralization and intergovernmental grants.
- We develop a micro-founded general equilibrium model that blends politics and macroeconomics. (See the working paper.)
We propose a theory of tax centralization and inter governmental grants in politico-economic equilibrium. The cost of taxation differs across levels of government because voters internalize general equilibrium effects at the central but not at the local level. This renders the degree of tax centralization and the tax burden determinate even if none of the traditional, expenditure-related motives for centralization considered in the fiscal federalism literature is present. If central and local spending are complements and the trade-off between the cost of taxation and the benefit of spending is perceived differently across levels of government, inter governmental grants become relevant. Calibrated to U.S. data, our model helps to explain the introduction of federal grants at the time of the New Deal, and their increase up to the turn of the twenty-first century. Grants are predicted to increase to approximately 5.5% of GDP by 2060.