How do local governments set policy in the presence of mobile factors, spillovers, and information flows?

For answers, see our article "Local Policy Choice: Theory and Empirics" (w/ @WilliamHHoyt and @WilsonJayD), forthcoming in @AEAjournals J. Economic Literature.

Thread

Full paper is available here:
https://www.aeaweb.org/articles?id=10.1257/jel.20201490&&from=f

The emphasis of the article is on how local governments set policy.

But first: why should local policy determination be of interest to all economists?
#EconTwitter #TaxTwitter #UrbanEcon

Many classic problems in economics deal with externalities, imperfect competition, imperfect information, and undesirable distributions of economic well-being. The literature on local policy choice provides interesting applications into each of these issues.

(1)Both tax and expenditure decisions by local governments impose externalities on non-residents. The externality from the same policy can have different signs under different conditions.

(2)Imperfect competition may actually be welfare enhancing in tax competition models because large jurisdictions face less elastic supplies of capital, reducing the degree to which they lower taxes below the efficient levels in their attempts to attract investment.

(3)Imperfect information, which is central to political economy models of local government behavior, has conflicting effects in some cases.

(4)Factor mobility across localities constrains the ability of local governments to redistribute income. One response of higher-level governments is to intervene in the decision-making and responsibilities of local governments.

Our review then discusses how local governments set policy and, implicitly, how policy would be different if set at the national level. A motivating goal is to understand and predict *policy outcomes.*

Some topics we cover are discussed below:

We first describe various mechanisms of policy determination at the local level, including fiscal competition, yardstick competition, and expenditure spillover models. All of these mechanisms result in policy functions that have the same reduced form.

We emphasize theoretical models of fiscal competition. Whereas the tax competition literature previously found that competition can lead to inefficiencies across jurisdictions, bidding for firms raises the possibility that firm subsidies may allocate firms efficiently.

Two types of competition:
(1) if the local area faces a perfectly elastic supply of capital, then price-taking jurisdictions do not strategically compete for capital with any one other jurisdiction.
(2) with market power, governments may interact strategically.

Taxes and spending are related via the government budget constraint and local governments offer a package deal. What governments spend money on and how people value this spending are important. Studies that focus on a single fiscal policy have only limited relevance.

Next, we discuss local government decision-making in dynamic settings, where decentralization may affect economic growth. Decentralized policymaking may come with efficiency-enhancing benefits, including increased growth-enhancing total investment and labor productivity.

A distinguishing feature of local governments is that they set policies in the presence of constraints set by state or national governments. We examine -theoretically and empirically- how government behavior is influenced by fiscal equalization policies, including school finance.

Next, the empirical literature on policy determination has focused on reaction functions. Fiscal competition, yardstick competition, and expenditure spillovers have the same reduced-form reaction functions, and we discuss creative ways to identify the form of the interactions.

However, the empirical absence of strategic interactions between a jurisdiction and its “neighbors,” does not preclude the existence of decentralized *competition* and a resulting divergence from the policies that a central government would undertake.

Whether strategic interactions are positive or negative says little about the welfare implications of policy interdependence, the race to the bottom, or whether equilibrium policies are higher or lower than those that would be set by a welfare-maximizing central government.

We discuss how a tighter link between the literature on fiscal competition and the literature on policy-induced migration/mobility can help determine if governments compete for factors rather than interact for other reasons. We need more work connecting models with empirics.

The paper also discusses capitalization, the degree of spillovers, policy-induced migration elasticities, debt policy, zoning, regulatory policy, and place-based policies, among other topics.

Finally, a synthesis model, containing multiple mechanisms and fiscal instruments, resolves some puzzles and provides guidance for future research.

To help guide future research and add value to PhD courses using the review, most sections also have our own reflections:
(1) What are important empirical questions generated by the theory literature and vice-versa?
(2) What important open questions remain for future modeling?

How governments choose policies has implications for analyzing the policy effect. When estimating behavioral responses, researchers often exploit local variation. Understanding policy determination is essential to developing strategies to identify the effects of policy.

We are grateful to @sndurlauf for his support of this topic, his excellent guidance throughout the process, and his patience with us writing this survey.

We also appreciate the researchers who provided us with comments on earlier drafts or encouraged us while writing. Some on twitter are: @Marius_Brulhart @Thiess_Buettner @drlisadcook @StacyDickertC @nhendren82 @cailin_slattery @J_C_Suarez @omzidar