Decentralized taxation and the size of government: evidence from Swiss state and local governments.

• Author: Feld, Lars P.

It is better to keep the wolf out of the fold, than to trust to drawing his teeth and claws after he shall have entered.

Thomas Jefferson (1)

1. Introduction

   According to studies (Oates 1972, 1985, 1999; Brennan and Buchanan 1977, 1980) on the impact of fiscal federalism on the size of government, fiscal competition between jurisdictions is hypothesized to restrict the ability of governments to over-spend or to excessively tax citizens. Following Brennan and Buchanan (1980), governments are better able to behave as revenue-maximizing Leviathans in a centralized as compared to a decentralized system, because the threat of migration restricts government behavior. (2) If sub-central jurisdictions enjoy tax autonomy, they find themselves competing for mobile tax bases. The ensuing tax competition leads to lower public revenue and forces governments to adjust their publicly provided goods and services to the preferences of mobile taxpayers, in order to enhance the efficiency of the public sector, or to cut spending by dropping less important public projects. The more decentralized a country is, the more intensive fiscal competition is supposed to be. A higher fragmentation of a state into sub-central jurisdictions also facilitates fiscal competition as migration becomes less costly.

   In the empirical literature on the effects of decentralization on government size, (3) the potential transmission channels through which decentralization reduces public sector size are not fully investigated. On the one hand, decentralization of revenue or spending (Oates 1972, 1985) and fragmentation (e.g., Oates 1985; Nelson 1987; Zax 1989) are taken mainly as indicators of tax autonomy and, thus, of the intensity of tax competition. As such, both indicators serve only as proxies for fiscal competition if sub-central governments enjoy sufficient fiscal powers, in particular sufficient tax autonomy. When sub-central governments use the grants received from the federal government mainly to finance their spending needs, fiscal competition cannot fully unfold because fiscal equalization systems can be seen as collusive arrangements between sub-federal governments. Thus, several authors (Grossman 1989; Grossman and West 1994; Jin and Zou 2002; Rodden 2003) acknowledge the role of grants and establish a decentralization effect despite the influence of grants. On the other hand, further potential forces that affect government size and performance in fiscal federalism are seldom considered. In his survey on fiscal federalism, Oates (1999) emphasizes that tax exporting and laboratory federalism may be such alternative mechanisms. Tax exporting allows sub-central governments to spend more than their citizens want to finance, while laboratory federalism leads to political innovations. The different mechanisms prevalent in systems of fiscal federalism may also interact, for example, to compensate for each other, as can be argued with respect to the opposing impacts of tax competition and tax exporting (Sorensen 2004). If the different mechanisms of fiscal federalism can be identified empirically, a more precise picture may be drawn as to how fiscal decentralization affects government size.

   The purpose of this article is to analyze empirically whether a decentralization of the power to tax to sub-federal jurisdictions has an impact on the size and structure of government revenue of Swiss cantons from 1980 to 1998. The main contribution of the article stems from the identification of the different mechanisms by which revenue decentralization might influence the size of the public sector. We distinguish tax competition, tax exporting, and fragmentation empirically as three potential transmission mechanisms that affect government size. The residual impact of decentralization could be interpreted as evidence for laboratory federalism (Oates 1999). Switzerland is particularly suited for such a test because it provides unique data of sub-federal governments. In addition, Swiss cantons and local jurisdictions have extensive tax autonomy with respect to the quantitatively important and progressive taxes on income and property.

   The remainder of the article is organized as follows: The different transmission channels by which fiscal federalism affects government size are discussed in section 2. In section 3, the Swiss tax system is explained in order to demonstrate the importance of sub-federal Swiss taxing powers. Data issues and the specification of our econometric model appear in section 4, while section 5 relates the obtained results. Finally, section 6 provides some concluding remarks.

2. Transmission Channels of Fiscal Federalism on the Size of Government

   What are the channels by which fiscal federalism affects government size? According to Brennan and Buchanan, emigration imposes a serious restriction on the ability of governments to exploit tax bases. If emigration is possible at low cost, tax bases can avoid excessive taxation by leaving the jurisdiction that levies taxes. In their decentralization hypothesis Brennan and Buchanan (1980, p. 185) conclude that "total government intrusion into the economy should be smaller, ceteris paribus, the greater the extent to which taxes and expenditures are decentralized." A similar interpretation of fiscal federalism is provided by Oates (1972). He argues that political agents have a better knowledge of the preferences of their constituency if the fiscal power is decentralized, such that the provision of public goods can be tailored more efficiently to their needs. The Wicksellian (1896) connection between spending and taxing decisions is much tighter on the local than on the federal level, which favors a smaller size of government. On the other hand, as Oates (1985) mentions, if local governments have more information about the preferences of citizens than do central governments and, therefore, if public services can be better tailored to the needs of voters, this might increase their demand for public spending, leading to a larger share of government. (4) In another analysis, Persson and Tabellini (1994) demonstrate the importance of decentralization in restricting government discretion to exploit the fiscal commons.

   Despite the emphasis on exit as a disciplinary device, it is not clear which mechanism leads to smaller government. Brennan and Buchanan (1977, 1980) provide for a first transmission channel by developing their fragmentation hypothesis: The competitive impact of fiscal federalism depends on the number of possible alternative jurisdictions that are available for voters and firms and the transaction costs that migrations induce. The more jurisdictions that exist, the less costly is emigration. They argue that "the potential for fiscal exploitation varies inversely with the number of competing governmental units in the inclusive territory" (Brennan and Buchanan 1980, p. 185). Epple and Zelenitz (1981) show that with increasing numbers of jurisdictions the scope for taxation diminishes without disappearing entirely. In a political economics model in which voters have a group-based social conscience, Lind (2007) hypothesizes that social fractionalization reduces political support for redistribution and thereby also reduces the size of government. From a regional perspective, fractionalization results in a more fragmented territory when individuals sort themselves into more diverse communities, thus inducing a smaller government sector. Of course, decentralization and fragmentation could also lead to inefficiencies since increasing returns to scale in the consumption of public goods cannot be fully exploited (Sinn 2003). With respect to the impact of fragmentation on government size, competing results could thus be obtained.

   A second argument for the dampening impact of decentralization on government size stems from the tax competition literature and could be called the tax competition hypothesis (see Wilson [1999] for a survey). In particular, with respect to public revenue, a more intense tax competition will lead to lower tax rates of the mobile high-income recipients and thus to lower tax revenue. Mobile taxpayers move to jurisdictions with--ceteris paribus--lower tax rates. The lower the mobility costs, the higher the pressure for a jurisdiction to compete with other jurisdictions by lowering tax rates as well. The result is a smaller government sector. As Fuest and Kolmar (2007) argue, tax competition could also shift the revenue structure from broad-based taxes to user fees and charges if the government provides private goods to a nonnegligible extent in addition to public goods. In this case, the exclusion mechanism allows governments to compensate the revenue decline that is due to migration of mobile factors with revenue from user charges and fees.

   The pressure to reduce the size and scope of the public sector by a decentralization of government is reduced by the possibility of tax exporting (tax exporting hypothesis). Taxes are exported to nonresidents if they pay some of the taxes of foreign jurisdictions. State and local jurisdictions thus have an incentive to provide public services at a higher level. An example of tax exporting can be found in the taxation of tourist trade or of natural resources in some U.S. states. Already for the year 1962, McLure (1967) estimated for the U.S. states that overall tax export rates were between 19% and 28% in the short run. Tax exporting need not be restricted to natural resource taxes. It is also possible in the case of corporate income taxes on foreign-owned firms (Fuest and Huber 2002; Sorensen 2004).

   While Oates (1972) emphasizes the advantage of a decentralized government with respect to preference costs of centralized provision of public services, Oates (1999) more strongly underlines the role of laboratory federalism. A decentralized competitive government structure allows for experimentation with new public policies without...