Tuesday, May 19, 2015

Federalism and economic growth

In a recent paper by J.W. Hatfield ("Federalism, taxation, and economic growth." Journal of Urban Economics, 2015. A draft version can be found here.) the author shows that federalism and the resulting competition for capital leads to a tax policy that maximizes economic growth. From the conclusion:

"Our work shows that federalism, and the attendant competition for capital, will drive tax policy to the growth maximizing level, while a centralized government will choose tax policy that does not maximize growth....When many districts exist, competition will drive the districts to choose tax policies that maximize the private rate of return and hence the growth rate of the economy. A centralized government, by contrast, will choose to maximize its own objective function, the welfare of the median voter..."

Their model does make some important assumptions that do not exactly match reality, namely that labor is completely immobile and that all capital is mobile. Neither assumption is true, since labor i.e. workers are able to move to new locations and some capital, such as buildings and roads, are immobile once they are built. But a lot of capital is relatively more mobile than labor, which is the primary reason countries often tax capital gains at lower rates than labor income. Because there are international capital markets capitalists are able to invest their capital where it will get the highest rate of return.

What this paper does show is that municipal and state competition is an important condition for generating economic growth. Just like in the business world, competition encourages governments to produce the stuff that people want. When people are able to vote with their feet government officials must be attentive to the needs of their constituents. If people are unable to exit the jurisdiction of a bad government there is less of an incentive for the government to change course. The federal government can afford to be less attentive than the state governments, and the states less than the cities, towns, and villages, because it is harder to leave the US than it is to leave South Carolina or the city of Clemson.

Competition is also important because it fosters innovation. Economist and Nobel Prize winner F.A. Hayek noted that competition is a discovery process. He explained that we need competition to help us discover what are the best ways of doing things. Because firms have to compete with each other for customers they are continuously looking for new and better ways to provide a good or service that already exists or create a new good or service that satisfies a consumer want. Firms need to provide consumers with value, and that means giving them what they want at the lowest possible cost. Competition ensures that firms are always on the lookout for new ways to create more with less, which keeps prices low and conserves resources that can then be used on other things. Competition between governments fosters similar outcomes.

In the business world it is well known that monopolies stifle innovation, reduce output, and charge high prices. But it is less understood by the general public that a government monopoly leads to these same bad outcomes. Federalism is important and needs to protected. It helps create the conditions necessary for innovation and economic growth, both of which make us all better off.

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