The flypaper effect: Identifying areas for further research

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1 Public Choice 95: , Kluwer Academic Publishers. Printed in the Netherlands. 335 The flypaper effect: Identifying areas for further research STEPHEN J. BAILEY & STEPHEN CONNOLLY Department of Economics, Glasgow Caledonian University, Glasgow G4 0BA, Scotland, U.K. Accepted 31 October 1997 Abstract. The flypaper effect literature dates back three decades. It is overwhelmingly neoclassical in approach, attempting to improve the median voter demand model and/or temper it with public choice supply-side perspectives. Whilst this approach provided valuable early substantial analytical insights, more recent papers seem to have contributed only marginally to an understanding of the flypaper effect, if indeed it exists at all. Hence, as well as providing a long-overdue comprehensive review of the literature on the flypaper effect, this paper identifies more productive avenues for further research. 1. Introduction The flypaper effect relates to the impact on exhaustive expenditures of a general lump-sum grant paid by central to local government. The traditional theories of the effects of grants-in-aid showed how, in terms of the stimulatory effect on local government spending, a general lump-sum grant has the same effect as an equivalent increase in the disposable incomes of the individuals in the community. In the traditional theories, the increase in spending, by local governments and by their local citizens, on goods and services reflects only the preferences and utility functions of the latter. However, studies have shown that a general lump-sum grant to a community has a far greater stimulatory effect on local government spending than the equivalent increase in individual incomes. This is puzzling since the traditional theory assumes that local government expenditures (both in total and in terms of the distribution of spending across the various services provided) are determined through democratic vote-counting processes. In effect, it assumes that the local voting system clearly and consistently reflects the utility functions of the local community of voters and that local politicians and bureaucrats act in accordance with voting outcomes. Hence, the additional public expenditures generated by an increase in local voters disposable incomes or, alternatively, by an increase in lump-sum intergovernmental grants of the same monetary amount received by their local government, should be identical. The fact that empirical research finds that these outcomes are

2 336 not identical casts doubt on the traditional theory which effectively assumes that grants income is returned to local taxpayers either directly via rebates or indirectly via reduced local taxes. Provided that the results of the empirical studies are accurate, the flypaper effect therefore either disproves the traditional theory of intergovernmental grants, or demonstrates that it is not fully developed enough to explain these seemingly contradictory results. Alternatively, the empirical results are themselves flawed because statistical and/or specification errors lead to an overestimation of the flypaper effect. Although fifty or so publications in journals and textbooks have attempted to find theoretical and/or empirical explanations of the flypaper effect, the search for a comprehensive and definitive explanation still proceeds apace. Many different avenues of research have been followed but the end result is always frustrating in that, at best, only partial explanations have been found and doubt remains about the size, and even existence, of this effect. The earlier theoretical and empirical research has been almost completely restricted within the confines of neoclassical economics, the attempt being to improve the median voter demand model and/or temper it with public-choice perspectives and to develop more robust empirical estimations of that model. Considering the substantial analytical and empirical insights provided by some of the earlier research, it seems that more recent research has provided rapidly diminishing marginal returns to intellectual and empirical effort. Hence, it would be opportune to provide an up-to-date review of all the literature in order to assess the achievements of the various avenues of research and identify the most promising avenues for future research. It is the contention of this article that much of the more recent research has lacked strategic direction, has too readily accepted the validity of the median voter demand model in testing the median voter hypothesis, and has often simply tried yet another variant of earlier econometric tests. Such apparently promising avenues of research have all too often ended prematurely in culs-de-sac. 2. A summary of the traditional theory of grants-in-aid There are three main conclusions arising from traditional grants-in-aid theory. First, general lump-sum and specific lump-sum grants have the same effects on grantee spending because they have only an income effect. Second, openended matching grants have a greater stimulatory effect on grantee spending than equivalent lump-sum grants because they have both income and substitution effects. Third, general lump-sum grants have similar (or the same) stimulatory effects on grantee spending as an equivalent rise in income in the community.

3 337 Traditional indifference curve theory maps the preferences of an individual between two alternatives (Wilde, 1968, 1971; and Bradford and Oates, 1971). Mapping the preferences of the decision-making body of the grantee authority is in principle the procedure likely to give the best predictions of the effects of grants (King, 1984: 89). Both Scott (1952) and Wilde (1968) assume that the decision-making body satisfactorily reflects the preferences of the community. Hence, the positive predictions of this model are similar to the predictions of both the median voter and the community indifference mappings, the latter being used by Oates (1972), Boadway (1979) and King (1984) because of their ability to make both positive and normative predictions. However, whilst Oates (1972) believes that the median voter is essentially the same as the community, Buchanan (1988) believes there is no comparison between the two. Scott (1952: 393) notes that the redistributive effects of a grant may result in the community indifference curves crossing and giving no clear indication of the desirability of contemplated changes. This problem is accepted by users of community curves and is normally dealt with by assuming that there are no redistributional effects. This is a major deficiency because many grants-in-aid programmes are intended to have redistributive effects. The median voter framework is used by Romer and Rosenthal (1980) and by Bradford and Oates (1971). The Bradford and Oates model shows how the traditional equivalence conclusions of the models of Wilde (1971) using the individual framework, can also be derived through a model of simple majority voting with fixed tax shares. While not directly referring to the median voter, the Bradford and Oates model is implicitly a median voter model. They refer to the well-known theorem of Duncan Black [which] informs us that the equilibrium level of provision of the collective good is the median peak, (i.e., the median of the members most preferred budgets) (Bradford and Oates, 1971a: 425), and apply this theorem to their model. The well-known traditional result of the median voter model can be demonstrated in Figure 1. A general lump-sum grant of CD received by the local government shifts the budget line from AC (pre-grant) to BD (postgrant), the equilibrium shifting from e 1 to e 2. An equivalent increase in the disposable income, equal to AB, of the median voter would have exactly the same result as a lump-sum general grant of the same amount (the equivalence theorem) since it would also produce the budget line BD with equilibrium again at e 2. This outcome will be the case as long as the goods are normal goods. This conclusion is reached in all of the traditional theories, irrespective of which indifference mapping is used because the neo-classical assumptions underlying all of the traditional models are the same. However, the empirical

4 338 Figure 1. Possible effects of varying general lump-sum grants and median voter income. evidence (summarized in Table 1) contradicts this theoretical result in finding a significant difference between the stimulatory effects of an unconditional general lump-sum grant and an equivalent increase in individuals incomes. Hence, the traditional model appears invalid. In Table 1, de/dg denotes the rate of change of expenditure relative to the rate of change of intergovernmental grant. Gramlich and Galper s (1973) measure of de/dg was Increases in individual s incomes yield the measure de/di (where I represents income) which lies between 0.05 and Hence de/dg is more than four times greater than de/di the flypaper effect. Whilst there is a wide disparity in the measures of de/dg, varying between 0.25 and 1.00, the empirical results overwhelmingly confirm the flypaper effect. This result is demonstrated in Figure 1. ICP represents the income consumption path, showing the locus of consumption choices arising from the increase in median voter income. However, GCP (the grant consumption path) represents the empirical result where receipt of a lump-sum grant has a greater stimulatory effect on local government spending than an equivalent increase in median voter income, X 3 being greater than X 2. A flypaper effect occurs as long as GCP lies below ICP.

5 339 Table 1. Some empirical studies of the effects of general lump-sum grants Author Year Sample de/dg Gramlich and Galper 1973 Time series data of federal grants to 0.43 local and state governments Gramlich and Galper 1973 Cross-section data of federal and 0.25 state aid to 10 large urban governments Feldstein 1975 State block grants to Massachusetts 0.60 towns Bowman 1974 West Virginia untied aid to independent 0.50 school districts Weicher 1972 State school aid to fiscally independent 0.59 school districts Inman 1971 Panel study of 41 city budgets 1.00 Weicher 1972 Untied aid to 106 municipal governments 0.90 Nathan et al Monitoring of revenue sharing in state or local governments Olmstead, Denzan, and Roberts 1993 Missouri state aid to local school 0.58 districts Case, Hines, and Rosen 1993 Federal grants to 48 states Sources: Gramlich (1977), Hines and Thaler (1995), Becker (1996). Notes 1. Dollery and Worthington (1996) provides a summary of the major studies of the flypaper effect undertaken during the 1980s and 1990s. Although no estimates of de/dg are given, there is overwhelming evidence in support of the flypaper effect. 2. Becker (1996) provides results for logarithmic and linear estimates 3. Questioning the empirical evidence If errors, of whatever form, exist in the empirical studies, then doubt may be cast on the existence or size of the flypaper effect. The wide variance in the level of the flypaper effect (Table 1) suggests that a number of the studies overestimate the size of the flypaper effect. There are three main types or errors Mis-specification of the type of grant King (1984) emphasized the importance of the type of grant to the empirical result, an open-ended matching grant having a greater stimulatory effect than a lump-sum grant of the same amount. This is because, whilst both types of

6 340 grant have an income effect, only the matching grant has a substitution effect. Chernick (1979) observed that a non-matching grant may effectively become an implicit matching grant if the grant administrators award the grants to the recipient who is willing to commit a substantial amount of their own funds to the project. Chernick (1979) found there to be a positive and significant relationship between the cost contribution of the recipient and the size of the grant awarded, ceteris paribus (Fisher, 1982: 338). Chernick s results applied to HUD Basic Water and Sewer Facilities grants in the USA between 1966 and 1972 and have been criticized for their inapplicability to general revenuesharing grants which are truly unconditional (Hines and Thaler, 1995). Nonetheless, the model does highlight a problem for empirical studies. If this process of negotiation occurs for other grant programs, then the flow of causation assumed in many of the models is questionable. The assumed flow from the amount of the grant to its stimulatory effect on the level of expenditure, can occur the opposite way, with the amount of the grant awarded dependent upon the grantee s level of expenditure on the project. This mutual dependency destroys the distinction between the dependent and independent variables and therefore invalidates attempts to model the flypaper effect. Barnett (1993) notes that joint use of lump-sum and matching grants within a programme of grants-in-aid is not uncommon and characterized the system of intergovernmental grants in England and Wales prior to Moffitt (1984) proved that treating such project grants differently in econometric terms could eliminate the flypaper effect. Where the expenditure level of the local government and the matching rate they received (and thus the marginal price) are determined simultaneously, use of simultaneous equations avoids creating an upward bias in the estimates. Moffit s study of the AFDC (aid for dependent children) programme in the USA shows that when the AFDC grants are treated in this way, any flypaper effect disappears. Megdal (1987) also found upward biases using ordinary least-squares (OLS) models. However, after comparing an OLS model with one in which the bias is eliminated through the freeing of the correlation between price, income and the error term, Wyckoff (1991: 316) concluded that there is no doubt that Moffitt and Megdal have pointed out the theoretically correct way to estimate demand functions in the face of closed-ended matching grants, but their correction does not explain the flypaper effect Use of an inappropriate functional form Overestimation of the flypaper effect may also occur because most studies use a linear, rather than logarithmic, functional form because of its ease of use. For example, Becker (1996: 97) finds that linear equation produces

7 341 estimates of the spending responses to grants that are inflated by a factor of nearly six, while the use of a logarithmic form with identical data and explanatory variables provides no evidence of the flypaper effect. In a similar vein she finds that not taking into account the biases created by endogeneity can result in the flypaper effect being inflated by a factor of almost ten. In effect, this is a measure of the impact of the inter-dependency between the amount of grant awarded and the recipient s expenditure promises to grant administrators identified by Chernick (1979) Use of inappropriate variables or omission of appropriate variables A flypaper effect may also be created by exclusion of appropriate variables from (or inclusion of inappropriate variables in) the model. Hamilton (1983) develops an idea of Bradford, Malt, and Oates (1969), expanded upon by Oates (1977, 1981), that the quality of the residents of a jurisdiction is an important input in the provision of local public services (Hamilton, 1983: 347). The suggestion is that a given level of service can be achieved using less resources for some types of populations than for others. For example, according to educational research, children from higher income and higher socioeconomic-status communities require less public expenditure to attain a particular standard than those on lower income, and therefore with lower socioeconomic-status. Similarly, those higher-income communities have a lower level of street crime and require therefore less policing, again reducing the level of public expenditure required. Hamilton (1983) is in effect claiming that other models have omitted relevant variables (i.e., socioeconomic status) and are therefore incomplete. In its use as a proxy for socioeconomic characteristics, Hamilton uses an income as an input hypothesis in the production of education to explain a significant part of the flypaper effect. He finds that, based upon obtaining reasonable parameters for the relevant variables, technology for producing local goods, and price elasticity of output demand, a significant portion (but not all) of the flypaper effect can be explained in this way. However, Wyckoff (1991) contradicts Hamilton (1983). His model included many socioeconomic variables mentioned by Hamilton, and some more besides. While he admits that he may have omitted some variables, he included the crucial variable of the educational level of the community. Using a non-linear model in the form suggested by Moffitt (1984) and Megdal (1987), Wyckoff (1991) compared a model with the extra variables to one without. He discovered that, while the extra socioeconomic variables helped to explain expenditure levels,they do not help to explain the flypaper effect in terms of increases in expenditure subsequent to receiving lump-sum grants. This seems a reasonable conclusion since, whilst socio-economic status is

8 342 positively related to educational achievement, it is by no means clear whether higher or lower status would have a greater stimulatory effect on expenditure. Wyckoff (1991: 320) concludes that... the flypaper effect is unlikely to fade away with the inclusion of these omitted variables. A second potentially relevant variable that has been omitted is the local government s savings ratio. Econometric studies take account of median voter savings by default since they consider median voter expenditures. However, to the extent that they use local government budgets inclusive of financial balances, they overestimate municipal expenditures. This is clearly invalid because balances are used to finance future, not current, expenditures. If account was taken of municipal balances, and if savings ratios were the same for the median voter and his or her local government, the flypaper effect would disappear. Even if it is not the same as the median voter, any positive marginal propensity to save on the part of local government would mean that such econometric studies overestimate the flypaper effect. A third potentially relevant variable that has been omitted is expenditure on private sector alternatives. Local government expenditure figures necessarily exclude voter expenditures on private sector alternatives (e.g., for school education and leisure and recreation). Substantial alternative private sector provision could lead to median voter preferences for lower levels of public sector provision by the local public sector, preferences to which local governments may be reluctant or slow to respond, in the latter case because of delays inherent in adjusting service capacity to rapidly fluctuating (rising or falling) demand. 4. Theoretical explanations of the flypaper effect 4.1. Deadweight loss Hamilton (1986) argues that the deadweight loss of welfare created by local government taxation (e.g., because of disincentive to work effects) creates added costs for locally-raised tax revenues. In comparison, grants received from central government are free from these additional costs and therefore it is not as costly in terms of lost economic potential for the community to spend grant money as it is to spend taxation revenues raised locally. However, this explanation has been rejected since the marginal deadweight losses from taxation are typically far too small to reconcile the large differences between propensities to spend out of changes in grants and changes in private incomes (Hines and Thaler, 1995: 221).

9 Transaction costs Quigley and Smolensky (1992) analyse the impact of transaction costs in terms of the costliness of changes in tax rates. Local government tax rates may be determined only once each year (i.e., when budgets are set) such that a mid-year change in the disposable income of the median voter would require the full scale redetermination of the budget if tax rates were to be altered. This would be very costly in terms of both democratic decision-making and administration. Hence, the impact on local government expenditure of an increase in mid-year income will be small. Similarly, transaction costs will be considerable if additional grants are received during the financial year. Hence, high transaction costs lead to the most economically efficient situation being to increase local government expenditure by the full amount of the grant rather than returning a proportion to the voters in the form of a tax cut. Under certain scenarios of modest adjustment costs, the median voter is absolutely better off by not reoptimizing in response to a block grant but instead spending the entire grant on public production. Reoptimization will not be necessary if grant values are announced in advance of local budgeting such that Quigley and Smolensky s model would become inapplicable A low-income constraint Here, the median voter s utility is maximized subject to the constraint that the tax rate set must not leave the authority s poorest citizens with a net income below some level specified by the median voter (King, 1984: 114). Higher levels of output of local government services require higher local tax rates, assuming intergovernmental grants are fixed. At some point, increasing the tax rates set by the local authority would result in the poorest citizens having disposable incomes below the level specified by the median voter, assuming that all income groups are liable to pay the local tax. It is then possible to demonstrate the flypaper effect in diagrammatic terms (King, 1984: ). However, the assumption that all income groups are liable to pay local taxes is invalid. By definition, the poor do not pay local income tax and their payment of a local sales tax or a local property tax will be reduced by sales tax exemptions (e.g., food and fuel) and by income-related rebates for the local property tax Failure by institutional structure Failure by institutional structure negates the assumption that the political process is highly responsive to the preferences of individuals, either because of the restrictions placed upon the lower level of government by higher authority, or by the rules of the local government itself (Bradford and Oates,

10 ). It can be failure by neglect rather than by design. A flypaper effect could occur under certain conditions Failure by learning or habit Failure by learning or habit occurs when citizens don t know, and can t correctly imagine the consequences of some proposed collective action. If those preferences are confused then government failure occurs (Bradford and Oates, 1971). This could create a flypaper effect Tax capitalization Turnbull and Niho (1986) argue that the flypaper effect is due to tax capitalization arising from the payment of grants-in-aid, the resultant increase in the local property tax base leading to greater local tax receipts (for a given tax rate) and thus higher expenditures. However, it could be expected that, in subsequent years, voters would seek lower tax rates if their demand elasticities remain unchanged. This emphasizes the need for a dynamic model (see below) Disharmony of interests The traditional model s assumption is one of a harmony of interests between voters and politicians/bureaucrats. Wilde (1968) argued that disharmony could occur because politicians and bureaucrats may act in their own interests rather than those of local citizens and Gramlich (1977) explicitly pointed towards disharmony as the primary reason for the flypaper effect. There are three models of disharmony Niskanen s model of bureaucratic behaviour Niskanen (1968) assumes that bureaucrats are only interested in maximizing their own welfare, not that of the community (i.e., voters and politicians) for which they provide services. The bureaucratic welfare function contains many variables, for example, salary, perquisites of the office, public reputation, power, patronage, ease of managing the bureau, and ease of making changes. Niskanen argues that all of these are a positive monotonic function of the budget, thus making budget maximization the goal for bureaucrats seeking to maximize their own utilities. This explains the flypaper effect because an equivalent rise in the incomes of voters would have increased the budget of the bureau by a lesser amount. Schneider and Ji (1987) find that whilst competition does not consistently limit the flypaper effect, nonetheless the negative relationship between the

11 345 degree of competition and the size of the flypaper effect is consistent with Niskanen s model of bureaucratic behaviour as moderated by the Tiebout (1956) model of the local market for municipal outputs. The greater the degree of competition between municipalities attempting to attract residents by means of alternative tax/expenditure packages, the more constrained are bureaucrat s attempts to maximize their own welfares by maximizing their budgets. Hence the Niskanen model is limited in its usefulness to explain the existence of the flypaper effect because it assumes that the bureau has some degree of monopoly power, presenting governing politicians with an all-or-nothing choice The setter model Romer and Rosenthal s (1980) model is in similar vein to the Niskanen model. It assumes use of referendum voting to decide upon the level of expenditure on the single public output proposed by a legally-designated agent which knows the preferences of the voters it represents and which seeks to maximize the budget. If the proposed level of expenditure is defeated in the referendum, the level of public provision is established by an exogenous, legally-designated reversion level. The agent proposes an expenditure level where the median voter is indifferent between the proposed level (such as X 3 in Figure 1) and the reversion level (which is therefore X r ), or is marginally better off under the proposed level (i.e., an expenditure level just below X 3 ), thus ensuring maximization (or nearly so) of expenditure. In contrast to the traditional model, the rise in incomes would have no effect on the expenditure level in the setter model, so long as the rise does not result in the point of tangency between the indifference curve and the new budget line rising beyond the agent s proposed level of expenditure. Therefore, since it is assumed that the lump-sum grant has to be spent in addition to the pre-grant reversion or proposed levels, the flypaper effect occurs. However, the Romer and Rosenthal (1980) model s results are affected by different reversion levels and the type of good (i.e., normal or inferior), such that the effects of a grant can be less than an equivalent increase in income. Moreover, the assumptions of the setter model can be criticized as unrepresentative of the way local government operates, usually without referenda. Romer and Rosenthal developed their model to analyze U.S. school boards and, whilst their model can be generalized (King, 1984), their assumptions cannot. It is not clear why local voters would agree to a suboptimal level of output, e.g., any level of output other than X 2 in Figure 1. They could be forced to acquiesce to a suboptimal level of output if the legally-designated authority (agent, setter) has powers to override local voters preferences.

12 346 Whilst this may not be unreasonable in the case of U.S. school boards it would abrogate the underlying democratic rationale of local government The greedy politicians model McGuire (1975) assumes that politicians spend all the money they can get their hands on, as long as individuals are not made any worse off, in order to maximize their chances of political survival and hence their own welfares. Again, this is similar, in essence, to Niskanen s model. That both politicians and bureaucrats may not act in the best interests of the individuals they represent is a more comprehensive explanation of the flypaper effect Fiscal illusion Fiscal illusion models have been developed by Oates (1979), Courant, Gramlich, and Rubinfeld (1979) and Logan (1986). In Oates model, lump-sum grants also have substitution effects, arising because of fiscal illusion on the part of voters. Local government officials are assumed to be output maximizers and to use the grant to deceive local voters into thinking that the cost of service is less than it actually is. Reference is made to the reduced average tax price. Since, however, the marginal cost to the electorate is unaffected, the level of output is excessive. The stimulatory effects of a lump-sum grant are not equivalent to an increase in individual s incomes, because although they may generate the same true budget constraint, they do not result in the same perceived budget constraint (Oates, 1979: 29). Dollery and Worthington (1995) find some support for the fiscal illusion explanation in Australia, and Heyndels and Smolders (1994) find important illusionary effects in Flemish municipalities. Borge (1995) demonstrates that fiscal illusion unambiguously predicts a flypaper effect. However, Oates (1979) theory and the public-choice theories of Filimon, Romer and Rosenthal (1982) were rejected by Wyckoff (1991) because they were rejected statistically by his study. Moreover, both the Oates (1979) and Courant, Gramlich, and Rubinfeld (1979) models admit that while voters using average instead of marginal prices can create an illusion that may lead to a flypaper effect, this may only explain part of that effect Uncertainty and risk aversion Fossett (1990) and Turnbull (1992) develop models incorporating uncertainty and instability of grant revenue. Fossett s model also incorporates risk-averse behaviour of local officials. He believes that the uncertainty about grantsin-aid, both in terms of the level of aid and the type of aid, results in local

13 347 officials being cautious about any future support from the federal level of U.S. government. There would be both political and financial risks in passing on to local voters a tax reduction made possible through the receipt of a grant this year which may not occur in future years, since local tax levels would fluctuate markedly, leading to voter discontent. Prudent local officials may, therefore, decide it is in the best interest of the community to spend the grant on local government outputs. The resultant empirically-observable flypaper effect is the result of caution on the part of local officials, not of greed on the part of output-maximizing bureaucrats. He believes that this model is more realistic in its political assumptions than the agenda-type models, and the fiscal illusion models. Certainly, there is U.K. evidence that local governments increased their financial balances during periods of grant instability (Audit Commission, 1984) Pressure groups Dougan and Kenyon (1988) develop a model in which interest groups, rather than voters, are the key actors in budget determination. The political power of pressure groups inevitably varies from programme to programme and so the size of the flypaper effect varies according to the expenditure category. This could explain why measures of the flypaper effect vary between 0.25 to 1.00 in Table 1 above. Dougan and Kenyon s model is, however, not tested on actual observation. Additionally, their use of a categorical grant rather than a general grant in their analysis may cause a bias in their model, even though both types of grant may be lump-sum. Pressure groups can be expected to be more easily mobilized in respect of categorical (specific) grants rather than general grants. 5. Summary and lessons from the literature review It is clear that there is, as yet, no single explanation of the flypaper effect that has been verified both theoretically and empirically. While many of the theories reviewed above can explain some part of the flypaper effect, their authors have usually conceded that they are not full explanations. The traditional theory of grants-in-aid would appear to be defective since it cannot predict the flypaper effect, accepting that effect has been confirmed by empirical studies. Modified traditional theories relax some of those assumptions by taking account of transaction costs (incurred when reoptimizing consumption patterns) and of local deadweight losses arising from local taxation (but not from centrally financed growth), or by arbitrarily imposing a minimum

14 348 disposable income constraint upon median voter preferences. Doubt has been cast on the magnitude of the excess burden, and transaction costs have been shown to depend upon the disjuncture (if any) between the chronological schedules for local budgeting and for announcement of grant allocations. The minimum disposable income constraint is at best a special case. These competing theories are clearly based upon different models of local government. The traditional theory of grants-in-aid, whether qualified or not, implicitly adopts the fiscal exchange model of local government, namely that local governments act in accordance with the wishes of the median voter and the constraints of grant-assisted budgets. In fact, despotic, benevolent local governments may provide higher levels of output than voted for because of the public good, merit good and positive externality characteristics of their services. In this case, local government is not simply a vote-counting mechanism but, instead, pursues the public interest extending beyond the self-interest of the median voter. Even if the despotic benevolent model of government is invalid because of principal-agent disharmony, the public choice leviathan models of local government are deficient in failing to demonstrate how self-serving bureaucrats, politicians or the budget-setting agent (setter) acquire sufficient power to be able to override the wishes of voters. However, even though the effect of institutional structure and the behaviour of local officials may not be as strong as the public-choice models suggest, the literature now recognizes that supply-side factors must be considered as well as demand-side factors. Any empirical evidence of excess expenditures may be the result of institutional failure by neglect rather than by design, there being no decision-making mechanism by which to consider lowering taxes subsequent to receiving grant. Such outcomes could still be consistent with the despotic benevolent model. Alternatively, they may be due to fiscal illusion on the part of voters themselves, their voted for preferences for service levels being based on average rather than marginal costs. Of course, budget maximizing bureaucrats may seek to engender such fiscal illusion. However, uncertainty created by any instability of intergovernmental grants from year-to-year may cause bureaucrats and local politicians to soak up grants in terms of services and financial balances rather than risk unpopularity by causing large annual swings in local tax levels to offset similar fluctuations in grants. A high level of gearing between grants and local taxes (i.e., where the latter are small relative to the former) would encourage such caution on the part of bureaucrats and local politicians. Local politicians may also be susceptible to pressure from, or otherwise seek to benefit, particular interest groups who stand to benefit from expansion of specific services much more than they would benefit from a reduction in local tax

15 349 levels, the benefits of which are spread over the community as a whole. This would be consistent with the fiscal transfer model of local government. Local governments are also more attuned to deciding how to spend money rather than how not to spend it (i.e., return it to local taxpayers). 6. The median voter model and the median voter hypothesis The two main areas for further research relate to the median voter model of demand aggregation and the median voter hypothesis that actual expenditure conforms to that predicted by the model The median voter model Developed into a powerful model to analyze political decision-making (Hotelling, 1929; Bowen, 1943; Downs, 1957; Black, 1948 and 1958; Barr and Davis, 1966), the median voter model concludes that the median voter s most preferred tax and service package will be chosen under a majority rule because the median voter is the pivotal voter. The explicit and implicit assumptions of the median voter model are voter sovereignty, single-issue decisions, single-peaked preferences, majority voting, all voters vote, the cost to the local electorate of producing alternative levels of services is known, the full marginal cost of changes in service provision is reflected in the median voter s payment of local government taxes, all voters benefit equally from provision of local government services (which must, therefore, all be pure public goods), a perfectly functioning local democracy exists where local governments have full autonomy regarding local tax levels and service provision (voting mechanism acting as a perfect substitute for prices in connecting demands from consumer-voters with the supply decisions of elected local governments), utility functions are separable between private and public sector expenditures so that preferences expressed through voting reflect only the marginal costs and benefits to be derived from local government services, individual voters vote for their most preferred alternative, the political process is competitive (comparable with competitive market processes) and politicians seek to maximize votes allocated to them, bureaucrats serve politicians instructions who in turn reflect voter preferences, the median voter is the pivotal voter whose preferences are decisive, the median voter s identity is unaltered when grants are received or incomes change and, finally, a menu of distinct alternative policies and programmes is offered to voters. All of these assumptions are clearly open to dispute. Voters may not be sovereign, local governments take multiple decisions, preferences may be

16 350 multi-peaked rather than single-peaked, some local governments have proportional representation, many elections experience less than full voter turnout with the result that the median preference of the totality of those eligible to vote may differ from the median preference of those who do actually vote, imperfect knowledge and fiscal illusion may occur, not all voters pay the full marginal costs of local government services and not all benefit equally from them since not all are pure public goods (services such as school education being private goods, albeit with possibly substantial positive externality and merit good characteristics), democracies rarely function perfectly, private and public sector expenditures are often not mutually exclusive substitutes but may instead by complements, voters do not always declare their preferences honestly in that strategic voting may occur (individual voters voting for a less favoured alternative in order to block adoption of the least favoured alternative where the Arrow (1951) problem of cyclical majorities occurs), non-competitive institutions (bureaucracies) may exercise monopoly power, resulting in spending levels greater than those favoured by the median voter (Niskanen, 1975; Romer and Rosenthal, 1979a), and the identity of the median voter may change as a result of receipt of grant. The limitations of the assumptions of the median voter model have been widely acknowledged (Sorensen, 1995). Nevertheless, Turnbull and Djoundourian (1994) find that the median voter hypothesis explains the aggregate level of general local government expenditures, but does not provide a good explanation of spending on individual services. Therefore, whilst it has considerable explanatory power, the model can be criticized as overly simple and naive in its appreciation of local political processes (effectively ignoring them). The median voter model has only one criterion (income) which creates political alliances. A more sophisticated model (Inman, 1979) takes account not only of median income but also the voter s tax price, the voter s share of intergovernmental aid, the size of the jurisdiction s population and its socioeconomic composition. Poole and Rosenthal (1996) argue that the median voter, issue-by-issue approach to the analysis of public expenditure decisions is inadequate as a model of the political process. It assumes that preferences on specific issues or alternatives are directly linked to votes on those issues, failing to recognize that votes are traded across issues within political parties. Hence, whilst economic interests do have an influence on voting, they work in such complex ways that Poole and Rosenthal (1996) regard purely economic theories of voting as a failed idea. There is some evidence that the median voter model performs better, in terms of modelling local governmental expenditures, under direct democratic processes than under representative institutional arrangements (Pommerehne, 1978; Santerre, 1986). Whilst this corroboration has not been replicated

17 351 elsewhere (Chicoine, Walzer, and Deller 1989), political parties and special interest groups clearly become more influential in decision making under representative democracy (Nelson, 1992). Politicians may seek a balance between adopting a spending programme which is likely to win the election and one which is more in tune with their own (or their party s) preferences (Hansson and Stuart, 1984). Elections give majority parties mandates rather than commit them to specific decisions. Since the flypaper effect demonstrates that the median voter model s explanatory power is limited, further development of the model is required. The most productive approach (see below) would seem to be to relax its most highly restrictive assumptions. The response of neoclassical economists is the standard one that the validity of a model is to be found in who well it explains local fiscal behaviour, rather than in terms of the realism of its assumptions The median voter hypothesis The questioning of the validity of the median voter model has to be distinguished from inappropriate uses of the model. The proponents of the model have attempted to use it to fully explain local government outputs through the median voter hypothesis. The crudest version of the hypothesis assumes that the median voter has the median income of the local community, so that local government expenditures should correlate with median income. In effect, this is a reductionist form of the argument that expenditures are determined by socioeconomic factors (e.g., Davis, Dempster and Wildavsky, 1966). The flypaper effect is regarded as a contradiction of the median voter hypothesis rather than of the model itself. Holcombe (1989) argues that the median voter model is a valid description of how demands are aggregated under majority rule in many situations. Whilst the empirical evidence does not show that local governments produce what the median voter prefers this should not be misinterpreted as a refutation of the model. The questioning of the median voter model is a result of its over-zealous use in attempting to explain the real world. Nonetheless, most of the evidence is consistent with the model, if not with the hypothesis drawn inappropriately from it. The median voter hypothesis is very unlikely to hold in multi-party, multi-issue settings, often characterized by political compromises, coalitions and voting cycles. Sorensen (1995) presents evidence suggesting that politicians preferences for higher or lower expenditure levels are influenced by their occupational background, the political party to which they are affiliated, and the committee on which they sit. There are six crucial assumptions of the median voter hypothesis, all of which can be challenged:

18 that all the assumptions of the median voter model are valid. Thishas already been addressed above. 2. that the median voter is the person with median income, the median housing value and the median residential property tax bill. However, not all voters pay the local property tax. Those who do not can be expected to regard local government expenditure as a free good. In that case, the property owner would demand a lower level of local government expenditure than the non-property owner, making the usual assumptions of diminishing marginal utility and ceteris paribus. In other words, income and tastes are assumed to be identical and the service must have no effect on property values. 3. that an increase in lump-sum grants represents an increase in community income. However, Brennan and Pincus (1996) argue that grants from higher to lower levels of government are matched by a reverse flow of tax payments (they assume the higher level of government does not borrow to finance the grant). Hence, grants are not manna from heaven and do not represent increases in community income. They assume that tax and lump-sum grant payments are exactly matched for each recipient jurisdiction. Their argument applies specifically to a federal system because the grant has to be financed from within the federation by payment of higher federal taxes. It does not necessarily apply to intergovernmental grants in other constitutional types and does not apply to international grants. 4. that a comparative static approach is valid. However, the distinction between effort-related grants and lump-sum grants has already been questioned and that distinction may only apply to the year in question, rather than over a period of years. As public expenditure plans are reformulated each year, central government may feel obliged to increase the total level of grant support in line with the increased spending of local government in general and of individual local authorities in particular. Local authorities may realize that, year-on-year, there is a positive and significant relationship between their spending and grants, arising indirectly through the public expenditure planning process rather than directly through a geared grant/expenditure mechanism. They may, therefore, decide to increase spending in any one year above the level that would be expected based on the median voter s income elasticity of demand in anticipation of consequently higher lump-sum grants in the following year. This form of grantsmanship illustrates the deficiency of the comparative static approach of the flypaper effect. A comparative dynamic approach would seem more valid.

19 that lump-sum grants are exogenous such that there is a clear and absolute division between national and local government decision-making. Central government decisions about the level of grants to be paid to local governments must be made independently of local government, the latter having no influence on the former. This seems unlikely, however, not just because of the behaviour of grant administrators and local grantsmanship (both referred to above), but also because local voters also participate in national elections. There may, in fact, be a connection between local and national voting outcomes. 6. that the preferences of the median voter can be matched with those of a candidate for political office. This is much less likely to occur under representative democracy because elected politicians may have their own utility functions in which voter preferences are not the predominant components, the others being the national party line, the politician s own ideology and the need to cater for specific constituencies as well as the overall electorate (Poole and Rosenthal, 1984; Levitt, 1996). 7. that proportionality exists between the distribution of voters across jurisdictions in order that cross-sectional data (i.e., estimates of demand functions for local government services) can be used to test the median voter hypothesis. This assumption means that the output demanded by the voter with median income equals the median output demanded in each jurisdiction (Bergstrom and Goodman, 1973). This may not be the case in practice but, in assuming that it is, the median and mean will correlate with each other such that it will not be possible to distinguish between them for the purposes of the empirical research. The median and mean income will differ if jurisdictions income distributions differ from each other in terms of their degree of skewness. There is some evidence that the median performs better than the mean under direct democracy but its greater explanatory power (than the mean ) is reduced under representative democracy (Pommerehne, 1978). Micro-level surveys of voters preferences for local government services are an alternative to cross-sectional studies but are rarely used (Gramlich and Rubinfield, 1989). 8. that the tax reduction or, alternatively, the services that could be financed by the unconditional grant are of equal value to the median voter. However, the income in cash and in kind will only be of equal value if the median voter s tax share is the same as his or her share of service provision. The greater the median voter s local tax share, the greater that voter s tax reduction which can be financed by the unconditional grant. Eligibility criteria for service takeup will not automatically equate the value of service consumption with tax payment. Early versions of the

20 354 median voter model took no account of the distribution of tax share. This deficiency was later remedied, for example by Borcherding and Deacon (1972). Nonetheless, the median voter model continues to assume that the benefits of service provision are equally shared amongst the local electorate. The model is therefore deficient in this respect. Hence, the equivalence theorem does not hold and so the income-consumption path and the grant consumption paths depicted in Figure 1 will not be the same. 9. that the median voter s budget constraint is represented by the median income within the local community. This is only valid if voters consider only purely individual issues when casting their votes. If they take account of family or household interests, then median family income or median household income, respectively, should be used rather than median individual income (Turnbull and Mitias, 1995). Hence, the term median income is ambiguous. All three definitions of median income have been used in the empirical research, although it is not always clear precisely which measure has been used. In practice, the measure of median income is often determined by data availability. However, expenditure data alone cannot confirm that the median income earner is the pivotal voter. There is some evidence that median income outperforms other income measures (Mathis and Zech, 1986), although this may only apply to U.S. school boards education expenditures (i.e., which are unidimensional). However, after reviewing a number of studies, Romer and Rosenthal (1979b) concluded that there was no strong support for the median voter hypothesis. They have three main criticisms of empirical studies. First, they do not confirm that the median voter is the pivotal voter. Second, they fail to identify whether actual expenditures correspond to the level desired by the median voter or are some multiple (e.g., twice or one-third) of that level. Third, the median voter model is rarely tested against competing models and so it is not possible to demonstrate the superiority of the median voter model over other models. There are two alternative approaches. The first approach is to use alternative statistical models, of which there are two possibilities. The first is to correlate spending with the mean income or some other fractile, instead of the median income. Adoption of a particular fractile is invalid, however, if local governments are likely to differ in terms of that part of the income distribution the decisive voter s income is to be found (Aronsson and Wikstrom, 1996). A second possibility is to develop a more general model in which income is only one variable. The traditional approach sought to explain local government spending with reference to

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