The Marginal Value of Public Funds in a Federation

Abstract

Our objective is to establish and provide a framework for quantifying the welfare effects of fiscal policies in an open economy, with an emphasis on state and local governments in a federalist system. To do this, we develop a model of fiscal policy with benefit-spillovers, firm mobility, and household mobility effects from changing taxes and expenditures among interacting local jurisdictions. We then derive how mobility and spillovers influence the marginal value of public funds (MVPF). Because a federal planner internalizes interjurisdictional externalities, the MVPF for a federal and local planner can diverge substantially, and we derive theoretical conditions for when the local MVPF will be the larger or the smaller. We provide guidance on the additional empirical components of the marginal value of public funds necessary to understand the welfare effects of policies in a federalist system. Finally, we illustrate the key differences of social and local MVPFs using empirical applications to decentralized wealth taxation, bidding-for-firm subsidy competition, and education spending.