A New Approach to Evaluating the Welfare Effects of Decentralized Policies

Abstract

We establish a framework to quantify the welfare effects of decentralized policies. Local policies result in benefit-spillovers, mobility of households and firms, and interjurisdictional fiscal externalities that are not internalized by the government enacting the policy. We delineate and quantify these external benefits and costs. Their magnitudes are measured by a new metric, the « marginal corrective transfer » (MCT), that is, the grant a federal government should provide to induce a locality to internalize these interjurisdictional externalities. Formally, the MCT is estimated as the wedge between the marginal value of public funds (MVPF) of the locality enacting the policy and the MVPF of the entire federation. We develop a rigorous framework for separately distinguishing the benefits and costs that are internal and external to the enacting locality. The MCT enables comparisons of local policies, allowing the federal government to prioritize policies based on the external benefits and costs. Empirically, we show that property tax cuts, K-12 education and higher education have large federal subsidies -up to $0.48 per dollar spent locally- while race-to-the-bottom type policies such as wealth tax cuts and bidding-for-firm programs should be federally taxed. A MCT greater than one, like those found for education programs, implies that the federal government gives the local government funds in excess of the costs of the program.