More Regulation Needed?

On numerous occasions this semester we have discussed the concept of tax exportation (i.e. the practice of shifting the tax burden to non-residents). As we know, tax exportation is favorable for governments and politicians because it increases revenue without the negative political side effects of an increase in taxes or fees. Essentially, it shifts the costs.

According to Robert P. Inman, tax exportation is one of three cost-shifting revenue methods available to local governments. The other two are more nefarious. One approach is to borrow more money than can be paid back, then either default on the loan or ask the next level of government for a bailout, which shifts the costs to the creditor or another government. The third approach is to pay it forward by running up deficits in the short term and leaving the debt to be paid by future residents in the form of higher taxes. Inman argues that cost-shifting is an inefficient outcome because it localizes benefits that are essentially subsidized by national taxpayers, bondholders, or future tax payers.

The practice of cost-shifting begs several questions for the Federal Government: With its allocative efficiency role, does it have an interest in responsible subnational borrowing (as measured by minimal cost-shifting)? Additionally, should the Federal Government regulate subnational borrowing to promote macroeconomic stability? Furthermore, is regulation feasible? More broadly, how do the actions of the federal government affect subnational borrowing?

Several researchers have studied the interplay of centralized government and subnational borrowing in an attempt to answer these questions. Alexander Plekhanov and Raju Singh found that there are essentially four ways that centralized governments regulate subnational borrowing: market discipline (where incentives and penalties are determined by the market), administrative constraints (such as prohibition of external borrowing or a centralized approval process), rule-based controls (such as a debt or deficit ceiling), and cooperative arrangements (where borrowing decisions occur through a negotiation process between the upper- and lower-level government). Each regulatory approach has its respective strengths and weaknesses, and successful oversight is dependent on a number of unique factors.

In the United States, we generally rely on market discipline to regulate subnational borrowing, and the approach raises two concerns. First, it provides little defense against cost-shifting. Second, as Plekhanov and Singh explain, one condition necessary for effective market discipline is that “there should be no perceived chance of a bailout by the central government in a case of impending default.” But is this still a realistic fear? Large intergovernmental transfers are common practice, and the Federal Government quickly bailed out Wall Street to prevent widespread calamity sparked by a "self-regulated" market. One wonders the extent to which the market is accounting for a soft budget constraint—either in the form of higher taxes, a government bailout, or receivership. Is subnational borrowing in need of more oversight?

Sources:
Alexander P, Raju S. How Should Subnational Government Bor rowing Be Regulated? Some Cross-Country Empirical Evidence. IMF Staff Papers [serial online]. December 2006;53(3):426-452. Available from: Academic Search Premier, Ipswich, MA. Accessed April 4, 2011.

Inman, Robert. 2003. “Transfers and Bailouts: Enforcing Local Fiscal Discipline with Lessons from U.S. Federalism.” In Jonathan Rodden, Gunnar Eskeland, and Jennie Litvack, eds., Fiscal Decentralization and the Challenge of Hard Budget Constraints. Cambridge, MA: MIT Press.

Sorribas-Navarro P. Bailouts in a fiscal federal system: Evidence from Spain. European Journal of Political Economy [serial online]. March 2011;27(1):154-170. Available from: Academic Search Premier, Ipswich, MA. Accessed April 4, 2011.