Samevatting Public Finance (Rosen) - Deel 2

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter H: Efficient taxation

Because a tax distorts economic decisions, it creates an excess burden (also referred to as welfare cost or deadweight loss): a loss of welfare above and beyond the tax revenues collected.

The Pareto efficiency condition stated: MRS = MRT

With a tax, the marginal rate of substitution becomes: MRS = (1+t)P

Profit-maximizing firms set the MRT at: MRT = P

As long as t is not 0, the efficient allocation of resources is violated. Taxes drive a wedge between the consumer price and the price received by producers.

Figure 1

Obviously, a tax puts you on a lower indifference curve. The important question is whether the tax inflicts a greater utility loss than is necessary to raise revenues. If so, the tax has an excess burden. We can measure this with the equivalent variation – the change in income that is needed to cause a shift from an indifference curve to a lower indifference curve. It is a reduction in income that shifts the budget line downwards until it touches the lower indifference curve. If the equivalent variation exceeds the taxes collected, there is an excess burden.

Not every tax entails an excess burden. A lump sum tax – a certain amount that must be paid regardless of the taxpayer’s behavior – does not change the price ratios. A lump sum tax is just a parallel shift of the budget line. Because the revenue yield of a lump sum tax equals its equivalent variation, a lump sum tax has no excess burden. Lump sum taxes are unattractive as policy tools. Because the amount of income individuals earn is at least in part under their control and people’s choices affect their incomes, the income-based tax is not a lump sum tax. It reduces the price of leisure.

A tax creates two kinds of responses:

  • Uncompensated response: It shows that consumption changes because of the tax and incorporates effects due to both losing income (income effect) and the tax-induced change in relative prices.

  • Compensated response (substitution effect): The tendency of an individual to consume more of one good and less of another because of a change in the two goods’ relative prices.

An ordinary demand curve depicts the uncompensated change in the quantity of a commodity demanded when price changes. A compensated demand curve removes the income effect and the consumer remains on same indifference curve. Only the substitution effect is reflected. The compensated demand curve is important because only the compensated response affects the MRS. This means excess burden depends on movement along the compensated demand curve.

Figure 2

The excess burden can then be measured (η = absolute value of the compensated price elasticity of demand):

Excess burden = ½ * (Q0-Q1) * Dp

Dp = (1+t)p – p = t * p

η = (DQ/Q) / (Dp/p) → DQ = (η x Q) x (Dp/p) = h x Q x t

Excess burden = ½ * h * Q * p * t²

When the supply curve is upward sloping, the excess burden also depends on the compensated price elasticity of supply (ε):

Excess burden = ½ * 1/(1/η+1/ε) * Q * p * t²

This analysis assumed no distortions in the economy other than the tax. In reality, when a tax is introduced, there are already other distortions. For instance with negative externalities, a Pigouvian tax can even improve welfare.

A subsidy is just a negative tax, and is also associated with an excess burden, because people are encouraged to consume goods valued less than the marginal social cost of production. The theory of excess burden applies just as well to factors of production.

Figure 3 & 4

The differential taxation of inputs creates an excess burden. Such inputs are used ‘too little’ in taxed activities, and ‘too much’ in untaxed activities. Whenever a factor is taxed differently in different uses, it leads to misallocation of factors between sectors and hence to an excess burden.

Chapter I: Efficient and equitable taxation

The theory of optimal commodity taxation needs a government’s goal. We assume that the only goal is to finance the state’s expenditures with a minimum of excess burden and without using any lump sum taxes.

One individual consumes commodities X and Y as well as leisure (L). w=wage rate.

T=time endowment (maximum numbers of hours per year an individual can work.

No tax: w(T-L) = PxX + PyY

→ wT = PxX + PyY

With tax (t): wT = (1+t)PxX + (1+t)PyY + (1+t)wL
→ 1/(1+t) x wT = PxX + PyY + wL

A tax at the same rate on all commodities, including leisure, is equivalent to a lump sum tax and has no excess burden. However, putting a tax on leisure time is impossible. Only the commodities ca be taxed and therefore some excess burden is unavoidable. It might seem that the solution is to tax the commodities at the same rate (neutral taxation), but this is in general not efficient.

To minimize overall excess burden, the marginal excess burden of the last dollar of revenue raised from each commodity must be the same. Otherwise, it would be possible to lower overall excess burden by raising the rate on the commodity with the smaller excess burden.

Ramsey rule: (ΔX)/X1 = (ΔY)/Y1

The Ramsey rule states that to minimize excess burden, tax rates should be set so that the proportional reduction in the quantity demanded of each good is the same. When goods are unrelated in consumption the Ramsey rule implies that relative tax rates should be inversely related for the compensated demand elasticities (inverse elasticity rule). Efficient taxation requires that relatively high rates of taxation be levied on relatively inelastic goods.

Inverse elasticity rule: tx / ty = ηy / ηx

The Corlett-Hague rule (implication): when there are two commodities, efficient taxation requires taxing the commodity that is complementary to leisure at a relatively high rate.

Efficiency is not the only criterion for evaluating a tax system. Fairness is also important. A tax system should have a vertical equity – it should distribute burdens fairly across people with different abilities to pay. If society has distributional goals, departures from efficient taxation rule may be appropriate.

Sometimes the government itself is the producer of a good or service. Then the government should directly choose a price to be paid, a user fee.

Choosing optimal user fees is quite similar to choosing optimal taxes. In the optimal tax problem, the government sets the price indirectly by the choice of the tax rate. With a user fee, this is done directly.

Decreasing average costs often leads to public sector production. Under these circumstances it is likely that there is a natural monopoly. A monopolist produces an inefficient output, because its price is higher than its marginal costs (MR=MC). This inefficiency and the fact that the society may not approve the existence of a monopoly provide a justification for government production.

Figure 5

However, at the point of P=MC, the price is less than the average costs which means the government will have to incur losses. There are several solutions for this problem:

  • Average cost pricing

Price equals average cost (P=AC), no profits/losses. But still falls short of the efficient amount.

  • Marginal cost pricing with lump sum taxes

Price equals marginal cost (P=MC). Financing the deficit with lump sum taxes on the rest of the society guarantees that no new inefficiencies are generated by meeting the deficit. But lump sum taxes are generally unavailable, and there is a widespread belief that fairness requires consumers of a publicly provided service to pay for it (benefits-received principle).

  • A Ramsey solution

The government has to raise a certain amount of revenue, by setting the user fees so that demand for each commodity is reduced proportionately.

Now we are going to focus on how progressive an income tax should be. The goal of the theory of optimal income taxation is to provide a systematic way for thinking about the right amount of tax progressivity.

Edgeworth’s model (optimal income taxation) assumptions:

  1. The goal is to make the sum of individuals’ utilities as high as possible.

Maximize W=U1+U2+…+Un

  1. Individuals have identical utility functions that depend only on their incomes and these functions exhibit diminishing marginal utility of income.

  2. The total amount of income in fixed.

These assumptions imply that taxes should be set so that the after-tax distribution of income is as equal as possible. Edgeworth’s model reflects a very progressive tax structure. Marginal tax rates on high income individuals are 100%.

However, the assumption that income is fixed is not realistic. The process of allocating the tax burden involves distorting work decisions and creating excess burdens. That is why the total amount of real income available will be reduced.

The model of Stern takes these work incentives in account.

Tax revenues = -α + t * Income (t=marginal tax rate)

This is a linear income tax schedule (or flat income tax) – the geometric interpretation is a straight line. Note that the schedule is still progressive in the sense that the higher an individual’s income, the higher the proportion of income paid in taxes. The optimal income tax problem is to find the best combinations of α and t – the values that maximize social welfare. The more elastic the supply of labor, the lower the optimal value of t, other things being the same. One limitation of Stern’s analysis is that it constraints the income tax system to have only one single marginal tax rate.

Unless the government can credibly promise not to renege, it cannot conduct the fully efficient tax policy. This phenomenon is called the time inconsistency of optimal policy –the stated policy is inconsistent with the government’s incentives over time, and taxpayers realize this fact. In this way, policy recommendations based on optimal tax logic may actually reduce welfare.

We just argued that an efficient tax is one with a small excess burden. But tax systems may be evaluated by standards other than those of optimal tax theory:

  1. Horizontal equity

People in equal positions should be treated equally. The difficulty is to measure these equal positions. Because work effort is at least to some extend under people’s control, two individuals with different incomes may actually be in equal positions. It seems that the wage rate gives a better reflection of equal positions rather than income. However, the wage rate has problems too: (1) investments in human capital can influence the wage rate. (2) Wage rate per hour is often hard to measure. An alternative is to measure it in utilities.

The utility definition of horizontal equity:

  • If two people have the same utility level before the tax, they should also be equally well off with taxation.

  • Taxes should not alter the utility ordering.

However, as long as tastes for leisure differ, any income tax violates the utility definition of horizontal equity. People in different occupations pay unequal taxes (due to amenities that are not taxable), but there is no horizontal inequity, because of adjustments in the before-tax wage. The process of migrating between jobs continues until the net returns are equal (demand and supply of labor).

The conclusion is that a preexisting tax structure cannot involve horizontal inequity. All horizontal inequities arise from changes in tax laws, because individuals make commitments based on the existing laws that are difficult or impossible to reverse.

Transitional equity: The problem of fining fair processes to change tax regimes. Finding the right process is difficult and there are not may results available on the subject,

  1. Cost of administration

The assumption that collecting taxes involves no costs is clearly false. The choice of a tax and subsidy systems should take account of administrative and compliance costs. The trick is to find the best trade-off between excess burden and administrative costs. Any reduction in excess burden that arise from differentiating the tax rates must be compared to the incremental administrative costs.

  1. Incentives for tax evasion

Tax avoidance: change your behavior to reduce your tax liability (legal).

Tax evasion: failing to pay legally due taxes (illegal).

Positive analysis of tax evasion:

Figure 6

ρ = probability of being audited, R= amount hidden for tax authorities

Assume that you know the value of ρ and the penalty schedule. You make the decision by comparing the marginal costs and benefits of cheating. The optimal amount of cheating is where the two schedules cross. If the marginal cost of cheating exceed the marginal benefit for all positive values, the optimum of cheating equals zero. Still this model ignores some potentially important considerations:

  • Physic costs of cheating: tax evasion makes people feel guilty

  • Risk aversion: many people only care about expected income, and risk per se does not bother them.

  • Work choices: the tax system may affect hours of work and job choices and stimulate the underground economy – economic activities that are either illegal, or legal, but hidden from tax authorities.

  • Changing probabilities of audit :actually the audit probabilities depend on occupation and the size of the reported income.

Normative analysis of tax evasion

Consider two situations:

  • Society cares about the welfare of tax evaders

The existence of an underground economy can raise social welfare. In this case, leaving the underground economy intact might be desirable if society has egalitarian income redistribution objectives.

  • Evaders are given no weight in the social welfare function

The goal is to eliminate cheating at lowest administrative costs. Marginal cost of cheating is the product of the penalty rate and probability of detection. The probability of detection depends on the amount of recourses devoted to tax administration. Still the government can raise the marginal cost by setting really high penalties, but in reality we often see just a retribution, because society also cares about the process by which the result is achieved.

Chapter J: Deficit finance

Borrowing is an important method of government finance. The deficit during a time period is the excess of spending over revenues. If revenues exceed expenditures, there is a surplus. Because you need to take in account all revenues and expenditures, you should include the on-budget deficit (on-budget activities) and the off-budget deficit (off-budget activities) to arrive at the total deficit. The debt at a given point is the sum of past deficits and surpluses. Official figures concerning the size of government deficits, surpluses and debts must be viewed with caution for several reasons:

  • The state and local governments also have large amounts of debt outstanding.
  • Inflation erodes the real value of the debt. The official deficit/surplus does not reflect this fact.
  • The federal government lumps together capital (durable items) and current (consumed within the year) expenditures. Standard accounting procedures require that only annual depreciation of durable assets be included in the expenditures, not their entire purchase price.
  • Tangible assets owned by the government should also be taken into account.
  • Government’s implicit obligations to pay money in the future should also be considered.

Because the legal burden of debt is on future generations, it doesn’t mean that they bear the real burden. There are different views on this issue:

  • Lerner’s view

If you assume that the government borrows from its own citizens the obligation is an internal debt, it creates no burden for the future generation. Members of the future generation simply owe it to each other (intragenerational transfer). If the government borrows from abroad (external debt), the future generation bears a burden. To the extent that the project’s return is less than the marginal cost, the future generation is worse off. In Lerner’s model a generation is defined as everyone who is alive at a given time.

  • Overlapping generations model

If you define a generation as everyone who was born at about the same time, several generations coexist simultaneously. In this model, debt finance can produce a real burden on future generations. By comparing the net taxes paid by different generations, one can get a sense of how government policy distributes income across generations (general accounting).

  • Neoclassical model

When the government initiates a project, whether financed by taxes or borrowing, resources are removed from the public sector. If you assume that when the government borrows, it competes for funds with individuals and firms who want the money for their own investment projects (crowding out hypothesis – private investment get crowded out), debt finance leaves the future generations with a smaller capital stock. The debt imposes a burden on future generations is this way.

  • Ricardian model

Voluntary transfers across generations undo the effects of debt policy, so that crowding out does not occur and tax and debt finance are essentially equivalent. The form of government finance is irrelevant. Several factors influence whether a given government expenditure should be financed by taxes or debt. The benefits-received principle states that the beneficiaries of a particular government spending program should have to pay for it. If a project will benefit future generations, then having them pay for it via loan finance is appropriate. To analyse whether debt or finance tax generates a higher excess burden, you must realize that every increase in government spending must ultimately be financed by an increase in taxes. It is just a choice between the time of the taxes. With debt finance, many small payments are made over time to finance the interest due on the debt. As we still know, the excess burden increases with the square of the tax rate. When the tax rate doubles, the excess burden quadruples. If you look at it this way, it seems that a series of small tax increases generates a smaller excess burden than one large tax increase. However, this conclusion ignores the possibility for the crowding out effect. If crowding out occurs, the conclusion may be reversed.

Chapter K: Personal taxation and behavior

The effect of taxation on labor supply

Figure 7

The budget constraint above shows the combinations of leisure and income available to an individual given his wage rate. A proportional tax reduces the reward for working an hour to (1-t)w and therefore it lowers the labor supply curve. But we cannot conclude that every individual always reduces labor supply in response to a proportional tax. Depending on a person’s tastes, he will work more, less or the same amount.

Time endowment: The number of hours available for market work and nonmarket uses (leisure).

We can distinguish two effects generated by the tax:

  • Substitution effect – opportunity costs of leisure go down which creates a tendency to substitute leisure for work (effect decreases labor supply).

  • Income effect – if you assume that leisure is a normal good, the loss in income leads to a reduction in the consumption of leisure. And a decrease in income leads to an increase in work (effect increases labor supply).

The two effects work in opposite directions.

The analysis of a progressive tax is very similar to that of a proportional tax. Because of the increasing marginal tax rates, the individual is confronted with different slopes of the budget constraint. The opportunity cost of an hour leisure decrease when income increases.

Econometric studies indicate some general tendencies: prime age males vary their hours only slightly in response to tax changes, while married women are quite sensitive to variations in the after-tax wage rate.

Demand side considerations

Changes in the supply of labor might have an effect on the demand side. An increase in labor supply lowers the before-tax wage. This mitigates the original increase in the after-tax wage, so that the final increase in hours of work is less than originally guessed.

Some people fear that taxes induce people to invest too little in human capital – investments that people make in themselves to increase their productivity.

B=present value of the extra earnings, C=cost in forgone wages, t=marginal tax rate

Without taxes: B - C > 0

With proportional taxes: (1-t)B – (1-t)C = (1-t)(C-B) > 0

A proportional tax reduces the benefits and costs in the same proportion and therefore has no effect on human capital investment.

This simple model about human capital investment ignores several considerations:

  • Labor supply is assumed to be fixed. But if the tax induces to work more, it makes human capital investment more attractive.

  • The returns to human capital investment cannot be known with certainty.

  • Some human capital investments involve costs other than forgone interest.

  • Other aspects of the tax system (for instance the taxes on the return to physical investments) can affect human capital investments.

  • When a tax system is progressive, the benefits and the costs of human capital investments may be taxed at different rates.

Government revenues do not always increase if tax rates go up. The tax collected per hour can be very high, but the number of hours can drop so much that the product of the tax rate and hours is lower than before. The tax rate-tax relationship is known as the Laffer curve. The shape of a Laffer curve is determined by the elasticity of labor with respect to the net wage.

Figure 8

Also saving behaviour may be affected by taxation. Most analyses are based on the life cycle model in which the individual’s consumption and saving decisions are the result of a planning process that considers their lifetime economic circumstances.

This means the amount that you save also depends on the expected income in the future and the received income in the past.

Figure 9

I0=current income, I1=future income, S=saved amount, B=borrowed amount,

r =rate of return

The slope of the budget line (1+r) represents the opportunity cost of one good in terms of another. The cost of 1 unit of consumption in the present is (1=r) units of forgone consumption in the future. This is called an intertemporal budget constraint because it shows the trade-off between consumption across time. The exact position on the budget constraint depends on an individual’s preferences between future and present consumption. If you superimpose some indifference curves, you can examine which point of the budget constraint lies on the highest attainable indifference curve.

There are three combinations available to this budget constraint:

  • Consume all income as it comes (I0 = I1) → endowment point

  • Consume less than current income (save)

The future income increases to I1+ (1+r)S, because the saved amount can be invested against a rate of return r.

  • Consume more than current income (borrow)

The future income decreases to I1- (1+r)B, because he has to pay back B plus the interest.

Now we will consider how the amount of saving changes, when a proportional tax on interest is introduced. We have two possibilities:

  1. Deductible interest payments and taxable interest receipts

Tax reduces the rate of interest received by savers from r to (1-t)r. The effective rate to be paid for borrowing is (1-t)r. This results in the slope of the budget constraint which is [1+(1-t)r]. Savings do not always fall when an interest tax is introduced. It depends on the individual’s preferences (indifference curves).

Figure 10

  1. Non-deductible interest payments and taxable interest receipts

To the left of the endowment point, the opportunity of increasing presents consumption with 1 unit equals [1+(1-t)r] units of future consumption. However, to the right of the endowment point, the opportunity cost of increasing current consumption with 1 unit is (1+r) units. This is because interest is non-deductible, so the tax system does not affect the cost of borrowing.

Figure 11

Actually this two-period model ignores some real-world complications:

  • The analysis is formulated in real terms

  • The returns to different assets are taxed at different rates

  • The model only examines the private saving, not the social saving (government and private).

  • Some people question the validity of the life-cycle model. The model argues that people are forward looking but according to critics it is more realistic that people are myopic.

The personal income tax excludes the imputed rent from owner-occupied housing from taxation. This increases both the percentage of those choosing to own their homes and the quantity of owner occupied-housing.

Taxes may affect not only the total amount of wealth that people accumulate but the assets in which that wealth is held as well (portfolio composition).An often used argument is that low taxes increase risky investments. Tobin has developed a theoretical work on the relation between taxes and portfolio composition. He states that the investment decision is based on two characteristics; expected return and risk. Investors prefer safer assets that are expected to yield high returns. The typical investor holds a combination of both risky and safe assets to suit tastes concerning risk and return.

If a proportional tax is levied on the return to capital assets, (full loss offset assumed – all losses can be deducted from taxable income) the expected return of risky investments drops, but also lessens its riskiness. The net effect of these conflicting tendencies has not been empirically resolved.

Chapter L: Multigovernment public finance

A federal system consists of different levels of government that provide public goods and services and have some scope for making decisions. The field of fiscal federalism examines the roles of the different levels of government and the way in which they interact with each other. The centralization ratio reflects the proportion of total direct government expenditures made by the central government. However, if local and state government spending is constrained by the central government, the centralization ratio underestimates the true extent of centralization in the system. When we look at community formation, it is easy to think of a community as a club (a voluntary association of people who band together to share some kind of benefit). The optimal community is one in which the number of members and the level of services simultaneously satisfy the condition that the marginal cost equal corresponding marginal benefit. The ability of individuals to move among jurisdictions produces a market-like solution to the local public goods problem (Tiebout model). Individuals locate in the community that offers the bundle of public services and taxes they like the best. It is a market mechanism with the proportional tax on property as the price and the package of local public goods as the quantity. Key conditions of the Tiebout model:

  • Government activities generate no externalities
  • Individuals are completely mobile
  • People have perfect information on community’s public services and taxes
  • There are enough different communities
  • The cost per unit of public services is constant
  • Public services are financed by a proportional property tax
  • Communities can enact exclusionary zoning laws (statutes that prohibit certain uses of land).

Advantages of decentralization:

  • Tailoring outputs to local tastes

Individuals with similar tastes for public goods group together, so communities provide the types and quantities of public goods desired by their inhabitants. Besides this, a local government has a greater democratic responsiveness and can better fit to citizen’s preferences than the central government.

  • Fostering intergovernmental competition

The threat of citizens ‘voting with their feet’, and going to other communities creates an incentive for burocrats to produce more efficiently.

  • Experimentation and innovation in locally provided goods and services
    A system of diverse governments enhances the chances that new solutions to problems will be sought. Smaller governments can act an innovation laboratory for taxes and public goods.

Disadvantages of decentralization:

  • Efficiency aspects on the expenditure side

Communities impose externalities on each other. If each community cares only about its members, these externalities are overlooked. Moreover, for certain public goods, the cost per person falls as the number of users increases. In this way, a central government copes with greater economies of scale.

  • Efficiency aspects on the taxation side

Taxes levied by decentralized communities are unlikely to be efficient from a national point of view. Communities are likely to select taxes on the basis of whether they can shift them to outsiders. The perceived marginal cost are then less than the marginal social cost, which results in an inefficiently large amount of local public goods. Besides this there can also be economies of scale in the collection of taxes.

  • Equity aspects

People’s decision to locate somewhere is influenced by the available tax-welfare package. If the local income redistribution is unstable, this can lead to a downward inner-city spiral. Eventually the redistributive program has to be abandoned. A local public good: A good with benefits that accrue only t members of a particular community. An individual’s property tax is the product of the tax rate and the property’s assessed value (the value assigned to the property). The ratio of the assessed value to market value is called the assessment ratio. Assessment ratios differ across properties and that is why properties can have the same nominal tax rate, but different effective rates. There are three views on the incidence of a property tax:

  1. Property tax as an excise tax on land and structures

The incidence of the tax is determined by the shapes of the relevant supply and demand schedules.

    • Land → fixed, so a perfectly vertical supply curve

    Landowners bear the entire burden of a tax levied on it (for all time, because prospective land owners take into account the future stream of tax liabilities).

      • Structures → The construction industry can obtain all the capital it demands at market price, so there is a perfectly horizontal supply curve.

      The burden is shifted entirely to tenants.

      1. Property tax as an general capital tax with different rates
        • General tax effect

      Assume that a property tax is just a uniform tax on capital. While capital supply is fixed in the short-run, the property tax falls entirely on the owners of capital. Since the proportion of income from capital tends to increase with income, the tax seems to be progressive.

        • Excise tax effect

        Property tax is a set of excise taxes on capital. Capital tends to migrate from areas where it faces a high tax rate to those where the rate is low. The process continues until after-tax rates of return are equal. The impact on the other factor depends in part on their mobility.

          • Long-run effect

          The supply of capital is not fixed and depends on the tax rate. If the property tax decreases, the supply of capital, the productivity of labor and the real wage will fall.

          1. Property tax as a user fee for local public services

          The property tax is just the cost of purchasing public services. So the property tax is more like a user fee for public services. Why in the property tax so unpopular?

          • It is often levied on an estimated value
          • It is highly visible
          • It is perceived as being regressive
          • People can’t do anything against other taxes

          A better reform of the property tax seems to be the personal net worth tax – a tax based on the difference between the market value of all taxpayer’s assets and liabilities. However, this would undoubtedly have to be administered by the federal government while a property tax provides a local government with considerable fiscal autonomy. Federal grants are a very important source of revenue to states and localities. Grants help finance activities that run practically the entire gamut of government functions. Grants from the central government to states and localities provide a way of correcting the mismatch between where the tax is collected and where it is demanded. A grant’s structure influences its economic impact:

            • Conditional grants (categorical grants)

            Grants for which the donor specifies the purposes for which the recipient can use the funds.

            • Matching grant: for every dollar given by the donor to support a particular activity, a certain sum must expended by the recipient.
            • Matching closed-ended grant: to put a ceiling on the cost, the donor specifies the maximum amount that it will contribute.
            • Nonmatching grant: the donor gives a fixed sum of money with the stipulation that it will be spend on the public good.
              • Unconditional grants

              The federal government gives the community an unrestricted lump sum grant. These grants are sometimes referred to as revenue sharing. Contrary to what one might suspect, almost all studies conclude that a dollar received by the community in the form of a grant results in a greater public spending than a dollar increase in community income. This is called the flypaper effect, because the money seems to stick in the sector where it initially hits. A possible reason can be that bureaucrats seek to maximize the sizes of their budgets and have no incentive to inform the citizens about the true level of grant funding, which makes the citizens unaware of the true budget constraint. Since 1971 states have assumed an increasingly large role in financing elementary and secondary education. They use two basic kinds of grants to support local schools:

              • Foundation aid: seeks to ensure a minimum level of expenditure per pupil, regardless of local property wealth.
              • District power equalization


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