Theory of Public Finance in a Federal State

By Dietmar Wellisch | Go to book overview
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Incentive Equivalence through
Perfect Household Mobility

We now turn back to a federal state with fixed jurisdictional boundaries. In Chapter 3 we demonstrated that conditions of perfect interregional competition provide local governments with the correct incentives to choose an efficient allocation, provided they have a complete policy instrument set available. However, this result is restricted to small regions, and the question arises of whether there also exist conditions that take away all incentives for large regions to behave strategically. This chapter demonstrates that-under certain conditions-perfect household mobility may be such a mechanism, ensuring that noncooperative government policies of large regions result in an efficient allocation. Of course, this conclusion also holds only if regions have an efficiency-supporting instrument set available. It is of particular importance that regions can make an interregional transfer of resources. Without this instrument, it is generally not possible to achieve the efficient interregional population distribution.

Interregional household mobility is an incentive mechanism for regional governments to choose an efficient allocation because they become aware that any strategic behavior cannot be in the interest of their own residents. If regional governments act rationally, they must take into account migration responses of mobile households to government actions. Consequently, the migration equilibrium is an important and rational constraint on their behavior. By considering migration responses, regional governments take into account the effects of their actions-not only on their own residents' utility but also on the welfare of nonresidents. In the end, a beggar-my-neighbor policy would harm their own residents, since interregional utility differences are incompatible with perfect household mobility. For this reason, regions do not behave strategically. This general conclusion will be explained by using three examples that traditionally serve as classical cases to show why decentralized government policy fails (see Oates 1972; Gordon 1983; Boadway and Wildasin 1984). These examples are the interregional tax export, the existence of public good spillover effects, and interregional tax competition for scarce mobile


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