Federalism & Inequality, Part One

Constitutional debates swirling around the PPACA’s individual mandate have much to do with federalism. The core issue the Supreme Court is addressing is whether the federal government has essentially unlimited authority in economic policy, or whether they are yet some areas of economic policy-making (such as whether to compel commerce) exclusive to the states. As someone who believes that constitutions ought to be read according to – I don’t know – what their actual words say, I think the entire act is obviously unconstitutional. Article I, section 8 of the U.S. Constitution permits Congress to legislate in order to “regulate commerce…among the several states.” Thus, Congress has the authority to regulate interstate commerce. Not “anything that might be related somehow to interstate commerce,” plus “anything necessary and proper to any of those things.” Of course, no one on the Supreme Court, except perhaps Clarence Thomas on issues like this one, shares my judicial philosophy.

Putting the constitutional issues to one side, however, I want to address the desirability of the kind of federal system that classical liberals — and, perhaps, Justice Thomas — favor. We can summarize that federal system as follows:

  1. The primary regulatory authorities in the country are state and local governments.
  2. The economic role of the federal government is to ensure a common market: to prevent states from levying barriers to the free flow of goods, services, people, and capital, from tariffs to invidious regulations to local preferences in government procurement.
  3. The national court system protects basic human rights and civil liberties from infringement by federal, state, and local governments.
  4. State and local governments fund their activities almost exclusively out of their own resources. The federal government should not, in general, provide grants to state and local governments.
  5. State governments are politically autonomous, constitutionally sovereign, and independently elected. They may legislate freely within the bounds expressed above.
  6. State governments are permitted to form compacts to deal with externalities. For instance, states may choose to adopt uniform regulations on insurance so that companies can sell the same product in multiple states with a quicker approval process. Because states retain their sovereignty, they are free to enter and withdraw from such compacts at any time.

OK – so what are the arguments against this kind of system? (I go over some of the arguments and evidence in favor here.) One common objection to “states’ rights” is that state governments may violate the civil rights of some of their citizens. I share this concern, one reason I don’t think the term “states’ rights” is appropriate for my position; nevertheless, the concern is addressed with point 3 above. Another objection might be that problems like pollution and endangered species can cross state boundaries. Given a sufficiently small number of states, however, I do not see why they cannot contract with each other to solve their commons problems. What else?

There are two concerns about fiscal federalism that many progressives share that I take seriously: that inter-jurisdictional competition under federalism will undermine the welfare state, and that the system will lead to greater inequality among regions. The first concern derives from the argument that rich people will leave jurisdictions where their taxes are high for jurisdictions where their taxes are low. States will then try to prevent their tax base from fleeing by enacting low, flat tax rates and accordingly low spending on social welfare. Whether this is a problem or not depends on one’s ideological perspective, but it is worth noting here that among advanced democracies, fiscal federalism is not associated with lower social welfare spending.

The second argument, about regional inequality, is slightly more complicated. The argument here is that richer states can fund the same level of public goods as poorer states with a lower tax rate. Therefore, taxpayers will tend to flock to rich states, away from poor states, exacerbating the economic divide. One way to solve the problem would be to relax point 4 above and allow the federal government to give grants to poorer states to offset their disadvantage. However, it’s really an empirical question as to whether fiscal federalism disadvantages poor states. It could be that poor states can take advantage of the autonomy and policy flexibility that fiscal federalism permits in order to attract capital investment. Ireland, for instance, has chosen this course within the E.U., slashing business taxes, attracting investment, and growing their economy. Had there been a centralized, tax-harmonized E.U. in place, Ireland could never have pursued this strategy for catching up.

I have a paper on just this question forthcoming in the journal Regional Studies (PDF), and in my next post I’d like to go over the cross-national evidence on fiscal federalism and regional growth. Does the system advantage poorer or richer regions, or neither?

9 thoughts on “Federalism & Inequality, Part One

  1. Seems to be a conflict between 2 & 6.

    In addressing the commons, I think you’re overlooking the potential irrationalities of parties involved due to politics. So if state X is upriver from state Y, there might be an economically efficient outcome regarding use of water resources but there’s also the more politically likely outcome regarding political pressure on state X.

    1. Hm, I don’t see the conflict between 2 and 6. They seem harmonious to me – compacts encourage a freer flow of interstate commerce.

      About the commons – you’re right that these are problems that might end up having to be litigated. I do think the governments involved will generally reach Pareto optimal solutions, but Pareto optimality is consistent with a wide range of distributions. And centralization of the commons regulation is unlikely to help, as Ostrom’s work reminds us.

      1. I see “prevent states from levying barriers to the free flow of goods, services, people, and capital” as in possible tension with “states may choose to adopt uniform regulations on insurance so that companies can sell the same product in multiple states with a quicker approval process.”

        Uniform regulations on goods, services, people and capital between several states may become a barrier to the free flow of said goods, services, people and capital between states within the compact and without the compact. It’s a tension, I don’t think it’s automatic, but it’s worth expressing a concern over.

        I think your defense of federalism is strong, but rests on assumptions about the size of states which is well out of touch with modern America. If we could have some sort of nonpartisan “redistricting” of the states I think things would be a lot better.

      2. I see (I think). Larger businesses often complain when they have to follow many different rules from different jurisdictions. If some states adopt a standard package of regulations, even as others do not, I would tend to see that as fostering trade rather than damping it down – relative to the situation of no coordination. But I guess I could envision some kind of collusive or cartel model in which regulatory coordination has protectionist effects.

        I wonder whether the very stickiness and concomitant arbitrariness of state borders helps buttress federalism. If state boundaries are more or less fixed over generations, citizens will tend to have enduring state-level identities. If things were in greater flux, I doubt people would think of themselves that way, and state governments might not value their sovereignty highly. One system that I think of as being “redistricted” frequently is local government in the UK, especially England (http://en.wikipedia.org/wiki/Local_government_in_England). They change the boundaries & even basic institutional forms every 10 years or so, it seems like!

  2. >I would tend to see that as fostering trade rather than damping it down – relative to the situation of no coordination.

    You’re right, I think empirically lowering barriers between some states, even if it excludes others, is fostering trade, but I can’t help but remember in the back of my mind somewhere a paper I’ve read before arguing otherwise, that the proliferation of international multilateral free trade agreements actually dampers trade when you look at the big picture. I unfortunately can’t dig it up.

    >I wonder whether the very stickiness and concomitant arbitrariness of state borders helps buttress federalism. If state boundaries are more or less fixed over generations, citizens will tend to have enduring state-level identities.

    I think you can look at this empirically and I find the results questionable in the United States. The inequality in the size of states, in my mind, is one of the strongest progressives arguments for stronger centralization to offset regional inequality. It’s not just that some states are poorer, but some states are just too small to arguably exist at the same level of services that other states provide. Think of something like the market for health care insurance varying by the population of the state. Yes, some states could/should form regional compacts to sell insurance across state lines, but there are coordination costs for smaller states to come together to form those markets vs. one state starting out with a reasonably sized market.

    Your first progressive concern about regional inequality, that federalism could cause it, is more likely when you have arbitrary state lines that allow for spillovers. Look at, say, Northern Virginia relative to the rest of the Washington DC metropolitan area. The “wealth” generated in that area is due to the footprint of the federal government, but Northern Virginia (and by extension the rest of Virginia) benefits from that by simply being across the river with lower taxes than Maryland and DC.

    Or southern New Hampshire in relationship to Boston. You could argue Massachusetts makes all of the up front investments in education to foster a competitive economy, but New Hampshire benefits simply by being close by and having low taxes.

    You could argue that the result is that Massachusetts arguably underinvestment in education and innovation, because too many benefits are spilling over and being captured by New Hampshire. The same with Virginia’s approach to good public policy. If a progressive believes for some role of public policy to promote economic growth, through investments in transportation and education, they would argue this works better at the national rather than state level. But if we had more reasonable state lines I think their concerns would be less compelling.

    1. Yep, I get your point about the positive externalities of good state public policies. Right now I’m not sure how to address that without top-down control, but I’ll think about it.

      On the trade-diverting effects of regional trade agreements – there is a significant literature on that. The problem is that they include “local content” rules to give member countries’ products preferential access. So it’s unclear whether the trade-diverting (inefficient) effects of these regional trade agreements outweigh the trade-creating (efficient) effects.

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