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International Tax and Public Finance

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01-10-2016 | Original Paper

The political economy of pricing and capacity decisions for congestible local public goods in a federal state

Authors: Bruno De Borger, Stef Proost

Published in: International Tax and Public Finance | Issue 5/2016

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Abstract

This paper studies the political economy of pricing and investment for excludable and congestible public goods in a federal state. Although the model applies to many local congestible public facilities (such as libraries, museums and public swimming facilities), our main motivation is the problem of providing and pricing road infrastructure in federal states. The two-region model we develop allows for spill-overs between regions, it takes into account congestion, and it captures demand heterogeneity both between and within regions. Regional decisions are taken by majority voting; federal decisions are taken by a minimum winning coalition in a legislature of regionally elected representatives. We have the following results. First, when users form the majority in at least one region, decentralized decision making performs certainly better than centralized decision making if spill-overs are not too large. Centralized decisions may yield higher welfare than decentralization only if users have a large majority and the infrastructure in a given region is intensively used by both local and outside users. Second, if non-users form a majority in both regions, centralized decision making and decentralized decision making yield the same socially undesirable outcome, with prices that are much too high. Third, the performance of decentralized supply is strongly enhanced by local self-financing rules; this prevents potential exploitation of users within regions.

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The explicit reference to ‘federal’ states is made for convenience. In principle, the model applies to all political structures with multi-layered governments. For example, it applies equally well to decision-making processes of a regional government versus local urban governments.

Although our focus will be on pricing and capacity of transport infrastructure decisions, it is clear that the problem of dividing responsibilities over different levels of government also exists for many other public services. Convincing evidence is provided in a recent study by the OECD (see Blöchliger 2008); he analyzes how decision authority is divided across levels of government for a number of public services (including education, hospitals, public transport and nursing homes) in different countries. Substantial differences are seen, both between different public services and across countries. Uniform pricing is often observed, and the use of local user fees is typically quite limited; if they are used (as in the case of public transport in most countries), they cover only a small share of expenditures. The study further finds a widespread use of restrictions on users; for example, users are often limited to the services provided in the own jurisdiction.

See, among many others, Calthrop et al. (2010), Gutiérrez-i-Puigarnau and van Ommeren (2011), Kidokoro (2006), Small and Verhoef (2007).

We return to this finding in Sect. 4 below.

Adding more symmetric regions does not add new insights. We return to this issue in the conclusion.

The model could be generalized by having two groups of users within each region, intensive and less intensive users. However, in terms of policy implications, we would obtain the same qualitative results, in the sense that the inefficiency becomes proportional to the difference in user intensity. A model with a continuum of users with different intensity could also be worked out, but then the conflict within a region would depend on the shape of the distribution. In both cases, the derivation of results becomes much more complex. The advantage of the binary case is that the results depend only on the intensity of use of one group.

Admittedly, this strong assumption is more appropriate for some congested public goods than for others. For example, it is quite realistic in the case of libraries, public swimming facilities, museums, etc. However, in the case of transport trips, it is more plausible that there are two types of trips: local trips in one region and border-crossing trips that use the infrastructure of the two regions. This latter case can easily be modeled as well, but it raises two additional complications. First, it would imply nonzero cross-price elasticities between the demand for trips in the two regions. Second, it introduces horizontal tax competition, as local governments share part of the tax base. The extra cost in terms of additional complexity is substantial (see, for example, De Borger et al. 2007), and given the focus of the current paper, the benefit in terms of extra insights is small. We therefore stick to the assumption of independent demands throughout the paper and return to this issue in our concluding section.

One can think of several alternatives to the assumptions we make. First, assuming a minimum winning coalition mechanism at both the local and federal level would generate the same results. The reason is that, if within a region users have a majority, they would form a minimum winning coalition. Second, as long as the regional representative is selected by local majority voting, assuming majority voting at both the local and federal levels would also generate the same results. Of course, the political decision-making structure assumed does become more important for the results if one considers more complex preference heterogeneity. For example, consider a structure with highly intensive users, less intensive users and non-users; alternatively, one might specify a two-dimensional structure where decisions on two different local public goods are to be made. In those cases, the simple majority rule does no longer generate an equilibrium, and one has to resort to another type of model (e.g., probabilistic voting, models that explicitly study the coalition formation process). Deriving clear-cut results in these cases is much more difficult.

Alternatively, one could assume that each region delegates both users and non-users to the federal parliament (for example, proportional representation), and let one representative from the federal parliament randomly be elected as agenda setter. He/she then forms a minimum winning coalition with other members of the legislature. This approach would have required to analyze many more possible coalition formations. We therefore followed Besley and Coate (2003) and opted for a setup in which each region delegates one representative (elected by majority voting) to the federal parliament. Also note that we implicitly assume the central decision maker has perfect information on preferences and costs in both regions. This can be justified in our model, as the use of the local public good is observable (road use), and it can be priced.

The general asymmetric (\(\theta _1 \ne \theta _2 ,\eta _1 \ne \eta _2 )\) case is analyzed in the working paper.

One can also imagine other institutional constraints that improve decentralized solutions. For example, decentralization may in some cases lead to exploitation of one group by another (for example, users by non-users in case the latter have a majority). In our model, one obvious constraint has already been built in: governments were required to charge the same prices to non-local users as to local ones. The use of a ‘non-discrimination principle’ in pricing policies is widespread in practice, both in federalized countries and in the EU. We will not discuss its efficiency effects here (see De Borger et al. 2005 for such an analysis).

As mentioned in the introduction, Brueckner (2015) showed a similar result in a different context. Furthermore, Ogawa and Wildasin (2009) use a tax competition framework in which externalities depend on the stock of capital in a jurisdiction; capital is mobile and can be taxed. Under some conditions, they also find that decentralization yields efficiency, even in the presence of spill-overs. Van der Loo and Proost (2013) showed a similar result for one region facing local and transit traffic but where the federal regulator cannot observe the level of congestion.

One way to formalize this result would be to assume lexicographic preferences for non-users, in the sense that the welfare of users counts whenever non-users are indifferent.

For some other recent political economy explanations for the widely observed opposition to road pricing see, among others, De Borger and Proost (2012) and Russo (2013).

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Title: The political economy of pricing and capacity decisions for congestible local public goods in a federal state
Authors: Bruno De Borger
Stef Proost
Publication date: 01-10-2016
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 5/2016
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-015-9388-6

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