Interregional competition, spillovers and attachment in a federation

Abstract

We examine decentralized environmental policy making in a federation characterized by decentralized leadership and imperfect labor mobility due to attachment to regions. Energy consumption generates positive consumption benefits, but energy supply generates federal air pollution. Regional authorities regulate energy supply by controlling supplies of pollution permits. Energy and pollution permits are traded in interregional markets. The center redistributes incomes after it observes regional supplies of pollution permits. Regions are populated by mobile and immobile households and profits are expatriated. We show that the subgame perfect equilibrium for the federal policy game played by regional and central authorities is socially optimal.

Introduction

According to conventional wisdom in fiscal federalism, regional public goods that generate interregional spillovers – that is, goods whose economic jurisdiction exceeds the political jurisdiction of a regional or local government – should be subjected to a Pigouvian subsidy determined by a higher-level government, namely, the central government (see, e.g., Oates, 1972). Local governments should provide local public goods as far as economic and political jurisdictions coincide, but local public goods that generate interregional spillovers should be provided by a supra-local level of government.

Recent studies, however, demonstrate that there are circumstances under which competing regional governments may not only provide public goods that generate transboundary spillovers efficiently, but also implement interregional transfers to each other so that a socially efficient population distribution is obtained.¹ In Wellisch (1994), competing regional governments fully internalize externalities associated with provision of public goods in their regions whenever households are not attached to regions. Caplan et al. (2000) demonstrate that decentralized provision of a pure public good – a good whose economic benefit is available for an entire federation – may be efficient for a game where regional governments are policy leaders and a central government is a policy follower. Each regional government decides how much of the pure public good to provide in anticipation of the redistributive income policy implemented by the center. The efficiency result does not depend on the degree of household attachment.

In this paper, we extend the framework advanced by Caplan et al. (2000) in three significant ways. First, we consider commodities that generate regional-specific benefits as well as a federal benefit (good) or cost (bad). Consider, for example, provision of energy. Energy generates private consumption benefits as well as federal damages, since its consumption or production typically yields emissions of pollutants in the atmosphere (e.g., carbon dioxide). Regional governments are concerned with controlling emissions of carbon dioxide in their own regions. We postulate that such a control is done through setting up quotas of pollution permits that can be sold in a federal market for pollution permits. We also assume that the energy commodity is traded within and across regions. Thus, unlike Caplan et al. (2000), we consider an economy featuring tradable commodities and an impure public bad.

The second extension is that we examine the actions of large government authorities which fully recognize that their policies affect prices of all commodities traded in the economy. In our framework, there are three commodities which are traded globally: numeraire and energy goods and pollution permits. The third extension comes from the fact that we depart from the unrealistic assumption used in Caplan et al. (2000) that each household owns an equal share of the resources available in the region in which it resides. We consider instead a more general and realistic setting where two types of households, mobile and immobile, reside in each region. Each region’s immobile population owns the regionally fixed productive resource, which we shall assume to be land. The mobile population in this economy is its population of workers. Landowners earn land rents and workers earn wages. In addition, both types of households possess positive shares of profits produced in both regions, earn income from the sale of pollution permits and receive or pay centrally determined income transfers.

As in Caplan et al. (2000), we are interested in analyzing the allocation of resources for a federal economy characterized by imperfect labor mobility and decentralized leadership. Our example of such a federal economy coincides with theirs, namely, the European Union (EU). The governments of the member nations are endowed with considerable economic and political powers vis-à-vis the center concerning most types of policies, including environmental policies. Accordingly, in our setting, the regional governments select the regional quantities of pollution permits to be supplied in the pollution permit market prior to the center’s decisions of how to redistribute income in the federation.

This paper is organized as follows. Section 2 presents the model and determines the competitive equilibrium given the set of policy instruments. The problems faced by the decentralized agents (consumers and producers) yield the relevant indirect utility and profit functions that are taken into account by the governmental authorities when they make their decisions. Section 3 examines a setting in which the center controls all policy instruments and demonstrates that the implied allocation is socially optimal. Section 4 describes and solves the two-stage federal policy game played by regional and central authorities. We demonstrate that the subgame perfect equilibrium for this game is socially optimal by showing that it is isomorphic to the center’s most preferable allocation. Section 5 concludes the paper.