A warning for fiscal federalism

California Theatre, San Bernardino (picture Amerique)

The financial crisis claims another victim.  The Californian city of San Bernardino is going bankrupt.  Its liabilities are rising but its revenues are not, with the result predicted by Mr Micawber.  There is a lesson to be learned.

Not the obvious one, that governments cannot go on spending more money than they raise: we have already learned that.  In the case of San Bernardino, the bulk of its spending is on salaries and pension liabilities, and the tricky thing about the latter is that they go on rising even if spending on the actual services themselves is cut.  In the good old days, when the city was affluent, this was not a worry, but times have changed.

And what good old days.  The two chief sources of revenue were property taxes and sales taxes (£).  The housing boom saw property tax revenue rise, and the consumer boom saw income from sales taxes rise, too.  But the bursting housing bubble has taken with it the revenue from property, and the ensuing collapse in consumer confidence has slashed retail spending and thus sales tax receipts.

The two chief revenue sources for the city were highly correlated, meaning that they rose and fell together.  Nice in the good times, but very vulnerable in the bad.

This is the lesson.  The theory of federalism proposes that powers should be exercised by the most appropriate level of government, maybe decentralised, maybe centralised, according to the issue at stake.  Each level of government should have its own sources of revenue to pay for those powers, and each source of revenue has to make sense for the level of government that seeks to lay claim to it.  It would be impossible for a local authority to levy a financial transactions tax, for example, but it could levy a tax on property.  (And that is what most of them do.)

The drawback of this theory is made apparent in San Bernardino.  What if the sources of revenue available to a particular level of government are insufficient to pay for the powers of that level of government?

The purist answer is to cut spending regardless, which risks ending up depriving the citizens of services they really want and would be willing to pay for.  A better answer is to recognise that things can never be as neat as the theory.  Perhaps revenue sources need to be shared between different levels of government (and different member states at the same level of government, why not?) if those sources are the best way to raise the revenue that is needed.

The arguments over Scottish devolution or independence centre substantially on the idea that Scotland should be financially independent, even if not politically independent (this is what is mean by Devo Max).  As the example of San Bernardino shows, things might not be as simple as that.

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