Federalism and income inequality: whence it came, where it goes [en]

14 marzo -

 

Introduction

 

The aim of this article is to consider the question of the relationship between a political and administrative structure, federalism, and an outcome that is widely regarded as economic, income inequality. While not giving any definitive answer, I will try to provide an overview of some of the relevant literature on this issue. As such, I will begin by briefly explaining what we mean by federalism and why some countries would rather give more autonomy to their political subnational structures; then I will pose the question whether federalism is inherently skewed – that is, whether there is any bias towards conservatism. Following Erik Wibbels’s work, I will also focus on the distinction between fiscal and political federalism. Only then will I face the core problem of this relationship, the redistribution of income among the polity, or the regions. The use of some examples of economic and fiscal management in federal systems will help to understand how federalism can have deeply different outcomes in different countries.

 

 

 

What is federalism? Why federalism?

 

Far from being the kind of institutional arrangement that the Founding Fathers had in mind for the thirteen colonies, one of the most widely used definitions of federalism today is William Riker’s (1964), according to which “[a] constitution is federal if (1) two levels of government rule the same land and people, (2) each level has at least one area of action in which it is autonomous, and (3) there is some guarantee […] of the autonomy of each government in its own sphere.”

 

A more embracing definition, which does not overlook the possibility of a multiplicity (hence, more than just two) of governments, nor does see this autonomy strictly as pre-defined, is Daniel Halberstam’s (2011). Federalism, he says, means “the coexistence within a compound polity of multiple levels of government each with constitutionally grounded claims to some degree of organizational autonomy and jurisdictional authority”. To use Morton Grodznis’s famous metaphor, federalism is more often than not akin to a marble cake rather than a layer cake. Erik Wibbels (2005), instead, uses a more succinct definition, more concerned with the operationalization of the arrangement, whereby two criteria need to be fulfilled: first, provinces are represented by a national legislative body, usually the upper chamber; and secondly, provinces have an elected legislature of their own. Unlike the others, Wibbels is far more concerned with the harmony between federalism and the market, that is to say, between the fiscal and political arrangement of the federal state.

 

Exploring the origins of the federal systems goes beyond the scope of this article, although Chad Rector’s (2009) account of how federalism may impose greater costs for defection to the parties seems to be a good starting point for understanding the status quo bias from which some federal systems, most notably the US, suffer today – and have been for quite some time.

 

Why federalism, though? Is there a reason to undertake the federal path instead of having a unitary state, with a (more or less) strongly centralised government? There are at least four reasons to support federalism, and as many to reject it. On the one hand federalism allocates the governmental functions at the optimal territorial level: local government will reflect citizen preferences; it fosters the accountability of local governments; it relies on local expertise (who better to know local problems?); and finally, through the principle of redundancy, it helps to manage risk: if one level of government fails to complete its tasks, the other will swoop in, and the tasks will be passed to the other level of government – this is the principle of subsidiarity.

 

The dichotomy between the federal government and the states, while able to foster competition, may still be a double-edged sword. Matter-of-factly, the other hand – the dark side of federalism – is represented by political and legal conflicts, which lead to a paradoxical lack of accountability (who exactly is in charge?); by increasing administrative costs due to overlapping and doubling of competences; by a lack of balance between equality and competition, concerning the degree of freedom granted to the several states; and ultimately by a failure to achieve the political goals and exercise the functions correctly.

 

An example of how competition and the lack of balance between the states may exacerbate the federal architecture was given by Charles Tiebout’s sorting hypothesis in 1956. In his seminal paper, A pure theory of local expenditure, Tiebout re-examines Paul Samuelson’s notion of public goods by saying that Samuelson’s analysis “need not apply to local expenditures.” This is because “[t]he consumer-voter may be viewed as picking that community which bests satisfies his preference pattern for public goods” (Tiebout, 1956). In other words, public goods are not necessarily handed by the central government on a fixed pattern, but it can be the very same individual that somehow chooses those that best suit his interests.

 

There are some shortcomings in this model, also acknowledged by Tiebout himself, and which will be recalled later. What matters now is that Tiebout’s work can lay the foundations for the next two sections: even if the voter is not as mobile as Tiebout assumes, there is no doubt that “component jurisdictions within federal systems [often find] themselves in competition with one another for movable capital investments, leading to […] a race to the bottom” (Halberstam, 2011). On the one hand, this means that once the community has found an equilibrium at which it gets the maximum outcome, it has incentives to maintain the status quo, and therefore come at odds with the level of government (immediately) above it. On the other hand, Tiebout’s paper has inaugurated a long tradition of literature on fiscal federalism. However, as Erik Wibbels (2005) has mentioned, fiscal federalism needs to be separated from political federalism. The issue of redistribution is not only a matter of spending and taxing, but it also features the interlocking of political (dis-)agreement between the different level of governments: it is the way this interaction plays out that determines the outcome of redistribution and, by extension, income inequality.

 

 

Does federalism have a bias towards the status quo? The role of the veto players

 

The first line of reasoning deals with the status quo resulting from the equilibrium in a particular community. But what is exactly a status quo bias? Generally speaking, status quo is a cognitive state whereby individuals (and institutions) are reluctant to change the way things are. This is, in other words, the very basis for conservatism. As such, any kind of policy that promotes redistribution of income and equality seems not to be welcome.

 

The questions we need to ask ourselves are the following: is federalism, as an institutional arrangement, inherently conservative? Does it reject any possibility for equality? And if so, how does the status quo bias relate to income inequality? According to Aaron Wildavsky (1984), “federalism and equality of result cannot coexist”. Moreover, Enns et al (2014) argue that in the US there is “a variety of economic, demographic, and political factors [that] have created the conditions necessary for rising inequality,” and that “[w]ithout policy action, these conditions translate into more income concentration. But due to the status quo bias […] such policy action is rendered unlikely.” How can these factors be more clearly defined? And are they inherent to any federal system?

 

Analysing all the economic, demographic, and political factors would be a feat superior to the scope and length of this article. Therefore, I will mainly focus on one kind of such factors: the institutional one, namely, veto players. According to Tsebelis (2005) a veto player is “an individual or collective actor whose agreement is required for a policy decision.” The higher the number of veto players, the more difficult it is to pass a piece of legislation. Furthermore, Birchfield and Crepaz (1998) differentiate between collective and competitive veto points. The latter are to be taken into account when “different political actors operate through separate institutions with mutual veto powers” (Birchfield and Crepaz, 1998). One such kind is present in the federal structure, as well as being part of a strong bicameral system, as is the case for Italy. Separate powers and a bicameral legislation, therefore, translate into more veto players (Enns et al, 2014), and the higher the number of veto players, the lower the potential for policy change (Birchfield and Crepaz, 1998).

 

Let us take the US as an example. The Senate, whose composition changes by one-third every two years, is made up of two representatives for each of the several States, no matter the population. This has two implications. Firstly, the balance within the Senate is skewed: a senator of the State of California formally holds as much power as a senator of the State of Ohio, whose population is much smaller. There is no proportional representation like in the House of Representatives, and therefore poorer and smaller States are provided with important bargaining advantages. Secondly, it means that the senators first and foremost respond to their own constituencies. There is a problem of divergent constituencies – who are the senators serving?

 

The US Senate as a key actor of the American federal structure is consistent with Wibbels’s aforementioned definition of operationalization of federalism – that the interests of the regions are incorporated into the national decision-making; and the regional level of government has some area of autonomy (Wibbels, 2005). This plurality of constituencies, however, also means that subnational politicians may have no incentive to follow a policy that does not satisfy their own constituency. This is what Rodden and Wibbels (2002) call a “war of attrition”: states can become too big to fail and this makes the decision-making process much more difficult. This is particularly the case when the ideological distance between the median senator and the central government is significant. A senator’s job is mainly to gain benefits for their own home states. Their constituencies might be satisfied with their work, and elect them for another term. This leads to a paradoxical situation whereby many voters complain about no changes happening in a Senate that continually blocks policy reforms, while voting the same people in, simply because they do their job of serving their States. In the words of Sergio Fabbrini (2008), while there is some sort of “permanent distrust” towards the members of the legislature, and the Congress in particular, the members of the legislatures are confirmed because of their “individual responsiveness” to the requests of the electorate, so much so that “each representative or senator has become a sort of ombudsman”, channelling the discontent and the demands of their constituency into the conundrum of state bureaucracy. In other words, again, incumbency is “the outcome of very responsive legislators, but not a very responsible legislature” (Fabbrini, 2008).

 

Such a case is not exclusive to the US. As Wibbels (2005) notes, “[a]ny case in which policy change is within the competence of multiple governments and reforms are more likely to have an uneven geographical distribution of costs and benefits, intergovernmental conflict can complicate the reform effort,” and as Enns et al (2014) highlight, “[p]olicy stagnation exacerbates inequality.” Furthermore, the effects of status quo bias vary depending on the already existing levels of inequality – status quo bias serves the purpose of magnifying inequalities (Enns et al, 2014; Piketty and Saez, 2006).

 

Economic reforms can be seen as an Olsonian free-rider problem: they require individual regions to cooperate, whereas it is more rational for each career-oriented politician, or for a regional representative, to avoid the costs associated with cooperation (Wibbels, 2005). Therefore, on the one hand Birchfield and Crepaz (1998) emphasise how competitive veto point make it more difficult to change the status quo, and as such federalism tends to increase inequality “in a statistically significant manner”; on the other, we may conclude this section citing Halberstam (2011), according to whom federalism stalls redistributive reforms, in that status quo “is maintained by a structure-induced equilibrium.”

 

 

Fiscal versus political federalism

 

This section aims to give a brief summary of Erik Wibbels’s distinction between fiscal and political federalism. According to Wibbels, this distinction is important in order to understand why national and subnational governments may be out of kilter with each other regarding macroeconomic policies and income redistribution. As I wrote above, it was Charles Tiebout’s work that paved the way for the tradition of fiscal federalism. But what do we mean by fiscal federalism? And why do we need to differentiate it from the political tradition?

 

Wibbels (2005) argues that fiscal federalism is “a theory dealing strictly with fiscal decentralisation”, that is to say where the spending power is allocated. Oates (1999) reinforces Tiebout’s claims of salutary competition between the subnational jurisdictions. By following his reasoning, the maximum social welfare can be achieved when local outputs vary as a result of both differences in preferences (of the consumer-voter) and cost differentials (between jurisdictions). Reading between the lines, Oates believes the federal structure to be inherently unequal in its levels of redistribution, and that such inequality is justified by the inter-jurisdictional competition. Much like an economic system in which workers prefer to move to the sector with higher wages, the consumer-voters prefer to move to the jurisdiction that best satisfies his or her needs. In practice, however, these degrees of mobility are nowhere to be found, and people often take into account variables that are independent from the jurisdiction they live in or would like to move to.

 

Not only does Oates’s hypothesis go against most empirical findings (Wibbels, 2005), but fiscal federalism per se completely fails to account for the role of political accountability: any attempt to balance budgets must include simultaneous efforts by self-interested politicians (Wibbels, 2005). It is not merely a matter of what the governed want, but also of what those who govern can and want to do. This is political federalism, a consequence of which is that “the capacity for market reforms decreases with the divergence of political interests across levels of government within nations” (Wibbels, 2005).

 

Let us take Wibbels’s example of fiscal retrenchment. In times of recession, austerity is seldom the answer to overcome a crisis – especially for the poorer and less competitive countries (or, in this case, regions). Nonetheless, pro-cyclical measures are more often than not the hoped cure. In a multi-tiered government, poorer regions would want to hinder any possibility of fiscal retrenchment. They are able to do so since they participate to the legislative process. Under soft budget constraints (i.e., the national government is under pressure to finance the troubled regions, that is, to bail them out), regional politicians have few incentives to internalise the implications of their fiscal decisions for the rest of the federation (Wibbels, 2005). In this case, the national government can do one of three things: (1) increase its own spending to cover for imbalances; (2) transfer larger portions of the revenue to the subnational governments; or (3) ignore the problem (Rodden and Wibbels, 2002). The first two options are most likely to take place when the ideological gap between the national government and the regional one is small, if not null. In this case, not only is co-operation seen as a “forced path” (suppose both the federal and regional governments belong to the same party or are very close ideologically – what good would come from diverging policies?), but it is also seen as welcome (there likely is an ideology or common objective). The particular needs of the regional constituencies may constitute a challenge that would become harder the bigger the autonomy of the regional government, and the smaller the credibility of the federal one (Wibbels, 2005).

 

 

How income redistribution works. Conciliating federalism and soft budget constraints

 

Pablo Beramendi (2007) has shown that fiscal federalism operates on two levels: the size of the tax base, whereby richer regions prefer fiscal decentralisation; and the way income is actually redistributed across and within regions. In this last section I will try to explain these two dimensions through a particular case of federalism: Germany.

 

Why Germany? As the graph below shows, the countries where subnational fiscal significance in relation to revenues and expenditures is higher (Canada, Switzerland, the United States, Germany, and even the quasi-federal Spain) are mostly federal systems. This is no coincidence: by recalling Riker’s definition of federal state, one of the points he makes is that the subnational government has some degree of autonomy, either legislative or administrative, or both. This means that the regional governments usually have significant expenditures for administrative purposes, and a good part of the federal budget is allotted to the regions in order to ensure their smooth functioning. Federalism as a governing system is so entrenched in the German culture that article 79 of the Basic Law provides an eternity clause (Ewigkeitsklausel) whereby the federal structure is not subject to elimination. But the federal system is also part and parcel of the likes of the United States, Canada, and Switzerland. What, then, distinguishes Germany from these other countries?

 

Schermata 2015-02-22 alle 22.22.20

Graph 1: Fiscal significance of sub-central governments shares (Source: OECD, 2010)

 

Not only is German federalism more functional in nature, being the cooperative (as opposed to competitive) kind of federalism, but the German Basic Law also contains a particular clause that is deeply at odds with the standard vision of dual federalism (Rodden, 2003). Article 72(2) of the Basic Law states that federal action will be necessary to maintain equivalent living conditions throughout the federal territory. This is a complex system of fiscal equalisation that is carried out in four stages, summarised (except for the first one) in the table below. In the first stage the total tax revenue is divided vertically between the Federation and the Länder; in the second stage there is a horizontal redistribution among the Länder; thirdly, revenue-generation or financial capacity are taken into account: through the Länder Financial Equalisation (LFA) the funds are transferred from financially strong Länder to financially weak ones; finally, direct transfers from the Federation (Bundesergänzungsweisungen, or BEZ) come into play to even out the differences left open from the LFA. As Jonathan Rodden (2003) points out, this mechanism “tends to dilute fiscal accountability and soften budget constraints.” It is not far-fetched to think that the underlying reasoning is that, by levelling the playing field with regard to opportunity, governmental decisions are likely to also level the final tally of income (Enns et al, 2014).

 

Schermata 2015-02-22 alle 21.18.56

Table 1: How fiscal equalisation works (Source: Bundesfinanzminsiterium)

 

However, fiscal irresponsibility primarily translates into political unaccountability. The soft budget constraints imposed on the Federation make it so that electoral incentives for sound fiscal policy at the Land level are weak (Rodden, 2003). No Land has an incentive to keep the budget in line knowing that deficits are compensated by the LFA and the BEZ. Running deficits, therefore, could be seen as a way to keep the electorate happy and the subnational government unaccountable at the same time.

 

Two of the poorest Länder, namely Bremen and Saarland (respectively HB and SL in the graph below), are known for running constant deficits due to historical contingencies. The other Länder, as well as the federal government, are under a constitutional obligation to help them. However, it is unavoidable that richer Länder, such as Bavaria and Baden-Württemberg would be content with such a solution. Furthermore, soft budget constraints impose a greater toll on the Federation to avoid excessive debt accumulation and, in particular in the German case, to avoid exceeding the Maastricht criteria, namely the 3 per cent annual deficit cap – a feat that Germany seems be able to cope with.

 

 

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Graph 2: Financial balances of the German Länder (Source: DB Research, Bundesfinanzministerium)

 

Unlike a system of competitive federalism, such as the United States, where the limited government action in redistributive policy is still inspired by pro-market principles (Fabbrini, 2010), Germany proves to be a federal oddity. Germany de facto and de jure gives more importance to solidarity (principle of federal loyalty) and fairness (principle of federal equality) than competition and market-preservation. Even now, the country seems to be doing fine in spite of this restraint imposed by the Basic Law. Nonetheless, the importance of article 72(2) may be overestimated. As Rodden (2001, 2003) writes, this unique kind of administrative federalism has served the country quite well throughout the post-war years. It has created an inter-jurisdictional market amongst the best in the world, and it has facilitated the flow of goods and services between the Länder in a significant manner (Rodden, 2003).

 

I believe that this short excursus on the German federal system and fiscal equalisation is enough to explain the first question posed at the beginning of this section: why do richer regions prefer higher degrees of decentralisation? The answer is really simple: granting greater levels of autonomy to the subnational governments allows the richer regions to use fiscal resources more reasonably, since they would not have to divert part of their revenues to their poorer counterparts – this, supposing that a constitutional amendment to change the rules is passed. It was the case with Saarland and Bremen on the “poor” side, and Bavaria and Baden-Württemberg on the “rich” one. The second dimension on which Beramendi deems federalism to operate is explained by the German example less clearly, if at all. While it is true that the LFA and BEZ do provide a fairer redistribution of resources than a mere Land-based revenue, or even a pure joint fiscal system between the Federation and the Länder, it does not exactly explains where the resources are targeted in each Land.

 

A study commissioned by the DIW Berlin, the German Institute for Economic Research, (Bach et al, 2015) showed that financially needy households benefit most from means-tested basic social security payments, while other benefits are granted more evenly. Some of them, like the now-expired housing support for owner-occupiers even went so far as benefiting the upper income bracket. Albeit the redistributive effects of the tax and transfer system have led to a far more uniform distribution of net income compared to market income (Bach et al, 2015), it is only though a better-targeted government action, focusing on social mobility and equal opportunities that inequality between Länder will become less problematic. This is due to the fact that fiscal decentralisation has distributive effects that are contingent on the pre-existing patterns and structures of inequality (Beramendi, 2007). If the representatives of the richer Länder within the Bundesrat are going to act as veto players to hinder any possibility of a fairer redistribution, or if the representatives of the poorer Länder of fiscal responsibility, they both should be aware – as it has been said before – that it is exactly policy stagnation that exacerbates inequality (Enns et al, 2014), benefiting neither: it is the pre-existing inequalities that drive the decentralisation of the welfare state, which in turn reproduces these patterns of inequality (Beramendi, 2007). It will ultimately be up to the Federation to conciliate its legislative and administrative structure with its self-imposed soft budget constraints.

 

 

Conclusion

 

In this article I tried to give a summary of one of the possible ways in which the federal structure may affect regional and individual income. I have explained what we mean by federalism and why some countries would want to adopt it (or, conversely, would not want to do so). I have enquired whether federalism has some bias towards the status quo, finding a somewhat positive answer, and whether this status quo exacerbates pre-existing inequalities. In order to answer the last question, I took on Erik Wibbels’s distinction between fiscal and political federalism, underlining the great role played by political actors in economic policy-making. This was based on the assumption that regional redistribution (i.e. economic and fiscal policies) would somehow affect regional (and by extension, individual) income. In particular, the use of veto points by important political actors may serve the purpose of maintaining the status quo and magnify the inequalities. When analysing one of the ways income redistribution may work, I took Germany as an example of fairness and solidarity – a federal oddity in the political systems that nonetheless faces the same challenges. Soft budget constraints imposed by the Basic Law may constitute an even greater challenge that requires the Länder to work differently from what Olson’s free riders would do. The role of the federal government, instead, should be more similar to what Rector had in mind. As I have said, it is not merely a matter of what the governed want, but it is chiefly a quest to get different, if not diverging, political and economic interests to come together. This is federalism’s biggest challenge, and it goes far beyond its fiscal boundaries.

 

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