Conagra Foods Research Professorship in Strategic Management; Professor of Strategy
Equality is upheld as one of our country's highest ideals. In his second inaugural address, President Obama said, "a little girl born into the bleakest poverty knows that she has the same chance to succeed as anybody else because she is an American, she is free, and she is equal not just in the eyes of God but also in our own." But in a country where everything has a price, what mechanisms ensure that those without material means can secure equal opportunities to succeed?
The way some economists conceive of it, certain goods and services so pivotally affect an individual's life fortunes that access to them should trump the ability to pay. And broadly speaking, Americans tend to agree: our citizens should be able to enjoy basic nutrition, housing, health care, and education, regardless of whether they are rich or poor. Thus, we have an "egalitarian preference" for the distribution and consumption of these things.
Idea Mash-up: Oates Meets Tobin
The idea of a societal preference for equitable access to essential goods and services was first espoused in 1970 by James Tobin, a Nobel Prize–winning economist. In 1972, in an unrelated vein of inquiry, economist Wallace Oates published the book Fiscal Federalism, which examines how public-sector responsibilities and finances should be divvied up amongst multiple nested layers of government. From Oates's perspective, the optimal system—that is, the least wasteful system—is to put goods and services in the hands of local governments, who then decide the best ways to distribute the goods and services. Empowering local governments has become a basic tenet of fiscal federalism.
But in cases where there are egalitarian preferences for specific goods and services, is Oates's favored framework truly the best federal fiscal model? New research by Therese McGuire, a professor of management and strategy at the Kellogg School of Management, uses Oates's framework to investigate how to equitably distribute the goods and services that Tobin identified as crucial for determining an individual's life chances.
McGuire, who worked with two coauthors from the Universitat Pompeu Fabra and the Barcelona Graduate School of Economics, points out that Tobin's view conflicts with a central belief of most economists. "Efficiency in economics is about getting the most social welfare, the most utility, and the most happiness possible," McGuire says. "Which is why economists say to redistribute income, not goods and services, because that's how people will be happier and you get higher social welfare." But when society prefers to see certain essentials equitably distributed, which the authors refer to as "solidarity," McGuire and her coauthors take the position that it is more efficient to focus on equitable provisioning of the specific goods and services.
The researchers then ask, should the public administration of such services be centralized or decentralized? What is the best fiscal federal structure for these publicly provided services?
To answer these questions, McGuire and her coauthors designed a series of models representing a hypothetical society with multiple nested levels of government. (Regions could be states in the U.S. or countries in the European Union.) People were grouped into two categories: rich and poor. The poor controlled 20 percent of the assets, and the rich controlled the remainder. The authors assumed that the public opposed fluctuating levels of key services across jurisdictions.
The researchers then modeled five different types of federal fiscal structures: centralized, decentralized, voluntary transfers (where money is transferred between regions), matching grants (where local governments match grants made by the central government), and guaranteed minimums (where a minimum grant amount is guaranteed by the central government to local governments). Within each model, they allowed for a continuum of the public's preference for solidarity. They also assumed that this preference was organic, or reflective of a region's values, rather than imposed from elsewhere. With all the parameters in place, the researchers then ran simulations to find the most efficient fiscal system.
A Surprise Finding
While Oates argued for the superiority of a system where subcentral (or local) levels of government were fiscally empowered, the authors speculated that, once solidarity was taken into account, a decentralized system might not be the most efficient system. Indeed, the models showed that the strength of the solidarity preferences determined how well different systems performed.
"If the goods in question are privately consumed and there is no taste for solidarity," McGuire explains, "then a decentralized system is the most efficient one. But when a taste for solidarity is present, the most efficient system turned out to be the guaranteed minimum system."
Figure 1: Efficiency loss associated with varying tastes for solidarity
In fact, the guaranteed minimum system yielded the least inefficiency in every case considered, from when solidarity preferences were extremely weak to when solidarity preferences were extremely strong.
McGuire said it was surprising and notable that the guaranteed minimum system outperformed all the others. "We looked at many reasonable changes to the assumptions," McGuire said. "We allowed all kinds of variance in the models—how strongly you feel about solidarity, how we characterized the utility function of the various individuals—and no matter what we did, the guaranteed minimum came out as the most efficient."
Findings, In Context
Why is a guaranteed minimum so ideal? Essentially, it ensures that everyone has adequate goods and services while still recognizing regional differences by allowing regions that wish to provide more to do so. McGuire says the study represents the first time that Tobin's ideas of "specific egalitarianism" (or solidarity) have been crossed with Oates's framework of fiscal federalism. "We provide a new rationale for a fiscal federal system with a guaranteed minimum level of provision of key goods considered to be vital to economic and societal success," McGuire said.
There are plenty of real-world applications. The model indicates that the best way to offer healthcare is to enact a guaranteed minimum system. "If we all believe that a certain minimum level of health care should be provided for everyone to be on equal footing and succeed in our society, then the preferred system is either central provision or a central mandate that is common across the country," McGuire says.
Already, most public schools are funded with a guaranteed minimum form of state grant. However, the minimum spending level guaranteed by the states differs from one state to the next, which creates disparities.
According to McGuire, the findings are also relevant to Spain, one of several countries in the EU whose debt to GDP ratio is worryingly high. Part of the country's debt burden comes from borrowing by regional governments, who have important spending responsibilities, including health care and education, but whose revenues are in large part controlled by Spain’s central government. This separation of revenue-raising authority from spending responsibility “is an inefficiency of a highly centralized system that you would not necessarily have with a guaranteed minimum system," McGuire says. In a guaranteed minimum system, the regional governments would be responsible for raising any additional funds beyond their centrally financed minimal allotment.
Here at home, the federal government's reach is hotly contested, as the recent debates over "Obamacare" demonstrate. But this recent study by McGuire and her coauthors demonstrates that some issues are best solved by neither completely centralized nor decentralized systems. This is especially true when it comes to the critical goods and services to which society deems everyone should have access—even those in society who are, as President Obama put it, "born into the bleakest poverty."
Calsamiglia, Xavier, Teresa Garcia-Milà, and Therese J. McGuire. 2012. “Tobin Meets Oates: Solidarity and the Optimal Fiscal Federal Structure.” International Tax and Public Finance, pp 1-24.