Podcast Insight In Person

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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