Even devolving balanced-budget tax and spend powers is tricky

Phew.  Or, wait?  What economic form is devolution going to take?  I blogged before that there was an argument that devolving borrowing powers out to component states would weaken the speed and force with which discretionary fiscal policy could be used to stabilise the macroeconomy, an especially important tool when we are at the zero bound to nominal interest rates.  A natural question arises:  well, what about devolving balanced budget tax and spend powers, then?  Isn’t that ok?  If the Federal government needs to do discretionary borrowing and taxing later on top of these local taxes, won’t that  work?  This would allow great differences in the size of the state in Scotland versus England, for example.  Scotland could set much higher taxes, and spend more on education and health.

I’m not sure this can work either:  even balanced budget tax and spend powers would have to be proscribed.  To take an extreme example.  Imagine Scotland sets taxes right up to its Laffer limit, the point at which any further increase in taxes levied there would raise no more money, and would just shrink the tax base.  (I’m not accusing the Scots of wanting to do this.  It’s just an example).  In that case, although the Federal government could in principle borrow and spend to stimulate the economy at the zero lower bound, it would find that its borrowing costs were higher on account of the Laffer-maximising balanced budget policy in Scotland, since markets would know that there was no scope for paying the debt back out of that part of the UK’s tax base.  And, when it came to pay the debt back, that would wind up being paid out of taxes raised in the rest of the UK, which (just for argument’s sake) I’m assuming has a smaller state, with a tax base ripe for raising funds.  This would not be fair, since it places the burden of fighting recessions on a part of the Union only.  And it would limit the fiscal room that parts of the union with the smaller welfare states would have to do the recession fighting, leading to a choppier business cycle, and a greater chance of hitting and becoming trapped at the zero bound for all.

Devolving balanced budget tax and spend powers also limits risk sharing.  Following through the extreme example above, a boom in a Scotland which spends the increase in taxes and stays at the Laffer limit prevents redistributed flows away from Scotland to pay for a recession in England.  I see this as a terrible cost of fiscal localism.  But some local nationalists seem to celebrate it.


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