A State and Local Federalist Relationship Must Be Market-Preserving

Replacing the current, complicated relationship between states and local governments with an actual federalist relationship is appealing, provided that it disciplines government and preserves individual freedom.

Federalism describes a system in which no one entity is the sole source of political power within a given jurisdiction. States and local governments do not have a federalist relationship.

Instead, local governments are a form of administrative decentralization. A state’s political power is decentralized among a variety of local governmental units such as counties, municipalities, and school districts. Administrative decentralization is more about efficiency than local autonomy, but it gives the illusion of a federalist relationship between state and local government that often confuses citizens and local policymakers alike.

Replacing the current, complicated relationship between states and local governments with an actual federalist relationship is appealing, provided that it disciplines government and preserves individual freedom. But not all versions of federalism accomplish such a balance. To achieve this end, political scientist Barry Weingast argues for a specific form of federalism he calls market-preserving federalism.

According to political scientist William Riker, two conditions are necessary for federalism: (a) a hierarchy of governments, and (b) the institutionalization of autonomy of each government, such that federalism’s restrictions are self-enforcing. To these, Weingast adds three others: (a) subnational governments have primary regulatory responsibility over the economy, (b) they face a hard budget constraint (that is, their revenue cannot be augmented by higher level governments), and (c) they are prevented from erecting trade barriers against other lower-level governments.

Market-preserving federalism permits a variety of local governments to form, and these local governments can differ by the variety and amount of public goods they provide as well as by tax policy and other regulations. The presence of alternatives combined with the characteristics of market-preserving federalism together encourage local governments to credibly commit to economic policies that limit their ability to confiscate wealth and interfere with the economy. This interjurisdictional competition between local governments serves as a check on government power.  

Recognizing the relationship among the three additional characteristics of market-preserving federalism is important for understanding how a federalist relationship between states and cities should work. If cities are going to be given primary regulatory control over their local economy, then they must also face a hard budget constraint and be prevented from erecting trade barriers.

Hard budget constrains force city governments to confront the fiscal consequences of their decisions. For example, some residents may lobby for a higher statutory minimum wage, but if a higher minimum wage causes some employers to close or relocate to other jurisdictions—decreasing consumption and employment options as well as tax revenue in the process—they may change their minds.

Higher income taxes, property taxes, or regulations that increase the costs of doing business might also drive out employers and residents and decrease tax revenue. Ensuring that cities remain responsive to these signals requires that they do not receive supplemental revenue from the federal government or their state government. Currently, this is not the case. In fiscal 2013, local governments raised $1.52 trillion in general revenue, 36 percent of which came from higher-level governments, with the bulk of it coming from the state level.

State governments must avoid bailing out local governments in fiscal crisis. As Weingast explicitly notes, the hard-budget-constraint condition of market-preserving federalism is violated if higher-level governments rescue lower-level governments whenever the latter face fiscal problems.

Local governments must also not be allowed to impede trade. If trade is broadly conceived as the free movement not only of goods and capital between jurisdictions but also of people, then cities with extensive land-use regulations that artificially increase the cost of housing violate this condition. Such cities have not erected explicit barriers to new residents, but their land-use regulations have a similar effect by design. In these cases, states may have to intervene.

Trade barriers are prohibited because they enable governments to insulate firms within their borders from competition, which interferes with the market process that guides the most efficient use of scarce resources. Restricting labor mobility infringes on people’s individual freedom of movement and prevents labor from reaching its highest-valued use. And like a soft budget constraint, restricting the movement of goods and people dampens the feedback signals perceived by city officials, which reduces their incentive to modify ineffective economic policies.

Under this framework, local governments have a large amount of control over their economies. They can set their own tax policy, impose business-licensing requirements (e.g., thumbprints for Uber drivers), and implement price controls such as a minimum wage. The benefit of this framework is not that it prohibits certain economic policies but that it tightens the feedback between economic policies and their economic and fiscal impacts. This is important because feedback is crucial for effective decision-making.

Policies that lead to population loss, decreased tax revenue, or both will be hard to maintain so long as those signals are accurately transmitted to voters and government officials. Hard budget constraints and restrictions on trade barriers, including restriction on barriers to interjurisdictional migration, are vital for this reason.

Market-preserving federalism won’t eliminate local price controls or other economic interventions. In the short run, there will be local restrictions on economic activity that many free-market advocates will find objectionable. But, in the long run, this framework will expose the costs of such restrictions more rapidly and, thus, should decrease their use without requiring incessant intervention from the state. So, although it’s not a perfect solution, it would be an improvement over the status quo.