Precommitment in a system of hierarchical governments

Abstract

Local government tax and service policies, for reasons including tax competition, spillovers of service benefits, household migration, and a limited choice of tax instruments, may not be globally efficient. Policies used by state governments to remedy these inefficiencies include matching grants, mandates, and tax subsidies. We consider an additional strategy that the state government may employ to influence local policies, namely choosing or ‘precommitting’ to its policies before the local governments choose their policies. We argue that the conditions necessary for the state government to credibly precommit to its policies with respect to local government policies do exist. The unlikelihood of the state government being able to alter its policies after local governments have chosen their policies reduces problems associated with time-inconsistency. We first derive the general conditions necessary for precommitment to improve social welfare and then provide several examples from the literature on state and local public finance in which precommitment by the state government increases social welfare and leads to different policies than those obtained in the Nash equilibria normally considered.