Why decentralization could fix Germany

The Tiebout Model

Charles M. Tiebout was an American economist. He developed a model that has become a cornerstone of the theory behind efficient tax competition between local jurisdictions. I found this model to describe very accurately what I believe the issue behind centralization is. I have an economy background, but I am not a professional economist so take my explanation with a grain of salt, but I will try my best to accurately describe his model.

In his 1956 paper "A Pure Theory of Local Expenditures", he describes a problem that arises when governments provide public services and goods to citizens and charge them for this service using taxes. To accurately choose the level of public goods and services provided and taxes charged, the government needs to determine the true preference of citizens. The issue here lies that the government cannot accurately determine this level, because a rational citizen, would state a lower demand for public goods and services so that he is charged less, but then consume these goods and services at a higher level. This problem is also known as the free-rider problem.

Tiebout argues that this problem can at least be solved on a local level. He takes as an example a city resident that wants to move to a suburb. This exemplary citizen will choose a municipality that fits his preferences for public goods. If he has children, he will likely choose a municipality that has high expenditures on education for example. The more choices he has, the more likely it is that he will find a municipality that fully realizes his preferences.

He in essence, creates a market model of local governance. The municipalities are the producers, the citizens the consumers. Public goods and services are the good and taxes the corresponding price. The act of willingness to buy the good from a producer is moving to the corresponding municipality.

Another important factor in this model is the cost to move. Moving to another municipality incurs friction. This friction leads to suboptimal allocation, since we may choose to live in a municipality that does not fulfil our preferences, if the friction is higher than the benefit gained from moving.

So based on this model, should all government functions be localized? No, because an important factor are externalities–costs or benefits that spill over between municipalities. If the neighboring municipality lacks law enforcement or pollutes the air, this will also affect my municipality. So there is some form of integration necessary between municipalities.

This model obviously has limitations. It disregards the difference in incomes between individuals and employment opportunities in different municipalities. In reality, one must choose a location close to employment opportunities. It also assumes full mobility of citizens and that citizens can accurately determine the revenue-expenditure patterns of municipalities. It also disregards that poor municipalities might underfund essential services, leading to a severely diminished quality of life.

Despite these limitations, I believe that this model describes the cost that comes with centralization very accurately. In a monopolistic market, citizens may not choose based on their true preferences, but must live with what is offered. And just like in a private monopolistic market, this can lead to inefficiencies and overpriced public goods and services for consumers.