The Centralized System

The centralized system (i) should be suitable for nationwide decision-making. For example, the government is required to provide nationwide public goods such as national defense, large infrastructures, and diplomacy. In this regard, local governments or a fully decentralized system cannot handle the spillover problem effectively unless policy coordination is perfect. Each local government does not easily internalize the spillover effects of its public spending on other local governments. As explained in Chap. 11, at the non-cooperative Nash equilibrium, the private provision of public provision becomes too small. Even the Lindahl mechanism cannot easily solve the free rider problem. Thus, it is hard for local governments to provide pure public goods nationwide in an appropriate manner.

Moreover, with regard to income redistribution policy, local governments face a severe limitation in the sense that residents living in a region with high progressive taxes can move to other regions with low progressive taxes. For example, the rich can easily leave a region with high progressive taxes. This means that tax competition may occur among local governments by reducing taxes in order to attract the mobile tax base such as rich residents or capital income. As a result, not all local governments can raise enough taxes from the mobile tax base. From this point of view, redistribution should be conducted by central government.

In reality, income redistribution is often conducted by means of interregional redistribution rather than interpersonal redistribution. This is because governments may not know those are rich or poor. An indirect indicator of true income may well be the regions where people live; if so, interregional redistribution becomes useful.

However, it seems difficult for local governments to concur about the degree of interregional redistribution in the decentralized system. Rich regions are always against a large amount of redistribution, while poor regions always seek a large amount of subsidies. Hence, interregional redistribution may be conducted only by central government. Thus, the centralized system (i) is better than the decentralized system (ii) in many regards.

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