Functional federalism

In contrast to the benevolent government of the traditional welfare economics analysis, in Tiebout’s fiscal federalism model or in the yardstick competition approach institutional competition is considered an effective instrument to tame the Leviathan.

The functional federalism programme aims to show that both these short­comings disappear once the conceptual tension existing between the two institutions of the market and the government is solved. It has been observed that consumers can enter and exit from markets, but with positive mobility costs they are ‘locked in’ their political relations with the state (for example, the taxes and transfers determined by the government) (Buchanan, 1992). While a market that ends up with no customers just disappears, the political entity ruling in a certain territory can survive a certain amount of community aversion to the public goods provided. To establish the parallel between exit from markets and exit from governments, the positive costs of both ‘mobility by feet’ and ‘mobility by voting against the government’ are to be annulled. Once individuals are endowed with the right to opt out from a jurisdiction in the matter of consumption of public goods, institutional mobility comes at no cost.

To this end, functional federalism advocates the strategy of separating public goods provision from the political jurisdictions. Individuals who are not satisfied with the provision of public goods in their jurisdiction should not have to physically abandon the jurisdiction or to exit from their govern­ment by voting against it. Residents of different areas, but sharing the same preferences (for instance, because of the similarity of their income levels), may reach an agreement for a collective action aimed at setting up an agency for the provision of public goods (or choose among already established mono-functional providers) (Casella and Frey, 1992). The homogeneity of preferences that characterizes the markets for private goods is supposed to be replicable in the collective action for the production of public goods.

The strategy is the following. Since individuals belonging to different jurisdictions join a ‘club’ and each individual can participate in various clubs, the organization of the production of a public good overlaps various jurisdic­tions. Each individual or each community can freely enter or exit from one or more agencies, each offering a different package of tax and public goods. The self-selection of participants makes endogenous the number of agencies as a

function of desirable packages. The only limit to participation is the fulfilment of the congestion constraint according to Buchanan’s theory of clubs. The optimal dimension of each club is endogenously determined through the aggregation of the demands for a specific public good and controlled by exclusion clauses for members who do not pay contributions, so that the congestion constraint is met. Therefore, this model of organizing public goods production builds upon two main characteristics: (i) the clubs are mono-functional, whereby homogeneous groups of individuals vote on mono­purpose taxes, each one earmarked for the financing of a specific public good; and (ii) the clubs are inter-jurisdictional, as they do not derive their legitimacy from a state settled in a territory, but solely from the free choice of individuals to join one or more ‘extra-territorial jurisdictions’.

The functional federalism way to extend market competition to jurisdic­tions might require not only either Tiebout’s exit or the ‘voice’ mechanism devised by competitive federalism, but also the ‘loyalty’ to mono-functional and inter-jurisdictional agencies detached from the political jurisdictions set­tled in a territory.

However, the extension of market organization to public goods provision could result in a failure to fulfil both the efficiency and the equity objectives. As for the first, the stability across time of the sense of collective identity of a community group depends on the efficient governance of clubs and the influence on the functioning of the private sector. Due to interdependences and complementarities, the individuals participating in the various agencies are bound to suffer from strategic behaviour due to uncertainty and ex post opportunism in the agencies as well as in the markets. As for the second, the income-homogeneity character of the trans-jurisdictional agencies, by magnifying the demise of the solidarity principle, is disruptive for social cohesion.

It can be observed that the organization of the mono-functional agencies envisaged by functional federalism closely resembles the relationship with clients entertained by private companies operating in the insurance markets. Due to the well-known moral hazard and adverse selection problems of insurance markets, these latter agencies tailor contracts to suit just low-risk individuals. The high-risk individuals, to whom contracts are offered at the very high price corresponding to their ‘actuarially fair’ value, cannot afford insurance. They might also be low-income, due to spillovers across dimen­sions of well-being. The ‘cream skimming’ practised by private insurance companies (that is, the selection of best clients by implementing separating equilibria), represents the institutional design for the agencies operating pub­lic goods provision across jurisdictions. Moreover, those in the high-income and low-risk category have an incentive to change residence and settle in low tax and social expenditure jurisdictions.

The tendency to income homogeneity is not opposed by economic liberal­ism. On the contrary, the liberal appraisal of the social contract questions the redistributive outcome implied by the ‘pooling’ of high-income and low-risk individuals in the tax funding of public social protection institutions (Sugden, 1993). However, globalization has severely challenged the capacity of the modern democratic states to implement the social rights implied by the principle of ‘positive freedom’. As a consequence, the recognition that a person is an individual with rights is now an important factor that many international organizations for world cooperation incorporate explicitly in their statutes.