Capitalization, decentralization, and intergenerational spillovers in a tiebout economy

Many goods provided by various levels of government, such as police and health services, food assistance, and redistributional transfers, are intended for immediate consumption. Others, such as highways, public buildings, ports, parks and research and development are forms of public capital intended to last for many years. Providing these Durable Public Goods (DPGs) at efficient levels is difficult not only for the ordinary "free riding" reasons common to all public goods, but also because they produce intergenerational spillovers. Even if all existing agents truthfully revealed their willingness to pay and made their appropriate Lindahl contributions, they still would have no incentive to take into account the benefits that future generations receive from the stock of DPGs they leave behind. Clearly, unless this intergenerational spillover is somehow internalized, DPGs will be systematically under-provided.

We consider an overlapping generations model with a Durable Local Public Good (DLPG). We establish a Tiebout Theorem (equilibrium exists and is first best) as well as a Second Welfare Theorem in this dynamic DLPG economy. We also establish conditions under which local provision of durable public goods, as Tiebout suggested, results in the full internalization of the intergenerational spillovers that durability entails. We show that housing price bubbles or busts can result in a violation of these conditions. However, if housing prices fall within a "normal range", they give agents correct incentives for optimal investments in DLPG. In contrast, when durable public good are provided by the national government, internalization does not take place and under-provision of public goods will result. This sets up an institutional trade-off between national and local provision of public goods that balances the relative strength of intergenerational and interjurisdictional spillovers.