Weingast B.R., Wittman D. The Oxford Handbook of Political Economy
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352 the protection of liberty, property, and equality
the court has deferred to the ostensible expertise and impartiality of the legislature by
holding that any “conceivable” public purpose satisfies the “public use” requirement
of the takings clause (Hawaiian Housing Auth. v. Midkiff, 1984). Thus property could
be transferred from one party to another to break up a local monopoly or on tenuous
findings of blight control. The thunderbolt in this area, however, was Kelo v. City
of New London (2005) where a five-to-four majority of the Supreme Court upheld
condemnation of private homes for economic development, which in turn provoked
a firestorm of public protest and federal and state efforts to curb that limitless holding.
The insecurity of property rights has increased political intrigue, and the use of
restricted formulas for compensation has resulted in inefficient takings that have
moved property from higher to lower valued uses. On these matters, some state
courts, angered by high-handed local tactics, have taken a more restrictive view of
public use under the analogous provisions of their own constitutions.
Once the public use hurdle is overcome, compensation is owed when the state
occupies all or part of a parcel of property. The theoretical ideal suggests that the
compensation offered should leave the property owner indifferent between his former
holdings and the state compensation package. The legal rules advance that goal in part
by concentrating on the value of the property lost, and not that which is retained.
In addition, most courts properly make adjustments for any gains or losses in the
value of retained lands as a function of the taking, so that increased value from access
to a highway will reduce compensation, while any impediment to retained land will
increase it. But in calculating compensation, the legal rules that focus on the fair
market value of the “property taken” will in practice fall far below this standard. The
rules do not allow for any compensation of the owner’s subjective value because of
distinctive uses or attachments to property. That restriction is defensible perhaps on
the ground that subjective value is hard to measure. But even so, a small fixed bonus
of, say, 5 or 10 per cent is administrable, and offers a serviceable proxy for these hard
to measure elements of value. Less defensible than the subjective value rule are the
exclusions of any costs of defending against the taking, doing appraisals, moving,
and destroying good will. The upshot, however, is that the lax standards on public
use and just compensation lead to too much taking activity. It has been sometimes
suggested that individuals who are unhappy with these rules could purchase “takings
insurance,” but the risk that the state would selectively condemn such insured lands
makes it highly unlikely that any insurer would offer it, knowing that local political
processes could target insured lands for government occupation or regulation.
The second half of the takings issue involves regulatory takings, where the key
question is whether any compensation is owed at all for “mere” use restrictions. Here,
as noted, the lower standard of review means that many cases of value lost through
regulation are treated as non-compensable. In Pennsylvania Coal Co. v. Mahon (1923),
Justice Holmes famously held that a government was required to pay compensation
when it required a mine owner to conduct his operations so as not to remove the
support for the land and structures of the surface owner. The obvious defense of
Mahon’s result was that the miner had purchased the so-called support estate from
the surface owner, to whom he had to return it without compensation. But instead of
richard a. epstein 353
relying on that unexceptionable ground, Justice Holmes invalidated the regulation be-
cause it went “too far,” and thus plunged regulatory takings into deep confusion from
which they have never escaped. Normally, the “how far” is relevant to determine the
amount of compensation owed—the more that is taken the more that must be paid.
But here this manifest matter of degree was used to determine the yes/no decision
ofwhetheranycompensationwasowedatall.Threeyearslater,inEuclid v. Ambler
Realty (1926), the court held that a zoning ordinance that limited the owner of a
sixty-eight-acre contiguous commercial site to only residential uses did not go too far
because the zoned property had lost only 75 per cent of its previous value, even though
the proposed commercial use posed no threat of a nuisance to adjacent land. Justice
Sutherland did not realize that this private loss also counts as a social loss, and he did
not calculate whether the social gains from the regulation exceeded that local loss.
Requiring local officials to buy the right to limit development use would have helped
answer the question of comparative evaluation because it would increase the likeli-
hood that regulations would be imposed only when the community received benefits
greater than its costs. But so long as some viable use was left no compensation was
owed for the development rights that were taken. Euclid also gave the police power
a broad construction by treating (with covert racial overtones) the desire to stop the
construction of multi-unit dwellings as a legitimate public end. In essence, the zoning
law set up a system of veto rights, which could (as happened in Euclid) be sold back to
the owner in exchange for some other political concession. Once again it was the judi-
cial faith in public planning that led the court to disregard the risks of faction, and the
exclusionary effects that zoning laws could have on outsiders to the local community.
Euclid set the course by giving a narrow definition of takings coupled with a
broad account of the police power. The modern formulation of the takings doctrine
dates from Penn Central Transp. Co. v. New York (1978), where the court upheld
New York’s designation, without compensation, of the Penn Central building as a
landmark, which prevented the owner from using or selling the air rights over the
structure. These air rights are an ordinary property interest under state law, and the
statute singled out one landowner in a downtown area filled with tall buildings. In
upholding the statute, the court rejected the use of any fixed formula that stressed the
disproportionate impact of this regulation on a few selected sites. It opted instead for
an “ad hoc” balancing test. Under this test, the “economic impact of the regulation on
the claimant and, particularly, the extent to which the regulation has interfered with
distinct investment-backed expectations are, of course, relevant considerations. So,
too, is the character of the governmental action” (Penn Central v. New York 1978, 124).
This shadowy formula, however, gives no hint of what is meant by “investment-
backed” expectations, nor did it require the state to show any strong health or safety
interest. The upshot was that so long as the existing use of the current facility was
viable, then the loss of development rights was not compensable. The subtext of
Justice Brennan’s influential decision is that the legislature could take into account the
non-market values of preservation. But once again he ignored an alternative approach
more consistent with public choice principles. Treat the preservation restrictions as a
public use, but require the city to pay for the site value losses incurred by the owner.
354 the protection of liberty, property, and equality
In Lucas v. South Carolina Coastal Commission (1992), the state prohibited any
new construction at all, so the safety valve available in Penn Central did not apply.
In response to the draconian restriction, the court cut back somewhat on its Penn
Central formula by holding that any land use regulation that permitted no “viable
economic use” of vacant land constituted a regulatory taking unless those restrictions
were needed to prevent the occurrence of a common law nuisance, which could not
be established in the case of the construction of an ordinary beach house. South
Carolina quickly amended its statute to allow development after tortuous processes,
and to this day no one quite knows how many obstacles may be thrown in the path of
development before the delays and conditions trigger compensation for the value of
land immobilized through regulation. Since Lucas, it seems clear the court has looked
favorably on moratoria delays ostensibly for planning purposes, and it appears that
multiple delays, especially if done by different agencies, each start the clock running
anew, so that “temporary” takings of twenty years have passed constitutional muster,
even though a sounder solution would require that the state, after a short planning
interlude, compensate annually for the lost use value of the property. (See Ta h o e -
Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency 2002). In addition,
today’s set of permissible environmental and slow-growth purposes goes far beyond
the prevention of common law nuisance. Thus, in Ta h o e - S i e r r a , the run-off of plant
life from previous undeveloped land introduced ugly green algae into the pure blue
waters of Lake Tahoe. In allowing the planning authority to block new construction,
the court allowed concrete driveways of little value to remain in place. Yet insisting
that the incumbents pay to prevent newcomers from building as earlier arrivals had
done would have forced the incumbents to consider the future costs of their own
prior actions. By ignoring these incentives, the Tahoe decision gave undue weight to
the expertise of local land use planning operations, without taking into account their
powerful local biases. Outside developers in some instances provide counterweight
to these insider pressures, but their influence is predictably lower when the only new
construction is on isolated plots of land which are too small to support developer
coalitions. Only the super-rich make it through—by building mansions on large plots
of lake-front property. It further gave the perverse incentive in other areas to build
even if construction is not the most efficient use of the land to avoid later delays.
3 Conclusion
.............................................................................
The current state of constitutional law places different types of liberty and property
interests in different categories, and thus subjects them to different levels of review.
In general, this fragmentation leads to a loss of coherence in constitutional law, which
creates odd boundary problems (e.g. is an anti-sign ordinance a speech or a property
issue?). These problems are better solved by uniform rules with one objective: to
slow down those government maneuvers that shift wealth across factions, thereby
richard a. epstein 355
reducing public choice problems, while allowing those projects to go forward that
create social improvements that are shared, typically pro rata, by all individuals in
question, thereby enhancing efficiency. That objective can only be achieved by apply-
ing something akin to intermediate scrutiny to all forms of regulation regardless of
their content. That review should test for disparate impact and allow only a relatively
narrow set of police power justifications. Many have objected to this view on the
grounds that courts are at least as fallible as legislatures, but without their democratic
legitimacy. Yet oddly enough, it is difficult to identify any beneficial legislation that
the court struck down under these earlier views, unless one thinks that minimum
wage laws and collective bargaining improve overall social welfare. But for those who
accept the dominance of competitive markets in spheres in which they can operate,
the unity of liberty, property, and equality that forms the core of the Lockean heritage
may be implemented in a constitutional system that allows the state to overcome
coordination and holdout problems without opening the door to rent dissipation
through the unlovely squabbles that all too often dominate the current political scene.
The frequent judicial disregard of the insights of public choice theory has done much
to squander away a worthy constitutional tradition.
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356 the protection of liberty, property, and equality
List of Cases
Abrams v. United States, 250 US 616 (1919).
Adair v. United States, 208 US 161 (1908).
Allgeyer v. Louisiana, 1645 US 578 (1897).
Allnut v. Inglis, 104 English Reports 206 (KB 1810).
Baldwin v. G.A.F. Seelig, Inc., 294 US 511 (1935).
Brandenburg v. Ohio, 395 US 444 (1969).
Brown v. Board of Education, 347 US 483 (1954).
Carolene Products Co. v. United States, 304 US 144 (1938).
Coppage v. Kansas, 236 US 1 (1914).
Corfield v. Coryell, 6 Fed. Cases 546 (CCED Pa. 1823).
Duquesne Light Co.
v. Barasch, 488 US 299 (1989).
Eastern Enterprises v. Apfel, 524 US 498 (1998).
Euclid v. Ambler Realty, 272 US 265 (1926).
Grutter v. Bollinger, 123 S. Ct. 2325 (2003).
Hawaiian Housing Auth. v. Midkiff, 467 US 229 (1984).
Home Building & Loan Ass’n v. Blaisdell, 290 US 398 (1934).
Kelo v. City of New London, 125 S. Ct 2655 (2005).
Lochner v. New York, 198 US 45 (1905).
Loretto v. Teleprompter Manhattan CATV, 458 US 419 (1982).
Loving v. Virginia, 388 US 1 (1967).
Lucas
v. South Carolina Coastal Commission, 505 US 1003 (1992).
McConnell v. Federal Election Commission, 124 S. Ct. 619 (2003).
Minnesota v. Clover Leaf Creamery Co., 449 US 456 (1981).
Munn v. Illinois, 94 US 113 (1876).
Nebbia v. New York, 291 US 502 (1934).
New York Times v. Sullivan, 376 US 254 (1964).
Penn Central Transp. Co. v. New York, 438 US 105 (1978).
Pennsylvania Coal Co. v. Mahon, 260 US 393 (1923).
Plessy v. Ferguson, 163 US 537 (1896).
Reed v. Reed, 404 US 71 (1971).
Slaughterhouse Cases,
83 US 36 (1872).
Smyth v. Ames, 1690 US 466 (1898).
Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency, 535 US 302 (2002).
Truax v. Raich, 239 US 33 (1915).
United States v. Addyston Pipe & Steel Co., 175 US 211 (1899).
Usery v. Turner Elkhorn Mining Co., 428 US 1 (1976).
Virginia Board of Pharmacy v. Virginia Consumer Council, 425 US 748 (1976).
West Lynn Creamery, Inc. v. Healy, 512 US 186 (1994).
Ye e v. Escondido, 503 US 519 (1992).
chapter 20
..............................................................
FEDERALISM
..............................................................
jonathan a. rodden
At least since Montesquieu, theorists of federalism have viewed it as a solution to
a basic challenge—how to extend effective government beyond the confines of the
city-state. For Rousseau, good government was not possible in countries with large
populations or vast territories without some form of federalism. James Madison saw
federalism as a way to provide collective goods covering a large territory without
sacrificing local accountability. More recently, political scientists see federalism as
a path to peace and democracy in divided societies, while welfare economists see
it as a way to enhance the efficiency and accountability of government, and public
choice theorists see it as a way of protecting liberty and curbing government’s natural
tendency toward excess.
While each of these perspectives has produced testable positive arguments, the ab-
stract advantages of decentralized, federal systems over more centralized alternatives
often take center stage. The purpose of this chapter is to review the positive political
economy literature that has arisen in response to the disjuncture between such classic
normative theories and the practice of federalism around the world. The normative
tradition made blunt assumptions about the malevolence or benevolence of public
officials and attempted to design optimal federations, drawing on the notion that
federalism implies a rigid and clean separation of the spheres of sovereignty allocated
to central and lower-level governments while paying little attention to institutions
and modes of preference aggregation. This approach led to the establishment of some
useful normative benchmarks, but was not well suited as the foundation for empirical
work. The new political economy literature draws more directly on political science
by assuming that public officials are motivated by electoral goals. As a result, it places
much greater emphasis on political incentive structures like parties, legislative orga-
nization, and electoral rules. Thus the new literature leads to more refined empirical
predictions in which the effects of federalism—for instance upon fiscal behavior or
accountability—are contingent upon other political, institutional, or demographic
358 federalism
factors. Moreover, the prevailing view of federalism as a clean division of sovereignty
between higher- and lower-level governments is giving way to a notion that authority
over taxation, expenditures, borrowing, and policy decisions is inherently murky,
contested, and frequently renegotiated between governments, with federal constitu-
tions analogized to the “incomplete contracts” of industrial organization theory.
The first section of the chapter introduces the classical approach to the study
of federalism. The second section reviews the influential normative approaches in
economics in the 1970sand1980s and some of the empirical literatures they spawned.
The third section reviews the newer positive political economy literature and the
resulting empirical work as complements to the normative approach, highlighting
crucial questions of institutional design—fiscal discipline, accountability, macroeco-
nomic and political stability—in contexts as diverse as the European Union, Brazil,
and Iraq. Because this literature has largely ignored the endogeneity of institutions,
the fourth section counsels caution in drawing policy implications from the new
literature as it stands, and goes on to preview a nascent literature that attempts to
explain cross-national variations in forms of federalism as well as diachronic evolu-
tion within countries.
1 The Classical Normative Roots
of the Modern Political
Economy Literature
.............................................................................
Montesquieu and Rousseau argued that citizens are more likely to get what they
want from government if it encompasses a small, relatively homogeneous area rather
than a vast territory. Yet small units are vulnerable to attack, while large jurisdictions
can, if properly structured, avoid internal warfare and pool resources to repel attacks
by outsiders. Alexander Hamilton emphasized additional advantages of large size—
above all free trade—and modern public economics has added a few more, including
advantages in tax collection, inter-regional risk-sharing, common currencies, and
scale economies in the production of public goods.
The goal of federalism—to achieve simultaneously the advantages of small and
large governmental units—boils down to a vexing dilemma of institutional design.
While Alexander Hamilton ruminated that a fragmented federation cannot pro-
vide collective goods or fight effectively against centralized despots, Thomas Jeffer-
son feared a center that would accumulate too much power and run roughshod
over the rights of the constituent units. Herein lies the central tension of much
scholarship on federalism among political scientists since The Federalist:federations
have a natural tendency to become either too centralized—perhaps even despotic—
or so decentralized and weak that they devolve into internal war or fall prey to
external enemies.
jonathan a. rodden 359
Thus the task facing institutional designers is the creation of a central government
that is simultaneously strong and limited: strong enough to achieve the desired
collective goods, but weak enough to preserve a robust sense of local autonomy. This
was the central project in William Riker’s (1964) classic work on federalism and the
political science literature that followed. It is also the central challenge of institutional
design in federations ranging from the European Union to Brazil and India.
Political scientists take federalism as a necessity in large, diverse societies, and have
been preoccupied with finding the right balance between centripetal and centrifugal
forces, searching for institutional, cultural, and political circumstances that allow
for stable federalism and the avoidance of oppression or war in diverse societies
(e.g. Bednar 2001; de Figueiredo and Weingast 2005). Recently, Russia’s precarious
balance between despotism and dismemberment has taken center stage (Treisman
1999; Filippov, Ordeshook, and Shvetsova 2004).
However, many of the world’s federations are plagued with neither centralized
dictatorship nor armed insurrection, but rather with bad policies, poor fiscal man-
agement, and in some cases persistent economic crisis. Policy-makers in Brazil and
Argentina, for example, are less concerned with interstate military conflict than with
inter-provincial trade wars and distributive battles over revenues and debt burdens.
The classical approaches in economics provided general prescriptions for a more
efficient federal system to alleviate the problems of poor fiscal management and
bad policies, but assumed away problems of politics, incentives, and stability. This
division of labor between classical public finance, which concentrated on optimal tax
collection and the optimal provision of public goods, and classical political science,
which concentrated on the problems of centrifugal versus centripetal forces, has, until
recently, allowed some important questions to fall between the cracks separating the
disciplines.
2 Benevolent Despots,Local
Competition, and Leviathans
.............................................................................
Let us examine more closely the influential first generation of economic theories that
generated such optimism about decentralization and federalism. Some of the basic
insights of public finance theory suggest that federalism should have beneficial, even
if unintended consequences for efficiency, accountability, and governance. Above
all, decentralized federalism is thought to align the incentives of political officials
with citizen welfare by improving information and increasing competition. First, the
most basic observation is that in any political entity larger than a city-state, local
governments will have better information than distant central governments about
local conditions and preferences. The welfare economics literature, which takes its
name from Wallace Oates’s 1972 book Fiscal Federalism,
1
flows naturally from the
¹OateswasprecededbyMusgrave1959.
360 federalism
classics of political philosophy that emphasize the advantages of small jurisdictions.
It assumes that political leaders are benevolent despots who maximize the welfare
of their constituents, and prescribes decentralization according to the principle that
“the provision of public services should be located at the lowest level of government
encompassing, in a spatial sense, the relevant benefits and costs” (Oates 1999, 5).
Once the “assignment problem” is solved and appropriate tasks are devolved to local
governments, “the hope is that state and local governments, being closer to the
people, will be more responsive to the particular preferences of their constituencies
and will be able to find new and better ways to provide ...services” (Oates 1999, 1).
Second, a vast literature on “competitive federalism” examines the supposition
that, under decentralization, governments must compete for mobile citizens and
firms, who sort themselves into the jurisdictions that best reflect their preferences for
bundles of governmental goods and policies. The first generation of theory analogized
decentralized governments to the private market and celebrated the efficiency gains
associated with the promotion of competition among decentralized providers of
public goods. Much research has been inspired by the work of Charles Tiebout (1956),
according to whose simple market analogy, intergovernmental competition allows
citizen landowners to sort into communities that offer their desired levels of taxes and
bundles of goods, thus allowing citizens a powerful preference revelation mechanism
beyond voting and lobbying.
2
In contrast to the above, the “Leviathan” theory (Hayek 1939; Brennan and
Buchanan 1980) takes a less generous view of governments. Under centralization,
Leviathan has monopoly power over the tax base and will extract as much as possible
given the constraint that people can withhold their labor if taxed too much. In
contrast, under decentralization, politicians and bureaucrats must compete with one
another over mobile sources of revenue, preventing them from lining their pockets
and resulting in smaller and less wasteful government. This notion has been revisited
by Weingast (1995) and Persson and Tabellini (2000), who view capital mobility under
federalism as a way for government to commit not to over-tax capital or over-regulate
the economy.
As pointed out by Winer’s essay in this volume, the social planner model has not
been a good starting point for empirical work. For instance, the actual vertical struc-
ture of tax authority in much of the world does not resemble the textbook solutions
to the “tax assignment problem” in fiscal federalism theory, and intergovernmental
grant programs are not limited to conditional, open-ended matching grants aimed
at internalizing externalities (e.g. Inman 1988). Though preferences are difficult to
measure and the causal mechanism difficult to identify, empirical implications of
the Tiebout model are more amenable to testing (e.g. Brueckner 1982; Gramlich
and Rubinfeld 1982). Even more empirically tractable is the simple version of the
Leviathan hypothesis, which has received mixed support in US and comparative
studies (e.g. Marlow 1988;Zax1989;Oates1985).
² For more detailed reviews of this literature see the contributions of Winer and Wildasin to this
volume.
jonathan a. rodden 361
3 Positive Political Economy:
Rethinking Institutions and Politics
.............................................................................
The classic economics literature yielded some testable positive claims, most of which
linked federalism and decentralization to broad improvements in efficiency, giving
the literature a strong normative flavor that found its way into policy debates. As
decentralization and federalism spread around the world along with democratization
in the 1990s, these claims seemed increasingly anachronistic in the face of subnational
debt accumulation and bailouts among large federations and evidence of corrup-
tion and inefficiency associated with decentralization programs. Furthermore, cross-
national empirical studies linked federalism with macroeconomic distress (Wibbels
2000; Treisman 2000b) and corruption (Treisman 2000a).
Though these experiences by no means constituted natural experiments for evalu-
ating classical economic theories of federalism, they engendered a decade of scholar-
ship aimed at rethinking federalism. It was not difficult to identify politics as the miss-
ing component in the prevailing literature. Leaving behind benevolent dictators and
malevolent rent-seekers, the new literature takes more seriously the role of preference
aggregation through voting and lobbying. Some of the recent contributions rely on
the median voter framework, some on probabilistic voting models, and others on the
citizen-candidate framework. Most derive insights from assumptions that politicians
are primarily interested in maintaining and enhancing their political careers, through
either re-election or movement to more desirable offices.
Thus political incentives—ranging from electoral rules to legislative organization
and party structures—take center stage in the new literature, which draws on theoret-
ical traditions developed to address legislative bargaining and principal–agent prob-
lems, and borrows liberally from concepts in industrial organization theory. A key
theme is that like multilayered firms, federations will not function effectively unless
incentives are properly structured. Returning to the classic theme of The Federalist,
the central challenge is how to structure incentives so that local politicians have strong
incentives to collect information and serve their constituents, while minimizing in-
centives and opportunities to exploit common-pool problems and undermine the
provision of national collective goods.
Three themes stand out in this new literature—the nature of political represen-
tation, the structure of intergovernmental fiscal systems, and the organization of
political parties.
3.1 Representation
While the classic economics literature minimized the role of other institutions, po-
litical scientists have emphasized the role of such institutions as independent courts,
legislatures, and requirements of super-majorities for constitutional changes. In most