Optimal fiscal policy for the provision of local public services: some simulation results for the case of elementary education in Korea

Abstract

This monograph presents policy simulation models for the evaluation of alternative fiscal policies for the provision of local public services where equity is relatively emphasized. For this framework, we propose four equalizing grant-in-aid schemes (the lump-sum general and the lump-sum specific grant-in-aid, the matching grant-in-aid, and the foundation aid plan), and compare them with perfectly decentralized and perfectly centralized fiscal schemes. Our models are characterized by an endogenous central government acting as a grantor cum tax collector. The central government is also subject to a full financing constraint (revenue from central taxation = expenditures for equalizing grants), which makes the central tax rate indicate the relative scale of financial cost (or the degree of decentralization) of each fiscal scheme. We simulate the six fiscal models with various values of five selected system parameters: income and price elasticities of the service concerned, alternative evaluating criteria, share of expenditures for the service, and welfare cost of central taxation. The simulation study primarily searches for any systematic relations between the five parameters and the two key variables: the central tax rate and relative priority rankings of each fiscal scheme. The simulation results provide valuable guidance in selecting a particular fiscal scheme for the provision of a particular public service. In the simulation, Korean elementary education is selected as an example. The simulation results show that income elasticity is the most important parameter that affects the relative priority rankings of each fiscal scheme as well as the financial cost. The lump-sum general grant-in-aid scheme turns out to require the highest, while the foundation aid plan requires the lowest intervention rate. It is also found that matching grants are more stimulative than lump-sum general grants. Based on the results of policy priority rankings and the endogenous central tax rates in each fiscal scheme, we select the foundation aid plan as the optimal policy scheme for the provision of elementary education in Korea.