UC Berkeley, Law And Economics Workshop Presentation, April 11, 2011

The Economics of Horizontal Government Cooperation

Matt DalSantoBerkeley Center for Law, Business and the Economy

Law and Economics WorkshopApril 11, 2011

Outline of Today’s Presentation

• Introduction– Brief History– Overview of Enacted Compacts

• Relevant Case Law• Policy Commitment• Negative Externality• Positive Externality• Intrastate Analog: Joint Powers Agreements• Policy Conclusions• Further Research• Questions/Comments

What is an Interstate Compact?

• Interstate Compact – An interstate compact is an agreement in which states commit themselves to a legally binding (contractual) agreement.

History

• Use predates the American Revolution– Colonies had poorly defined borders

– Boundary Disputes Settled in One of Two Ways• Joint Commission would attempt to negotiate a settlement

– If successful, submit to Crown for approval

• If unsuccessful, then appealed to Crown in process similar to litigation

History

• Articles of Confederation (Article VI, Section 2)– “No two or more States shall enter into any treaty, confederation or alliance whatever between them, without the consent of the United States in Congress assembled, specifying accurately the purposes for which the same is to be entered into, and how long it shall continue.”

• Mere agreements between states– Congressional Consent not typically required

• Consent required – if the general authority of Congress would be “weaken[ed]” or “encroach[ed] upon.”

History

• US Constitution– “[n]o State shall enter into any Treaty, Alliance, or Confederation....”

– Compact Clause  (Art. I, Sect. 10, Cl. 3)• “No State shall, without the Consent of Congress, ... , enter into any Agreement or Compact with another State, or with a foreign Power....”

History

• Articles of Confederation v. US Constitution– “Treaty, Alliance, or Confederation”

• Permitted with Congressional Consent under Articles• Prohibited under Constitution

– “Compact” or “Agreement”• Permitted with Congressional Consent under Constitution

– Attempting to Avoid Problems Under Articles• No real distinction• Preserve economic and political power of federal government

– “In other cases the Fedl authy was violated by Treaties & wars .... By compacts witht. the consent of Congress as between Pena. and N. Jersey, and between Virga. & Maryd. From the Legisl: Journals of Virga. it appears, that a vote to apply for a sanction of Congs. Was followed by a vote agst. a communication of the Compact to Congs.”

» Personal journal entry by James Madison at Convention.

History

• 1783 to 1920– 36 compacts

• 1920 to present– over 150 compacts

Compact Statistics

Mean = 29.4 Compacts/State, Max = 54 (VA), Min = 16 (HI)

Types of Interstate Compacts

Types of Interstate Compacts• AGRICULTURE (2)• BOUNDARY COMPACTS (26)• BRIDGES, NAVIGATION, AND PORT AUTHORITIES (13)• BUILDING CONSTRUCTION AND SAFETY (1)• CHILD WELFARE (3)• CONSERVATION AND ENVIRONMENT (24)• CORRECTIONS AND CRIME CONTROL (17)• EDUCATION (8)• ENERGY (16)• GAMBLING AND LOTTERIES (3)• HEALTH (4)• INSURANCE (1)• MOTOR VEHICLES (15)• PARKS AND RECREATION (4)• PEST CONTROL (1)• PLANNING AND DEVELOPMENT (10)• PROPERTY (2)• PUBLIC SAFETY (11)• TAXATION (2)• TRANSPORTATION (12)• WATER (37)

Interstate Compacts Case Law

• Two Legal Mechanisms to Resolve Interstate Disputes– Interstate Compact– Supreme Court

• “[t]he judicial power [of the Supreme Court] shall extend to ...controversies between two or more states...” Art. III, Sect. 2, Cl. 1

• “We cannot withhold the suggestion, inspired by the considerationof this case, that [this] grave problem ... is one more likely to be wisely solved by co‐operative study and by conference and mutual concession on the part of representatives of the states so vitally interested in it than by proceedings in any court however constituted.”– People of State of New York v. State of New Jersey, 256 U.S. 296, 313 

(1921).

Interstate Compacts Case Law

• Compact Ratification and Cong. Consent– All state legislatures must pass identical implementing legislation, governor signs into law

– Congressional Consent• “[n]o State shall, without the Consent of Congress,..., enter into any Agreement or Compact with another State...” Art. I, Sect. 10, Cl. 1

• Com. of Va. v. State of Tenn., 148 U.S. 503, 519 (1893),– Congressional consent for a compact is necessary: when the compact’s enactment would “[tend] to the increase of political power in the states, which may encroach upon or interfere with the just supremacy of the United States.”

Compacts that Create Admin Agencies

• State ex rel. Dyer v. Sims, 341 U.S. 22 (1951)– Upheld legality of the relatively recent inception of states entering into a compact that delegates administrative authority to an interstate agency.

Compacts As Contracts

• “[A] Compact is, after all, a contract.”– Texas v. New Mexico, 482 U.S. 124, 128 (1987) (quoting Petty v. 

Tennessee‐Missouri Bridge Comm’n, 359 U.S. 275, 285 (1959) (Frankfurter, J., dissenting))

• “It remains a legal document that must be construed and applied in accordance with its terms.”– Texas v. New Mexico, 482 U.S. 124, 128 (1987).

• Offer & Acceptance – All signatory states adopt the exact language of the compact 

agreement as a statute.

Breach of Compact

• Supreme Court sometimes analogizes a compact to a treaty between sovereign nations, but....

• Signatory states are held to their compactual obligations– Old Legal Theory: “a State has no more power to impair an obligation 

into which she herself has entered, than she can the contracts of individuals....”

• Green v. Biddle, 21 U.S. 1, 39 (1823).

– New Legal Theory: “[W]here Congress has authorized the States to enter into a cooperative agreement, and where the subject matter of that agreement is an appropriate subject for congressional legislation, the consent of Congress transforms the States’ agreement into federal law under the Compact Clause.”

• Cuyler v. Adams, 449 U.S. 433, 440 (1981).

Remedies for Breach of Compact

• Prospective Relief & Damages– “We find no merit in its submission that we may order only prospective relief, that is, requiring future performance of compact obligations without a remedy for past breaches. If that were the case, New Mexico's defaults could never be remedied.”

• Texas v. New Mexico,  482 U.S. 124, 128 (1987).

• Damage Measure– Presumably Expectation Damages

• A monetary amount that would put the breached against states in as good of a position as they would have been had the breach notoccurred.

Policy Commitment

• Tying Hands of Future Legislatures

• IC for Mississippi River Flood Plain Control– The Great Flood of 1993

• $20 billion

• 50,000 homes either destroyed or severely damaged

Negative Externality: Great Lakes

• Legislators only represent interests of state’s citizenry not those of other states.– Do not internalize costs to other states.

• Lake Michigan (late 19th Century)– Chicago residents ill from dumping sewage into Chicago River which flowed into Lake.

• Chicagoans drank from the Lake

Negative Externality: Great Lakes

Repeated Prisoners’ Dilemma

• States repeatedly make decisions that affect other states year after year.– Play a period Prisoner’s Dilemma game.

• No foreseeable end in sight.– Repeated

– Assume states want to maximize their payoffs today plus the net discounted value of future payoffs.

Repeated Prisoners’ Dilemma

• In this environment cooperation can arise endogenously.– But incentives to cooperate and incentives to defect are both influenced by

• The response to the defection by the other states– Are they punished?

• The rate at which future payoffs are discounted

– If discount rate too high, or if unable to commit to punishing defecting state, then cooperation may not be possible.

Repeated Prisoners’ Dilemma

• Solution– Interstate Compact

• Compact requires cooperation

• If defect, then liable to other states for expectation damages award.

“Even before the Constitution we find that the common interest in natural resources, of a region embracing two States, was furthered by an agreement between such States. . . . An exploration of the possibilities of the compact idea furnishes a partial answer to one of the most intricate and comprehensive of all American problems.”– Frankfurter and Landis (1925).

The Great Lakes‐St. Lawrence River Basin Water Resources Compact

• Requires the GL states to adhere to minimum regulatory standards to which all signatory states have agreed.

• No new transfers of water outside of GL Basin.

Compact Solution

• Problem– State may want to breach even though know forced into compliance in the future.

• Secondary Problem– Is efficient breach possible?  Should it be?

• Solution– Let states determine how to calculate damages in event of breach.

– Sophisticated government actors; not unsophisticated private parties.

Pos. Externality: Productivity Spillovers

• Most studies agree that there is an increase in TFP from an increase in public infrastructure (capital).– Bridges, Ports, Railroads, Highways, Airports, Public Transit, etc.

• When a jurisdiction undertakes investment in such capital, it cannot confine the investment’s effects to just its jurisdiction.– Spillovers between jurisdictions– Too little capital investment

States

Group of states, P = {1,2, . . . , P}, that experience increases in

TFP from other states’ investment in public capital.

State Environment

Each state

has a representative household

−preferences over consumption: uj(·)−discounts next period utility at the same rate β

−endowed with an amount of private capital kj,0

has a representative firm that rents capital from the household

and sells its output in a national market

government has a sales tax τc (equivalent to the lump-sum tax

instrument Tj,t)

Representative Household’s Problem for State j

max(ch

j,t,xhj,t,k

hj,t+1,lhj,t)

∞t=0

∞∑

t=0

βtuj(chj,t)

s. to (1 + τj)ptchj,t + ptx

hj,t ≤ rj,tk

hj,t + wj,tl

hj,t + πj,t

khj,t+1 ≤ (1− δk)k

hj,t + xh

j,t

lhj,t ≤ lj

chj,t, x

hj,t, k

hj,t+1, lhj,t ≥ 0

lj = 1

khj,0 given.

Representative Firm’s Problem for State j

maxy

fj,t,k

fj,t,l

fj,t

πj,t ≡ ptyfj,t − rj,tk

fj,t − wj,tl

fj,t

s. to yfj,t = F j(h′j,t, k

fj,t, l

fj,t)

yfj,t, k

fj,t, l

fj,t ≥ 0

where h′j,t =∑P

i=1 ωj,ihj,t.

State Governments Run Balanced Budgets

ptij,t = τjptcj,t

hj,t+1 = (1− δh)hj,t + ij,t.

Market Clearing

∑

j∈Py

fj,t =

∑

j∈Pchj,t +

∑

j∈Pxh

j,t +∑

j∈Pij,t

kfj,t = kh

j,t ∀j ∈ Plfj,t = lhj,t ∀j ∈ P.

Characterization of Equilibrium

Letting f j(h, k) = F j(h, k,1) and given ((Ti,t)∞t=0)i∈P, each re-

gion’s, for j ∈ P, equilibrium allocation is characterized by

ujc(cj,t)

βujc(cj,t+1)

= fjk(h

′j,t+1, kj,t+1) + (1− δk)

cj,t + xj,t + Tj,t = f j(h′j,t, kj,t)

kj,t+1 = (1− δk)kj,t + xj,t

hq,t+1 = (1− δh)hq,t + Tq,t ∀q ∈ Pkj,0 given

hj,0 given.

where h′j,t =∑P

i=1 ωj,ihj,t.

Non-Cooperative Equilibrium

State j’s Government’s Problem

Each government j ∈ P takes as given the investments of the

other P − 1 governments, ((Ti,t)∞t=0)i∈P−{j} and thus the value

of their public capital stocks ((hi,t)∞t=0)i∈P−{j}. In each period

t, state government j chooses its optimal value of public capital

in period t + 1, hj,t+1, so as to satisfy

max(Tj,t,hj,t+1,cj,t,xj,t,kj,t+1)

∞t=0

∞∑

t=0

βtuj(cj,t)

s. tou

jc(cj.t)

βujc(cj,t+1)

= fjk(h

′j,t+1, kj,t+1) + (1− δk)

cj,t + xj,t + Tj,t = f j(h′j,t, kj,t)

kj,t+1 = (1− δk)kj,t + xj,t

hq,t+1 = (1− δh)hq,t + Tq,t ∀q ∈ P

cj,t, kj,t+1, xj,t ≥ 0

kj,0 given

Tq,t given ∀q ∈ P − {j}hq,0 given ∀q ∈ P.

where h′j,t =∑P

i=1 ωj,ihj,t.

Compact Equilibrium

Given the terms of the compact, U, the compact authority’s

problem is to choose taxes ((Tj,t)∞t=0)j∈S and thus

((hj,t+1, cj,t, xj,t, kj,t+1)∞t=0)j∈S, so as to solve,

max((Tj,t,hj,t+1,cj,t,xj,t,kj,t+1)

∞t=0)j∈S

U((∞∑

t=0

βtuj(cj,t))j∈S)

s. tou

jc(cj.t)

βujc(cj,t+1)

= fjk(h

′j,t+1, kj,t+1) + (1− δk)

cj,t + xj,t + Tj,t = f j(h′j,t, kj,t)

kj,t+1 = (1− δk)kj,t + xj,t

hj,t+1 ≤ (1− δh)hj,t + Tj,t

cj,t, kj,t+1, xj,t ≥ 0

kj,0 given

hj,0 given.

where h′j,t =∑P

i=1 ωj,ihj,t.

Results

Assume: Symmetric Environmnet

Proposition 1: The growth rate of state governments in a Sym-

metric Compact Equilibrium, where S ⊂ P with S > 1, is greater

along a balanced growth path than any state in a Symmetric

Non-Cooperative Equilibrium.

Corollary: As the number of signatory states, S, increases all

states grow at a faster rate.

Proposition 2: If S = P, the states are strictly better off by

entering into a compact than if they had not.

Intrastate Analog

• California– Joint Powers Agreements– Special Districts

– Additional Uses• Insurance

– Spread Risk

• Achieve economies of scale– Police, Fire, etc.

Conclusions

• Compact– Internalization Principle (Cooter)

• Assign power to the smallest unit of government that internalizes the effects of its exercise.

– Can be used to internalize interstate externalities• An option between 

– single state independent action, and

– federal action

» takes into account preferences of other unaffected states

Further Research

• How are compacts negotiated?

• Intrastate Analogs.

• When is competition or non‐cooperation preferable?– Antitrust of intergovernmental agreements.

Thanks!

Questions, Comments?