How to improve state-level fiscal policy

by on October 21, 2012 at 2:41 am in Economics, Political Science | Permalink

Some states rely too much on income taxes for their revenue and others rely too much on sales taxes (see the paper’s map on p.26).  We could have better state-level automatic stabilizers.  Here is a paper from Nathan Seegert (pdf, currently on the job market from Michigan, by the way):

I find U.S. state tax revenue volatility increased by 500 percent in the 2000s relative to previous decades. State governments’ inability to smooth volatile revenue streams, due to self-imposed balanced budget restrictions, has caused this increased volatility to magnify U.S. state budget crises. The theoretical model demonstrates the cause of the increase in volatility is due to changes in tax rates, economic conditions, or tax base (e.g. what types of consumption are taxable). Despite ampli fied business cycles in the 2000s and important tax base changes such as the increase in e-commerce, I fi nd changes in tax rates explain 70 percent of the increase in tax revenue volatility in the 2000s. Motivated by this result I create a normative model of taxation and produce a condition for optimal taxation when tax-revenue volatility is considered (a volatility-adjusted Ramsey rule). I estimate the volatility-adjusted Ramsey rule and find thirty-six states in 2005 rely inefficiently on either the income or sales tax, up from twenty-six states in 1965. This increase in imbalance is due to an increased reliance on the income tax as fourteen states relied inefficiently on the income tax in 1965 compared to twenty-six states in 2005. This paper fi nds strong evidence the increase in tax-revenue volatility state governments recently experienced is due to changes in tax rates, causing states to expose their revenues to unnecessary levels of risk.

The idea of volatility-adjusted Ramsey rules is a good one.  Here is Nathan Seegert’s home page.

For the pointer I thank N.

DocMerlin October 21, 2012 at 8:42 am

“The idea of volatility-adjusted Ramsey rules is a good one.”

So you think that fiscal policy actually works and is exogenous?

JWatts October 21, 2012 at 9:06 am

States should have somewhat volatile tax revenue. Thus when the economy is sluggish they collect less revenue and the tax payers pay less. When the economy is roaring they collect more. During the roaring periods they pay off debt and accumulate a ‘rainy day’ fund.

Granted, state politicians need the maturity to actually practice fiscal discipline and not squander every dollar on pork barrel projects, but some states do reasonably well and most do ok. Only a few notable states with high public sector costs seemed doomed to failure and that’s more to consistently spending more than they collect than any tax revenue volatility.

steve October 21, 2012 at 10:31 am

What we used to call fiscal conservatives believed this. Now, the movement conservatives believe in cutting revenue when the economy is strong. Good electoral politics, bad economics.

Steve

JWatts October 21, 2012 at 3:10 pm

Plenty of states still have ‘rainy day’ funds. Most States are in decent shape financially and have balanced budgets. Indeed, most States are in far better fiscal shape than the Federal government. Outside of Pension fund liabilities, which is a quite different issue, there really isn’t a systemic State fiscal problem.

So, I don’t see where ‘movement conservatives’ come into the picture.

So Much For Subtlety October 21, 2012 at 10:01 pm

Outside of Pension fund liabilities, which is a quite different issue, there really isn’t a systemic State fiscal problem.

Apart from that, how did you like the play Mrs Lincoln?

joshua October 21, 2012 at 4:54 pm

Clearly we need to make our federal government more dependent on volatile incomes.

Dave Backus @ NYU October 21, 2012 at 5:34 pm

I love this from the references: S. Adam. The wealth of nations. Dent, 1776.

whatsthat October 21, 2012 at 8:01 pm

That’s incorrectly cited.

skh.pcola October 21, 2012 at 8:16 pm

Tyler, the map is on page 36, not page 26. Interesting paper and link!

Fred October 21, 2012 at 9:44 pm

I haven’t read Nathan Seegert’s paper, so when I have I may have to eat some crow. There is little doubt that, across states, state and local tax progressivity, revenue elasticity, and revenue volatility are so closely correlated that they look like manifestations of the same underlying phenomenon. Frankly, I think that matching spending to revenues on an annual basis is an arbitrary relic of an agrarian past. Revenues fluctuate daily, monthly, and quarterly. We regularly use savings and borrowing to smooth out spending over these periods. Why not from one year to the next? The answer given is that state and local governments face a “hard budget constraint” (Rodden, Eskeland, and Litvack 2003), although as an immediate practical matter that is rarely the case.

What needs fixing is unstable spending. The solution lies in using savings and/or debt to smooth out spending, thereby avoiding deep cuts when the economy goes bust and unsustainable spending growth during booms. This can be accomplished by basing spending on long-term revenue growth rather than annual forecasts (Dothan & Thompson 2009). This approach can also easily be adjusted to deal with emergencies. Maintaining resilience – the capacity to deliver what’s needed when it’s needed, which means maintaining a residual or surge capacity, the ability to respond rapidly in an emergency – is inherent to the governmental enterprise.

The effectiveness of this general approach, both for controlling expenditure growth and for stabilizing programmatic support, is suggested by various case studies, most persuasively by the Chilean experience (Frankel 2011). Chile has the world’s most volatile revenue structure and a commitment to balanced budgets. It avoids boom and bust by balancing spending against the long-term rate of revenue growth. Each year, economists in the Chilean Ministry of Finance calculate a sustainable rate of revenue growth and Chile’s executive and legislative branches use that figure to make their spending plans. If revenues come in above the long-term trend, they are kicked into a sinking fund, which can be used only to make up revenue shortfalls, to pay down the national debt, or to respond to emergencies.

If our purpose is stability, there are a couple of changes to fiscal practice that might make sense. First, transfer payments should be moved from the expenditure side of the budget to the revenue side and treated as negative taxes (Buiter 1990, Mirrlees et al. 2012). Second, a stable expansion path for expenditures should be identified and adhered to (see Dothan and Thompson 2009; Frankel 2011).

Buiter, Willem (1990) Principles of Budgetary and Financial Policy. Cambridge MA: The MIT Press.

Dothan, M.U., and Fred Thompson (2009) A Better Budget Rule. Journal of Policy Analysis and Management 28/3: 463-478. Available at SSRN: http://ssrn.com/abstract=1077555

Frankel, Jeffrey (2011) A Lesson from the South for Fiscal Policy in the US and Other Advanced Countries. Comparative Economic Studies 53/3: 407–430.

Mirrlees, J., Adam, S., Besley, T., Blundell, R., Bond, S., Chote, R., Gammie, P., Johnson, P., Myles, G., and Poterba, J. (2012) “The Mirrlees Review: A Proposal for Systematic Tax Reform.” National Tax Journal 65/3: 655-684.

Rodden, J., Gunnar S.E., and J. Litvack, eds. (2003) Fiscal Decentralization and the Challenge of Hard Budget Constraints. Cambridge and London: MIT Press: 35-83.

Dredd October 22, 2012 at 7:26 am

This CBS News Report shows why the East Coast area from Cape Saint Hatteras to Cape Cod is going to have taxing problems in coastal cities, including Manhattan Island.

It could put a wrench in the gears.

Jake October 22, 2012 at 9:20 am

Does he consider the deductibility of state income taxes paid on federal tax returns?

Fred October 22, 2012 at 1:51 pm

I have now read the paper. It is brilliant. Nevertheless, I think the conclusion is wrong. I think the conclusion is wrong because the significance of the elasticity of the variance of tax revenues with respect to the income and sales tax rate depends on the assumption that the volatility of government consumption necessarily depends on the volatility of revenue, which is not the case (see my previous comment), and that one can talk about the elasticity of tax revenue without reference to distributional/insurance considerations (see my previous comment). Also, as a practical matter, as Jake note immediately above, the paper ignores the fact that one can deduct income or sales taxes paid from the national PIT, but not both.

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