How to improve state-level fiscal policy
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 amplified business cycles in the 2000s and important tax base changes such as the increase in e-commerce, I find 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 finds 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.