Federal Tax Shocks and State Fiscal Federal Tax Shocks and State Fiscal Capacity: The Case of Natural Capacity: The Case of Natural

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Fidel Perez-Sebastian(University of Alicante)

Ohad Raveh(University of Oxford)

Yaniv Reingewertz(University of Haifa)

March 2015

Introduction

Objective

Motivation

Main results

Federal Tax Shocks and State Fiscal Capacity

Broad questions: • How do federal tax shocks affect states’ macroeconomy?• How do states respond to federal tax shocks?

These questions have been at the heart of debates in the federalism literature.

Previous work studied the average effect:• Federal tax increases have a contractionary effect, mainly due to decreases in

investment (Romer and Romer 2010 and others).

Objective:• In this work we make a first attempt at studying the heterogenous

effects of a federal tax shock across states, through which we present a new mechanism of vertical fiscal externalities.

Motivation and Main Questions Why should heterogeneous effects be interesting?

• Even the most ‘equalized’ federations present vast inter-regional differences, from income levels and prices, to levels of public good provision (see for instance Boadway 2006, for the case of Canada).

Hence: While a federal tax shock is uniform and equal across the nation, its effects are not.

In this paper we ask:

• Are there systematic differences in the effects of such shocks across states?

• Are there any states that may actually benefit from such a tax increase?

Fiscal Capacity

We aim to capture the differences in states’ responses to federal fiscal shocks through differences in fiscal capacity levels.

We define fiscal capacity as the capacity to be fiscally flexible with mobile tax bases: High fiscal capacity states have more leeway with capital/labor tax rates.

• Such differences may lead to corresponding differences in absorption of fiscal shocks and an unequal inter-regional competition over mobile factors.

Main hypothesis:• States with relatively high fiscal capacity have better absorption of federal

tax shocks, to the extent that they may actually benefit from them.

Since fiscal capacity can result from a significant, non-mobile, source of income, such as natural wealth:

• We proxy fiscal capacity through natural resource abundance.

Fiscal Capacity and Resource Abundance U.S. Case: States receive severance tax from natural resource exploitation.

• We use the share of severance tax in total state taxes as our main proxy for fiscal capacity.

Large cross-state variations in fiscal capacity levels; from 0 (Vermont, Rhode Island) to more than 0.4 (Alaska).

Mechanism: Intuition Construct a model of heterogeneous vertical tax externalities across fiscal

capacities, with two levels of government, and capital mobility.

Resource rich states exploit their fiscal advantage to present a more competitive fiscal environment (James 2014, Raveh 2013).

As a result they are more successful in the inter-regional competition over factors (Cai and Treisman (2005), Papyrakis and Raveh (2014), and Raveh (2013)).

These points are at the center of the theory we propose.

Model shows that with a federal tax increase:• Resource rich states increase their capital tax rates by less, because they have greater

tax base (in per capita terms).• Capital moves from resource poor to resource rich states.• Resource rich states benefit (may increase output), while the resource poor ones lose.

Empirics: Strategy and Results We take the main predictions of the model to the data. We use a maximized annual panel of U.S. states, 1963-2007. Follow Romer and Romer (2010), and use narrative-based federal tax changes.

Look into those shocks identified as exogenous.

Main results (following a federal tax increase):(1) Tax rates in resource rich states increase by less.

(2) Capital moves from resource poor to resource rich states (measure capital movement using firm level data, and disaggregated tax revenues).

(3) Contraction effect is overturned in resource rich states (specifically in 8 states: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, Wyoming).

(4) By disaggregating the federal tax shocks and state tax revenues, we see that only corporate related shocks and revenues are responsive – motivating our focus on capital, rather than labor.

(5) Results are robust to various resource measures, time periods, estimation techniques, and specifications.

Literature Review: Contributions (1) Vertical tax externalities (tax rates): Empirics (Besley and Rosen (1998), Deveraux, Lockwood, and Redoano (2007), Esteller-More

and Sole-Olle (2001), Fredriksson and Mamum (2008), Goodspeed (2000), and Hayashi and Boadway (2001))

• Looked into the average effect, used potentially endogenous federal-revenues/GDP measure, finding conflicting results.

• Contribution: We study heterogeneous effects across fiscal capacities, addressing the endogeneity through usage of narrative-based shocks.

Theory (Dahlby and Wilson (2003), Hoyt (2001), and Keen (1998)

• Studied a common-pool problem for the average state, focusing on elasticities of demand and the vertical channel.

• Contribution: We add heterogenous fiscal capacities to the otherwise standard model ; emphasize the horizontal effect of a vertical shock, and complementarities in federal-state public good provision.

Literature Review: Contributions (2) Tax Changes and Output (Vertical Output Multipliers) (Alesina and Perotti (1997), Blanchard and Perotti (2002), Perotti (1999), and Romer and Romer (2010);

Ramey (2011) provides a survey)

• Emphasized the contractionary nature of tax increases (distortionary effects, MCPF, suppressed investment), using national-level studies.

• Contribution: Through state-level analysis, we show such effects can in fact be expansionary given sufficient levels of factor mobility and fiscal capacity.

(3) Federal Tax Changes and Composition of GDP (See Gale and Orszag (2004) for a survey)

• Showed the share of consumption and investment in GDP falls, following a federal tax increase.

• Contribution: We show that with sufficient fiscal capacity federal tax increases may be positively associated with state-level investment.

The Model

Framework

Zodrow and Mieszkowski (1986) capital tax competition model, with a federal government and heterogeneous states with varying fiscal capacities.

Consider a federation (keeping the U.S. case in mind) of N states, competing for national capital stock using fiscal means.

Nash game: characterize states’ best response to federal tax changes, taking other states’ behavior into account.

Study the consequent capital reallocation across the nation.

Assumptions Closed economy (simplifying assumption):

• More relevant to the shock studied (increases in federal tax rates); what we need is that factors are more mobile within the federation than inflows from abroad (applicable via Kalemi-Ozcan et al. (2010)).

Focus on capital:• Labor less responsive to federal tax shocks; i.e. labor prefers densely populated, urbanized areas (Michaels et al.

QJE 2012).• Substantiate this in empirical part (providing evidence this is story is about capital specifically).

Federal and state public goods are complements (not substitutes):• Federal vs. State government spending once pensions and debt interest payments are subtracted

from it, 1960-2010:

• Evolution suggests complementarity: correlation of 0.98.

Setup Each state ‘i’ is populated by a fixed mass of consumers of size 1.

Each individual owns a fixed amount of capital ‘k’ that can be supplied to the production activity in any of the states.

State ‘i’ consumers obtain an interest rate ‘r’, and these proceeds net of taxes are allocated to the purchase of a private good ‘c’.

There are federal and state governments; both tax capital. The former (latter) sets tax rate ( ) to finance ( ).

State governments collect severance tax on natural resources of .

Profit-maximizing firms in state ‘i’ are owned by state residents, and produce output (y) using capital (k) according to the following production function:

Profits (π) from firms’ activity are distributed among their owners.

Characterizing Equilibrium

Capital flows between regions until:

Market clearing conditions:

Region’s Problem Nash game: State ‘i’ chooses to maximize the representative consumer’s utility

taken the behavior of other governments into account.

is the elasticity parameter, and lies in .• When : Perfect compliments• When 1: Perfect substitutes

is a government inefficiency parameter, and lies in (0,1).

Federal public good provision:

Region’s Problem FOC:

What do we learn from this?

1) decreases with if (that is if ‘G’ and ‘g’ are not perfect substitutes)• In this case the resource rich state/s will have lower tax rates, and greater capital per

capita.

2) can go up or down with , depending on the degree of complementarity between the public goods.

• If is sufficiently negative, the two tax rates go in the same direction.

Some more algebra leads to:

• As goes to minus infinity the LHS converges to 1.

How Do State Tax Rates Respond to a Federal Tax Shock?

Using the implicit function theorem we get:

Following the previous result, as the two goods become more complements:

First, the partial derivative is positive. Second, it will be lower for states with greater capital per capita (resource rich

states)

Resource rich states win the competition over capital due to their resources, and hence can increase tax rates by less (following a federal tax increase), given their bigger tax base, in per capita terms.

• This will then lead to capital flows to the resource rich states, and corresponding differences in output.

Conclusions from Model If G and g are sufficiently complementary, and capital per capita is higher in resource

rich states, then following a federal tax increase we would expect to see:

• 1) State tax rates increase more in resource poor states.

• 2) Following (1), capital flows from resource poor to resource rich states.

• 3) Following (2), state output increases in resource rich areas (if positive effect of capital inflows is larger than the negative government inefficiency effect).

However, prior to (1)-(3), we would also like to realize whether:

• (i) Tax rates are in general lower in resource rich states.• (ii) Capital per capita is higher in resource rich states.

We look into (i)-(ii), and (1)-(3) in the empirical part.

.

Empirical Part

Empirical Part: Objectives In this section we test the model’s assumptions and predictions,

through the case of the US.

Specifically, we ask:

• ‘Preliminary’ questions:– Are tax rates lower in resource rich states?

– Is capital per capita higher in resource rich states?

• Main analysis:– Do resource rich states make a relatively smaller increase in their tax rates,

following a federal tax increase?

– Does capital flow to resource rich states, following a federal tax increase?

– Does output increase in resource rich states following a federal tax increase?

Data We use an annual panel, over the period of 1963-2007, for the 50 U.S. states.

Federal tax shocks: narrative-based measures of tax shocks, derived from Romer and Romer (AER 2010).

• Using narrative-sources decompose changes in federal tax rates to endogenous and exogenous.

• Studied all significant tax acts from 1945 to 2007 (around 50), and classified their motivation and their approximate effect on revenues.

• Sources: “Economic reports of the President” ; “Report of the Secretary of the Treasury” ; “Budget of the US Government” ; Presidential speeches ; and more.

• Four categories of motivation for tax changes: spending-driven, countercyclical action, inherited-deficit-driven, and long-run-growth-driven. Consider the last two as exogenous.

• We use the exogenous shocks in our analysis; divide them to corporate/non-corporate related (based on nature of act).

Data

Exogenous federal tax shocks, 1963-2007:

Variation across years (increases, decreases, and no change).

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-100

-50

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1960 1970 1980 1990 2000 2010year

Data State characteristics:

• Population, GSP, etc. ; Source: Bureau of Economic Analysis.

States’ income data:

• Use data on state tax revenues (including: severance, corporate, non-corporate, and total tax income), and transfer payments. Source: Census Bureau.

Firm level data:

• Number of firms and establishments (1977-2007). Source: Census Bureau.

Inter-regional migration data:

• Inter-regional labor flows (2000-2007). Source: Census Bureau

Additional resource abundance measures:

• Mining output and oil prices. Source: Bureau of Economic Analysis.

Preliminary Questions Are tax rates lower in resource rich states?

Previous work:• Raveh (2013): Show in a cross-section of US states (1977-2008) that: 1) Tax rates are lower in

resource rich states ; 2) The better fiscal environment attracts capital [60% of resource-induced capital inflows are due to the business environment].

• James (2014): Show in a panel of US states (1958-2008) that tax rates are lower in resource rich states.

A cross-section of the Corporate Business Tax Climate Index (2006-2011 average):

We present similar results in our analysis.

Preliminary Questions Is the capital tax base (on per capita terms) larger in resource rich states?

Do not observe capital stocks directly; can make inferences on capital tax base through corporate tax revenues.

Estimate:

Corporate tax (rates) revenues per capita are (lower) higher in resource rich states => Indicates capital tax base is higher.

Empirical Model We estimate models of the following type, for state ‘i’ at year ‘t’, 1963-2007:

LHS: annual growth rate in an outcome variable (average tax rates, tax revenues per capita, inter-state migration, firm movement, and output).

RHS:• Lagged dependent variable, in levels.• Federal tax shock (total, corporate-related, non-corporate related), normalized by GDP.• Fiscal capacity measure: share of severance tax in total tax revenues.• Interaction between federal tax shocks and fiscal capacity.• Vector of controls ‘X’ that includes: GSP per capita, average GSP per capita of all other states

(horizontal channel), transfers from central government, population, and a ‘deductibility’ dummy.• Time trend.• State fixed effects.

Focus on .• Besides next exercise, focusing on .

Heterogeneous Vertical Tax Externalities Are tax rates in resource rich states less responsive to federal tax shocks? Examine average tax rates (Tax Revenues/GSP)

• Fiscal capacity threshold (mean): severance-tax/total-tax > 0.03 ; results hold for using median (0.005) as threshold.

Results follow model’s prediction: Tax rates are less responsive in resource rich states.

Factor Movement: Tax Revenues Does capital flow to resource rich states following a federal tax hike?

• As an initial step examine corporate/non-corporate tax revenues (per capita).

Magnitude: Having 20% fiscal capacity, a 1% increase in corporate-federal-revenues/GDP increases growth rate of corporate tax revenues per capita by 0.05%.

• Relevant for: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, and Wyoming. Corporate tax revenues increase in resource rich states – despite having lower tax rates: tax

base may increase.

Factor Movement: Firms and Labor Does capital flow to resource rich states following a federal tax hike? Look into inter-state labor flows and firm movement.

Magnitude: Having 20% fiscal capacity, a 1% increase in federal-revenues/GDP increases growth rate of number of firms (5+ employees) by approximately 0.1%.

Results suggest model’s predictions are valid: Firms move to resource rich states.

Heterogeneous Output Effects Can output increase in resource rich states following a federal tax hike?

Magnitude: Having 20% fiscal capacity, a 1% increase in federal-revenues/GDP increases growth rate of output by approximately 0.06%.

Results follow model’s prediction: Negative effect mitigated in high fiscal capacity states, to the extent of being reversed.

Robustness

Results are robust to:

• Different measures of fiscal capacity:– Mining share in GSP– Oil price: Mining share in GSP in initial year multiplied by price of oil at time ‘t’.

• Excluding all high fiscal capacity states (specifically, those with share of severance tax in total tax revenues greater than 10%).

• Different estimation techniques:– Level regressions instead of growth-based ones.– Arellano-Bond.

• Different specifications:– Inclusion of year fixed effects.– Dropping controls, excluding fixed effects, etc.

Summary of Empirical Results Start with:

• Tax rates are lower and capital tax base (per capita) is higher in resource rich states.

Only corporate-related federal tax shocks matter for heterogeneous effects.

Following a corporate-related federal tax hike, we observe:

• State tax rates increase only in resource poor states.

• Corporate tax revenues (per capita) increase in resource rich states, suggesting an increase in capital tax base.

• Number of firms increases (5+ employees) in resource rich states.

• No effects on labor movement.

• Overall the negative output effect is mitigated in resource rich states, to the extent that it reverses and becomes expansionary.

Extensions

Does this mechanism have anything to say about the effect on the national economy?

If capital reallocation across the nation is inefficient, it does.

Resource abundant states are less agglomerated (Perez-Sebastian and Raveh 2014):

Mechanism suggests capital flows from agglomerated to non-agglomerated areas, thus losing agglomeration externality – dropping national output.

Conclusion

How do states respond to a federal fiscal shock?• Uniform shock across the economy, with differential effects.

Studied heterogeneous effects across fiscal capacities (proxied by resource abundance).

High fiscal capacity states have a better absorption capacity for federal fiscal shocks.

Given a corporate-related federal tax hike these states can benefit from capital inflows that translate to increases in output, on the account of the other states.

These results highlight a new aspect of the equalization-related challenge dealt by federal governments.