Changing State Fiscal Capacity and Tax Effort, 1981 - 2003

John L. Mikesell

Professor of Public Finance and Policy Analysis

School of Public and Environmental Affairs

Indiana University

Distinguishing Feature of American Fiscal Federalism

• States must finance services they provide from their own fiscal resources.

• Devolution of domestic responsibilities by federal government makes state – local fiscal capacity even more important.

• Devolved taxing responsibility: 1965 – 64.0% of US taxes were federal; 2005 – 54.2% were federal.

Effects of Fiscal Autonomy

• Fiscal autonomy can improve efficiency and responsiveness but states differ in fiscal endowment.

• Result is disparity: “differences in fiscal effort required to achieve a particular fiscal outcome.” (Oakland)

• People in low capacity areas will be disadvantaged by fiscal system

Four Critical Questions to be answered here:

• Has state fiscal capacity (the capability of a government to finance its services) increased?

• How large is the difference in capacity among states and has the difference changed over time?

• Have states responded to changes in capacity and demand for service by changing their tax effort?

• Has dispersion in tax effort changed in response to competition and other harmonizing forces?

A Familiar Approach to Measuring Capacity

• Representative Tax System (RTS): estimate per capita yield that hypothetical, uniform, representative tax system would produce in each state, then compare to national per capita total calculated in same fashion.

Limitations to RTS Capacity Measurement

• Intermittent availability: important ideal bases not available every year

• Not appropriate for time series analysis: index for each year is ratio specific to that year

• Capacity v. choice• Prescriptive assumptions about what is “ideal” base• Non-independence of tax bases: RTS does not allow for

fact that application of one tax would reduce available capacity to collect from another.

Macroeconomic Alternatives

• State Personal Income: too narrow, doesn’t include corporate business income except as paid in-state in dividends or exporting potential (extractive, tourism, financial services, etc). Ladd – Yinger: exporting adjustment but business income not included directly.

• Gross State Product: adds business income but not income received in-state from outside sources and doesn’t handle all exporting.

• Total Taxable Resources: a broader option.

Total Taxable Resources as Start for Measuring Capacity

• Total Taxable Resources starts with GSP:– Subtracts flows not available for state to tax – federal

indirect business taxes, social insurance contributions, and federal civilian enterprise surpluses

– Adds dividends and interest earned from out-of-state, certain transfers from federal government, net realized capital gains, and earnings of state residents from work out-of-state.

• Result is more realistic indicator of base available for taxation, is able to capture business income flowing through the state, and recognizes that federal government sometimes gets to the base first.

Particular Advantages of TTR

• Basic data are available annually because they are used in certain federal transfer programs.

• Data are not dependent on annual ratio analysis, so they can be used across time.

• Measurement is not dependent on ideal base definition nor on any tax policy choices.

• Analysis here adjusts for inflation and state population so that real capacity can be compared across both time and states.

Fiscal Capacity Over Time

• National average increase in real TTR per capita; 1.8 % over 1981 – 2003. (Slightly below increase for real per capita GDP – 1.98 %).

• Wide range in growth by states: Alaska slightly negative, over 3 percent in Delaware.

• Growth rates highest in northeast quadrant; lowest in Far West, Rocky Mountains, and Southwest.

• Impact of recessions: national median fell by 1.04 percent in 1981 recession, by 0.98 percent in 1991 recession, and by 3.4 percent in 2001 recession.

Mean of State Real TTR per Capita, 1981 - 2003 (Relative to 1981 = 100)

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

More on Fiscal Capacity Over Time

• Not much change in year-to-year fiscal capacity of individual states – high correlation from one year to the next (see table)

• Substantially greater change over longer time period – much lower correlations for 1981 against 2003 (see table).

• But some states are in bottom ten each year: Alabama, Arkansas, Mississippi, and West Virginia

• And some states are in the top ten each year: Delaware, New Jersey, and New York.

• Some states have increased their position by more than 10 positions (a quintile): Massachusetts, New Hampshire, Rhode Island, Pennsylvania, Wisconsin, Minnesota, South Dakota, North Carolina, Virginia

• Some states have experienced a similar deterioration: North Dakota, Louisiana, New Mexico, Oklahoma, Texas, Montana, and Hawaii.

Table 2. Correlations Between Annual State Fiscal Capacity, Selected Years

Short Term Correlations Long Term Correlations

1990-91 0.8599 2000-01 0.9559 1982-1990 0.8094

1981-82 0.9954 1991-92 0.8766 2001-02 0.9950 1991-2001 0.7736

1982-83 0.9923 1992-93 0.9962 2002-03 0.9980 1981-2003 0.4653

1983-84 0.9967 1993-94 0.9940

1984-85 0.9969 1994-95 0.9944

1985-86 0.9105 1995-96 0.9902

1986-87 0.9910 1996-97 0.9899

1987-88 0.9888 1997-98 0.9850

1988-89 0.9810 1998-99 0.9959

1989-90 0.9714 1999-00 0.9775

Evidence on Fiscal Disparity

• Dramatic difference in fiscal capacity: in 2003, from $26,545 in Mississippi to $63,677 in Alaska at extremes and from $30,019 in Alabama to $47,598 in Wyoming at the edge of bottom and top decile.

• But – overall disparity, measured by coefficient of variation, has declined: from 31.4 in 1981 to 18.6 in 2003 (see graph).

• Fiscal devolution more feasible now than two decades ago, but is it low enough?

Convergence of State Capacity: CV of Mean Real State per Capita TTR, 1981 - 2003 (1981 = 100)

0.00

20.00

40.00

60.00

80.00

100.00

120.00

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Evidence on Tax Effort

• Tax effort measured by actual tax collections relative to total taxable resources for state.

• Effort measured both according to state alone and according to state and local combined.

Evidence on State Tax Effort

• Mean state tax effort in 2003 was 0.0478 or slightly below 5 % TTR, only slightly higher than its value in 1981 (0.0454). (see graph)

• Recession impact: effort increased by 3.5 percent with 1981 recession and by 4.4 percent in 2001 recession. Effort fell slightly in 1991 recession. But effort also increased in several non-recession years.

• Large effort reduction after 2001 recession.• Correlation of state effort from one year to next is usually high

(above 0.90), except 1986-87 (0.729) and 1993-94 (0.8079) [because of Alaska] Taxes are incremental in the extreme.

• Long-term correlations are much lower: 1981-2003 is only 0.236.

State Tax Effort, 1981 - 2003

0.0420

0.0440

0.0460

0.0480

0.0500

0.0520

0.0540

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1002 1003 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Additional Evidence on State Tax Effort

• States with effort below 0.035 in 2003: Colorado, South Dakota, New Hampshire, Texas, and Alaska.

• States with effort above 0.06 in 2003: Hawaii, Vermont, West Virginia, Arkansas, Mississippi, and Minnesota.

• Convergence in state tax effort: coefficient of variation declined from 32.6 in 1981 to 19.0 in 2003 – but the decline was in period to 1987, not much change since then.

Convergence of Tax Effort (CV), 1981 - 2003

0

5

10

15

20

25

30

35

State

State - Local

Evidence on State – Local Effort

• State - Local tax effort increased modestly from 1981 (0.070) to 2002 (0.078), but was above 0.08 from 1993 – 1995.

• During recessions: increased by 3.4 % in 1981 recession, increased by 2.7 % in 1991 recession, and by 1.8% in 2001 recession.

• Lower year-to-year correlation of state – local effort than found for state effort, possibly because property tax rates get set annually.

• Long term correlations are much lower than year-to-year correlations.

State - Local Tax Effort, 1981 - 2002

0.0640

0.0660

0.0680

0.0700

0.0720

0.0740

0.0760

0.0780

0.0800

0.0820

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1995 1997 1998 1999 2000 2001 2002

Additional Evidence on State – Local Effort

• In 2002, only Delaware had effort below 0.055.• Sixteen states had effort above 8 %: Kentucky,

Arkansas, Rhode Island, Michigan, Oklahoma, California, New Mexico, Mississippi, Oklahoma, Minnesota, Louisiana, West Virginia, Wisconsin, Vermont, Hawaii, New York, and Maine.

• Tax effort has converged: coefficient of variation has fallen from 20.2 in 1981 to 11.6 in 2002. More uniform demand for state – local services? Forces of global competition?

Capacity and Effort

• Correlations show no negative relationship between fiscal capacity and tax effort, whether state alone or state – local combined.

• Only statistically significant relationships were positive for 1987 and 1994 – higher state-local effort when capacity is greater.

• No evidence that low capacity areas compensate by applying higher tax effort.

Some Summary Conclusions

• Average real state fiscal capacity has grown over the 1981 – 2003 period at a pace slightly below that of real per capita GDP.

• Recession in 2001 had greater negative impact on state fiscal capacity than other recessions in past two decades.

• Fiscal capacity varies dramatically across the states. While some states have changed their relative capacity, many have remained consistently poorly endowed and many have remained consistently highly endowed.

• Fiscal disparity has declined over the past two decades.• Both state tax effort and state-local tax effort have increased over

the past two decades. • States rapidly reduced tax effort after 2001 recession. • Tax effort has converged over the past two decades.• States with low fiscal capacity appear not to compensate by

applying greater tax effort – no significant relationship between capacity and effort.