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Deductibility and optimal state and local fiscal policy
Economics Letters North-Holland
Deductibility fiscal policy Gilbert
217
39 (1992) 217-221
and optimal state and local
E. Metcalf
Princeton University, Princeton NJ, USA Received Accepted
6 February 1992 24 March 1992
I present a model of optimal state and local fiscal policy in the presence of deductibility and exporting to non-residents. model explains the puzzling continued reliance on the general sales tax after the 1986 Tax Reform Act.
This
1. Introduction An important provision of the Tax Reform Act of 1986 (TRA86) for state and local governments was the elimination of federal deductibility for general sales taxes. Based on research by Feldstein and Metcalf (19871, Holtz-Eakin and Rosen (1988) and others, most economists predicted a shift in reliance away from the general sales tax toward other taxes which continued to be deductible at the federal level. The argument is straightforward. Deductibility is a form of tax exporting which reduces the cost to residents of using a particular tax. Eliminating deductibility increases the cost of that tax and reduces the demand for its use. As Courant and Gramlich (1990) have noted, the use by states of general sales taxes did not decline after 1986 - if anything the opposite occurred. In this note I explain this puzzle and in the process highlight the interaction between exporting taxes to non-residents (e.g. tourists, out of state businesses) and to the federal government through deductibility. ’
2. The model I assume that a sub-national government to maximize the utility of a representative agent works and makes all consumption consumption and labor supply. The state does account for the taxes that they pay. *
(call this a state government) wishes to choose tax rates agent. Without loss of generality, I will assume that this purchases within the state. There is also non-resident is not concerned about the utility of non-residents but Individuals take prices as given and maximize utility over
Correspondence to: Gilbert E. Metcalf, Department of Economics, Princeton University, Princeton, NJ 08544-1021, USA. ’ While deductibility is a form of tax exporting, I will reserve the term ‘exporting’ for tax exporting which results from non-residential consumption and labor supply decisions. * This model is an extension of a model developed by Arnott and Grieson (1981). It differs from their model in the treatment of exporting to the federal government as distinct from exporting to non-residents.
0165-1765/92/$05.00
0 1992 - Elsevier
Science
Publishers
B.V. All rights reserved
G.E. Metcalf
218
/ Deductibility,
optimal state and local fiscal policy
labor supply (I), a commodity subject to a state sales tax (x), and a commodity that is not taxed by the state (z). Units for 1, x, and z are fixed so that the gross wage and the net commodity prices equal one. I will assume that these prices are not affected by taxation. However, the net wage and gross commodity prices are affected by taxation. The net wage (w) equals P,(l - 7) where PL is the federal tax price for the state income tax and T is the state income tax rate. If the agent itemizes deductions and his federal marginal tax rate equals m, then a dollar of additional state income tax deduction reduces federal taxable income by one and reduces the federal tax liability by m. Therefore, the net cost of raising a dollar through the state income tax (P,) equals 1 - m for this individual. The gross price for x (q) equals 1 + P,t where P, is the tax price for state general sales agent maximizes taxes (P, I 1) and t is the state general sales tax rate. 3 Thus the representative U(I,
x, 2)
s.t.
wl2qx
fz,
(1)
w=PL(l-T),
(2)
CJ= 1+P,t.
(3)
There is also taxable wage income earned by non-residents. Their net wage (6) on labor supply I equals PI!1 - T) and their gross price for purchase of the taxable commodity i is @ and equals 1 + p,t. Any variable with a tilde over it refers to non-residents. The government then takes individual utility maximization into account and chooses tax rates to maximize the indirect utility of the representative agent subject to the community budget constraint: 4 maxV(w,q, 1,T
,(1+1)
I),
(4)
=c,
+t(x+i)
where ?? is the fixed government Differentiating (4) with respect first-order conditions:
-OP,l-th
-B<,x+A
1 1
a~
revenue requirement and to t and r and applying
V( .> is the indirect utility Roy’s Identify gives the
function. following
ax
L+rz+tz
(6)
=o, i
ax
x+tat+7;
aL
1=o,
where 8 is the ratio of the private marginal utility of income to the social marginal utility of income, L is aggregate labor supply (I + f) and X is aggregate demand for the taxable commodity (x + i). For the purposes of considering the effects of changes in federal tax laws on the optimal choice of t, T (and O), comparative statics are conducted on eqs. (5) (6), and (7). I make the following simplifying assumptions. First, I assume that changes in wage taxes do not affect taxable commodity demand and that changes in sales tax rates do not affect labor supply. Second, I define 4L as the 3 I have not allowed for state deductibility
of federal
result. 4 I assume that the revenue requirement utility function of state residents.
for the government
income
taxes. Doing so clutters
the notation
is fixed and that government
without
spending
affecting
the main
does not enter
the
219
G.E. Metcalf / Deductibility, optimal state and local fiscal policy
ratio of non-resident to resident labor supply and similarly 4, as the ratio of non-resident to resident demand for x. I assume that +L and 4, are exogenous. Third, I assume a constant elasticity specification with respect to labor supply and demand for the taxable commodity. Given these assumptions, I can restate the three equations on which comparative statics are undertaken:
(9) T( 1 + c$,)l + t( 1 + 4,).X = c,
(IO)
and other where eL is the labor supply elasticity with respect to the net wage for residents, elasticities are similarly defined. All elasticities are defined to be non-negative. The solution to the three equations for 7, t and 13will maximize utility if the matrix D is negative definite where
-pi_
(11) Define the ijth element of D as Dij. D,, be negative if D,, and D,, are positive. and E, < 1 + (tP,>- (similar restrictions sales and income tax rates it is plausible
and D,, are both negative and the determinant of D will A unique set of tax rates maximizes utility if eL < T-’ - 1 apply for non-residents). Given the typical values for state to believe these inequalities hold.
3. Tax reform and the sales tax puzzle I characterize TRA86 as d P, > 0 and d PL = I) d P,. For an itemizer in a 40% tax bracket prior to tax reform, PL equals 0.60. Lower marginal tax rates due to TRA86 imply an increase in the income tax price since the tax price is 1 minus the marginal tax rate for an itemizer. If this taxpayer’s tax bracket falls to 0.15, say, then dP, = 0.25. With complete deductibility of the sales tax, P, equals 0.60 also and eliminating federal deductibility of the sales tax implies that d P, = 0.40. In this case, + = 0.625. However, for most taxpayers the federal sales tax deduction was generated from ‘look up’ tables based on Consumer Expenditure Survey data and there is widespread belief among tax experts that the tables significantly underestimated the sales tax liability actually incurred [e.g. Reschovsky and Chernick (198911. If only half of sales taxes were actually deducted, f, would equal 0.80 rather than 0.60. Now eliminating deductibility implies dP, = 0.20 and I&= 1.25.
220
G.E. Metcalf / Deductibility, opfimal state and local fiscal policy
Comparative
static results
dt -= d P,
-4, IDI
dr _=dPX
-4,
for tax reform
are:
(12)
e(ePx-PL)-PL i O(PL - 1c,PX)+PL
IDI
(13)
Considering eq. (12), a necessary condition for dt/d P,> 0 is for PI_ < $l'r. In general, there would be an increase in the sales tax rate as a result of TRA86 if there is incomplete deductibility of the sales tax prior to tax reform and if the demand elasticity for X is not too large. The two polar cases for exporting help clarify these results and show the relationship between deductibility and tax exporting. Consider the case where there is no exporting (4L = 4, = 0). Then eqs. (12) and (13) become
dt dP,
-4,
dr -=dP,
-D,,
_z-
IDI
(14)
and
IDI
) tc, qp,-wx) i
+PLl
(15)
9
Again, assume PL = 0.60, P,= 0.80and t,!t= 1.25. In addition, assume that t = 0.06 and E, = 1. The derivative dt/d P, will be positive if the private marginal utility of income is at least 8% of the social marginal utility of income. Because of the excess burden associated with taxation, the private marginal utility of income is typically larger than the social marginal utility. Exporting reduces the private marginal utility of income as there is ‘leakage’ to non-residents of any additional income used to reduce taxes. However, it is unlikely that the leakage would be sufficiently large that 8 would be less than 0.08. Even if E, were as large as 6 to reflect the possibility of out of state substitution for the taxable good, the derivative would be positive if the ratio of private to social marginal utilities was at least 0.50. What is perhaps surprising is that in the presence of complete exporting of the sales tax and no exporting of the income tax (4L = 0, 4, = co>, the sales tax rate is unambiguously reduced and income tax rate increased after tax reform: dt -=-
-t
d P,
P,
< 0
(16)
and
X[lr[l-(~/(l-r))~]
(tP,/&,]
++
- (tP,/4)E,]
+t[I-(r/(1-~))&]
>”
(17)
In effect, the state acts as a monopolist in setting its sales tax rate to maximize tax revenues from non-residents. An increase in the sales tax price requires an off-setting reduction in the sales tax rate to maintain sales tax collections at their revenue maximizing level. These polar cases illustrate that the interaction between Tax Reform (dP,) and tax exporting (d4,) can be quite complicated. If incomplete deductibility is sufficiently strong that the sales tax
G.E. Metcalf / Deductibility, optimal state and local fiscal policy
221
rate increases, then it is quite possible that the interaction effect (d2t/dPX d$,) is now negative. That is, states which would increase their sales tax rate after tax reform will be less likely to do so (or do so by less) if they export a substantial fraction of that tax. This result also suggests that empirical specifications based on the representative agent model should account for the interaction between federal deductibility and exporting to non-residents.
4. Conclusion Economists have been puzzled by the continued reliance on the state general sales tax after the 1986 tax reform eliminated its deductibility. In this note, I show that incomplete deductibility of this tax due to the use of the sales tax ‘look up’ tables combined with a reduction in marginal tax rates can explain this phenomenon. In addition, I clarify the relationship between responses to,changes in deductibility and changes in the ability to export taxes to non-residents. With greater tax exporting, incomplete deductibility becomes less important. Instead, states act more and more like monopolists as they export a larger fraction of a tax. In this case, they respond to changes in the federal tax price with off-setting changes in the tax rate to maintain tax collections from non-residents at their maximum possible level.
References Arnott, R. and R. Grieson, 1981, Optimal fiscal policy for a state or local government, Journal of Urban Economics 9, 23-48. Courant, P. and E. Gramlich, 1990, The impact of the TRA on state and local fiscal behavior, in: J. Slemrod, ed., Do taxes matter? The economic effect of tax reform (MIT Press, Cambridge, MA). Feldstein, M. and G. Metcalf, 1987, The effect of federal tax deductibility on state and local taxes and spending, Journal of Political Economy 9.5, 710-736. H&z-Eakin, D. and H. Rosen, 1988, Tax deductibility and municipal budget structure, in: H. Rosen, ed., Fiscal federalism: Quantitative studies (University of Chicago Press, Chicago, IL). Reschovsky, A. and H. Chernick, 1989, Federal tax reform and the taxation of urban residents, Public Finance Quarterly, 17, 123-157.
Deductibility fiscal policy Gilbert
217
39 (1992) 217-221
and optimal state and local
E. Metcalf
Princeton University, Princeton NJ, USA Received Accepted
6 February 1992 24 March 1992
I present a model of optimal state and local fiscal policy in the presence of deductibility and exporting to non-residents. model explains the puzzling continued reliance on the general sales tax after the 1986 Tax Reform Act.
This
1. Introduction An important provision of the Tax Reform Act of 1986 (TRA86) for state and local governments was the elimination of federal deductibility for general sales taxes. Based on research by Feldstein and Metcalf (19871, Holtz-Eakin and Rosen (1988) and others, most economists predicted a shift in reliance away from the general sales tax toward other taxes which continued to be deductible at the federal level. The argument is straightforward. Deductibility is a form of tax exporting which reduces the cost to residents of using a particular tax. Eliminating deductibility increases the cost of that tax and reduces the demand for its use. As Courant and Gramlich (1990) have noted, the use by states of general sales taxes did not decline after 1986 - if anything the opposite occurred. In this note I explain this puzzle and in the process highlight the interaction between exporting taxes to non-residents (e.g. tourists, out of state businesses) and to the federal government through deductibility. ’
2. The model I assume that a sub-national government to maximize the utility of a representative agent works and makes all consumption consumption and labor supply. The state does account for the taxes that they pay. *
(call this a state government) wishes to choose tax rates agent. Without loss of generality, I will assume that this purchases within the state. There is also non-resident is not concerned about the utility of non-residents but Individuals take prices as given and maximize utility over
Correspondence to: Gilbert E. Metcalf, Department of Economics, Princeton University, Princeton, NJ 08544-1021, USA. ’ While deductibility is a form of tax exporting, I will reserve the term ‘exporting’ for tax exporting which results from non-residential consumption and labor supply decisions. * This model is an extension of a model developed by Arnott and Grieson (1981). It differs from their model in the treatment of exporting to the federal government as distinct from exporting to non-residents.
0165-1765/92/$05.00
0 1992 - Elsevier
Science
Publishers
B.V. All rights reserved
G.E. Metcalf
218
/ Deductibility,
optimal state and local fiscal policy
labor supply (I), a commodity subject to a state sales tax (x), and a commodity that is not taxed by the state (z). Units for 1, x, and z are fixed so that the gross wage and the net commodity prices equal one. I will assume that these prices are not affected by taxation. However, the net wage and gross commodity prices are affected by taxation. The net wage (w) equals P,(l - 7) where PL is the federal tax price for the state income tax and T is the state income tax rate. If the agent itemizes deductions and his federal marginal tax rate equals m, then a dollar of additional state income tax deduction reduces federal taxable income by one and reduces the federal tax liability by m. Therefore, the net cost of raising a dollar through the state income tax (P,) equals 1 - m for this individual. The gross price for x (q) equals 1 + P,t where P, is the tax price for state general sales agent maximizes taxes (P, I 1) and t is the state general sales tax rate. 3 Thus the representative U(I,
x, 2)
s.t.
wl2qx
fz,
(1)
w=PL(l-T),
(2)
CJ= 1+P,t.
(3)
There is also taxable wage income earned by non-residents. Their net wage (6) on labor supply I equals PI!1 - T) and their gross price for purchase of the taxable commodity i is @ and equals 1 + p,t. Any variable with a tilde over it refers to non-residents. The government then takes individual utility maximization into account and chooses tax rates to maximize the indirect utility of the representative agent subject to the community budget constraint: 4 maxV(w,q, 1,T
,(1+1)
I),
(4)
=c,
+t(x+i)
where ?? is the fixed government Differentiating (4) with respect first-order conditions:
-OP,l-th
-B<,x+A
1 1
a~
revenue requirement and to t and r and applying
V( .> is the indirect utility Roy’s Identify gives the
function. following
ax
L+rz+tz
(6)
=o, i
ax
x+tat+7;
aL
1=o,
where 8 is the ratio of the private marginal utility of income to the social marginal utility of income, L is aggregate labor supply (I + f) and X is aggregate demand for the taxable commodity (x + i). For the purposes of considering the effects of changes in federal tax laws on the optimal choice of t, T (and O), comparative statics are conducted on eqs. (5) (6), and (7). I make the following simplifying assumptions. First, I assume that changes in wage taxes do not affect taxable commodity demand and that changes in sales tax rates do not affect labor supply. Second, I define 4L as the 3 I have not allowed for state deductibility
of federal
result. 4 I assume that the revenue requirement utility function of state residents.
for the government
income
taxes. Doing so clutters
the notation
is fixed and that government
without
spending
affecting
the main
does not enter
the
219
G.E. Metcalf / Deductibility, optimal state and local fiscal policy
ratio of non-resident to resident labor supply and similarly 4, as the ratio of non-resident to resident demand for x. I assume that +L and 4, are exogenous. Third, I assume a constant elasticity specification with respect to labor supply and demand for the taxable commodity. Given these assumptions, I can restate the three equations on which comparative statics are undertaken:
(9) T( 1 + c$,)l + t( 1 + 4,).X = c,
(IO)
and other where eL is the labor supply elasticity with respect to the net wage for residents, elasticities are similarly defined. All elasticities are defined to be non-negative. The solution to the three equations for 7, t and 13will maximize utility if the matrix D is negative definite where
-pi_
(11) Define the ijth element of D as Dij. D,, be negative if D,, and D,, are positive. and E, < 1 + (tP,>- (similar restrictions sales and income tax rates it is plausible
and D,, are both negative and the determinant of D will A unique set of tax rates maximizes utility if eL < T-’ - 1 apply for non-residents). Given the typical values for state to believe these inequalities hold.
3. Tax reform and the sales tax puzzle I characterize TRA86 as d P, > 0 and d PL = I) d P,. For an itemizer in a 40% tax bracket prior to tax reform, PL equals 0.60. Lower marginal tax rates due to TRA86 imply an increase in the income tax price since the tax price is 1 minus the marginal tax rate for an itemizer. If this taxpayer’s tax bracket falls to 0.15, say, then dP, = 0.25. With complete deductibility of the sales tax, P, equals 0.60 also and eliminating federal deductibility of the sales tax implies that d P, = 0.40. In this case, + = 0.625. However, for most taxpayers the federal sales tax deduction was generated from ‘look up’ tables based on Consumer Expenditure Survey data and there is widespread belief among tax experts that the tables significantly underestimated the sales tax liability actually incurred [e.g. Reschovsky and Chernick (198911. If only half of sales taxes were actually deducted, f, would equal 0.80 rather than 0.60. Now eliminating deductibility implies dP, = 0.20 and I&= 1.25.
220
G.E. Metcalf / Deductibility, opfimal state and local fiscal policy
Comparative
static results
dt -= d P,
-4, IDI
dr _=dPX
-4,
for tax reform
are:
(12)
e(ePx-PL)-PL i O(PL - 1c,PX)+PL
IDI
(13)
Considering eq. (12), a necessary condition for dt/d P,> 0 is for PI_ < $l'r. In general, there would be an increase in the sales tax rate as a result of TRA86 if there is incomplete deductibility of the sales tax prior to tax reform and if the demand elasticity for X is not too large. The two polar cases for exporting help clarify these results and show the relationship between deductibility and tax exporting. Consider the case where there is no exporting (4L = 4, = 0). Then eqs. (12) and (13) become
dt dP,
-4,
dr -=dP,
-D,,
_z-
IDI
(14)
and
IDI
) tc, qp,-wx) i
+PLl
(15)
9
Again, assume PL = 0.60, P,= 0.80and t,!t= 1.25. In addition, assume that t = 0.06 and E, = 1. The derivative dt/d P, will be positive if the private marginal utility of income is at least 8% of the social marginal utility of income. Because of the excess burden associated with taxation, the private marginal utility of income is typically larger than the social marginal utility. Exporting reduces the private marginal utility of income as there is ‘leakage’ to non-residents of any additional income used to reduce taxes. However, it is unlikely that the leakage would be sufficiently large that 8 would be less than 0.08. Even if E, were as large as 6 to reflect the possibility of out of state substitution for the taxable good, the derivative would be positive if the ratio of private to social marginal utilities was at least 0.50. What is perhaps surprising is that in the presence of complete exporting of the sales tax and no exporting of the income tax (4L = 0, 4, = co>, the sales tax rate is unambiguously reduced and income tax rate increased after tax reform: dt -=-
-t
d P,
P,
< 0
(16)
and
X[lr[l-(~/(l-r))~]
(tP,/&,]
++
- (tP,/4)E,]
+t[I-(r/(1-~))&]
>”
(17)
In effect, the state acts as a monopolist in setting its sales tax rate to maximize tax revenues from non-residents. An increase in the sales tax price requires an off-setting reduction in the sales tax rate to maintain sales tax collections at their revenue maximizing level. These polar cases illustrate that the interaction between Tax Reform (dP,) and tax exporting (d4,) can be quite complicated. If incomplete deductibility is sufficiently strong that the sales tax
G.E. Metcalf / Deductibility, optimal state and local fiscal policy
221
rate increases, then it is quite possible that the interaction effect (d2t/dPX d$,) is now negative. That is, states which would increase their sales tax rate after tax reform will be less likely to do so (or do so by less) if they export a substantial fraction of that tax. This result also suggests that empirical specifications based on the representative agent model should account for the interaction between federal deductibility and exporting to non-residents.
4. Conclusion Economists have been puzzled by the continued reliance on the state general sales tax after the 1986 tax reform eliminated its deductibility. In this note, I show that incomplete deductibility of this tax due to the use of the sales tax ‘look up’ tables combined with a reduction in marginal tax rates can explain this phenomenon. In addition, I clarify the relationship between responses to,changes in deductibility and changes in the ability to export taxes to non-residents. With greater tax exporting, incomplete deductibility becomes less important. Instead, states act more and more like monopolists as they export a larger fraction of a tax. In this case, they respond to changes in the federal tax price with off-setting changes in the tax rate to maintain tax collections from non-residents at their maximum possible level.
References Arnott, R. and R. Grieson, 1981, Optimal fiscal policy for a state or local government, Journal of Urban Economics 9, 23-48. Courant, P. and E. Gramlich, 1990, The impact of the TRA on state and local fiscal behavior, in: J. Slemrod, ed., Do taxes matter? The economic effect of tax reform (MIT Press, Cambridge, MA). Feldstein, M. and G. Metcalf, 1987, The effect of federal tax deductibility on state and local taxes and spending, Journal of Political Economy 9.5, 710-736. H&z-Eakin, D. and H. Rosen, 1988, Tax deductibility and municipal budget structure, in: H. Rosen, ed., Fiscal federalism: Quantitative studies (University of Chicago Press, Chicago, IL). Reschovsky, A. and H. Chernick, 1989, Federal tax reform and the taxation of urban residents, Public Finance Quarterly, 17, 123-157.