state tax structure and multiple policy objectives - national tax journal

STATE TAX STRUCTURE AND MULTIPLE POLICY OBJECTIVES WILLIAM M. GENTRY* & HELEN F. LADD**

Abstract - We use a portfolio model of state tax structure to examine how a state’s economy and the nature of its taxes affect the choices available to state policymakers. Data from North Carolina and Massachusetts indicate that the income tax is the dominant tax in both states, that the two states differ in the nature of the trade-offs between characteristics such as growth and instability and between progressivity and instability, and that differences in the economies of the two states and their characteristics lead to differing prescriptions about the optimal mix of taxes. We conclude that policy recommendations about state tax structures may not be transferable across states.

INTRODUCTION

The goals of tax policy are typically to provide a fair, efficient, and predictable means of financing government expenditure. To achieve these multiple objectives, policymakers choose a mix of taxes. Separately, each tax has its own

*Department of Economics, Duke Unwerslty, Durham, NC

27708-0097

**Sanford Institute of Public Policy, Duke University, Durham,

NC 277084243.

characteristics of fairness, efficiency, and predictability. Together, the properties of each tax and the interactions between the taxes determine the characteristics of the tax system. These characteristics of the overall tax system are the starting point for our analysis of state decisions about the composition of state taxes. Specifically, we view state policymakers as having preferences over the characteristics of the tax system, which in turn generate a demand for specific taxes. The desired mix of taxes will vary from one state to another, both because of differences in policy preferences and because of variation across states in the characteristics of individual taxes and how they interact with the state economy.

We focus our attention on two states- Massachusetts and North Carolina-and four characteristics of state tax structures. Our goal is to compare and contrast the characteristics of different pos- sible tax structures for each state and the choices made by the two states. The four characteristics are revenue growth, stability, equity, and competitiveness with other states.’ Each of these characteristics is likely to be important to state policymakers who are faced with the

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challenge of raising money to finance public services with limited information about the future of the economy and how agents will respond to a given tax structure. Because short-term changes in the tax system generate political and economic costs, revenue shortfalls or ex- cesses impose costs on policymakers. Hence, policymakers WIII strive to design a tax system that provides growth in revenue that corresponds to the predicted growth in expenditures and provides a stable source of revenue. Equity is clearly of concern, although the acceptable amount of progressivity will typically vary from one state to another. Competitiveness with other states loosely accords with notions of economic efficiency in that a tax burden that is out of line with those of other states can cre- ate economic distortions.

As a methodology for comparing the characteristics of different tax structures, we use a portfolio choice model of tax structure. Pioneered by White (1983) for Georgia, this approach modifies the portfolio model of finance theory to construct an efficiency frontier to depict the trade-off between revenue growth and stability In a state’s tax structure.’ Using data from New York, Harmon and Mallick (1994) extend White’s methodology to include equity considerations. Our analysis advances this line of research further by incorporating into the analysis a broader set of characteristics, directly comparing two staites, and addressing three specitic policy questions: What is the mix of state taxes in an efficient portfolio? What changes in its tax mix are required for the state to move to its frontier? And are there trade-offs between policy goals?

Our research is motivated in part by the observation that economists have de- voted considerable attention to the characteristics of indivildual taxes, but little attention to the broader question of the

appropriate mix of taxefs within a gov- ernmental jurisdiction. tb addition, it is motivated by previous lpolicy prescriptions of the Advisory Cbmmission on In- tergovernmental Relations (ACIR). Kleine and Shannon (1986) add Shannon (198’7) recommend tha$ states adopt relatively uniform state-local tax structures and that these structurqs be balanced in the sense that about ode-third of tax revenues come from eakh of three major taxes--property, sales, @nd income. Ladd and Weist (1987) counter that neither recommendation necessarily improves tax policy. If the compositi& of economic activity or the value tha~t policymakers place on different tax plolicy goals varies across states, then varidtion, rather than uniformity, in state tax /structures is appropriate. Furthermore, i data suggest that moving toward a

t

ore balanced state tax structure will ot promote the standard goals of tax policy in all states. Missing from the Ladd Bnd Weist analysis was a comprehensive and integrated model, such as a portfc#io choice model, of the state tax decisioq. As developed further below, our analysis based on such a model supports the Ladd and Weist conclusion that tgx structures need not be similar acrbss states.

We begin by comparing the portfolio approach to other modlels of tax structure. The following secttion describes the characteristics of state Iax structures in North Carolina and Ma$sachusetts. Sub- sequent sections describe the derivation of the efficiency frontie~r, compare the frontiers for Massachusetts and North Carolina, and discuss tqe policy implications of the results. Wq end with a brief evaluation of the portfOlio approach.

COMPARISON OF THE 1

ORTFOLIO MODEL WITH OTHER MODELS OF TAX STRUCTURE

The centerpiece of the IportfolIo approach is the derivatiori of a frontier

I STATE TAX STRUCTURE

that depicts the trade-offs among characteristics of a state’s tax system. Thus, the focus is on how the tax structure interacts with the state economy to con- strain the choices available to state policymakers. As the approach has been implemented by others and as we imple- ment it in this paper, the preferences of the policymakers among the characteristics are left unspecified. Hence, most of the conclusions about whether one portfolio of taxes is better than another are conditional on the specification of one of the characteristics, such as the growth rate of revenue, and on the reasonable assumption that certain characteristics, such as equity, are desirable and others, such as instability, are unde- sirable.

The main alternative to the portfolio approach is optimal taxation theory (see Auerbach (1985) and the references therein). According to this theory, an optimal tax structure maximizes an explicit social welfare function, defined as some aggregation of the welfare of individuals. Underlying the approach is the view that tax-induced inefficiencies are potentially large and must be considered in the design of policy. Standard optimal tax models prescribe a tax system by specifying (1) a model of economic behavior based on consumer preferences, technology, and market structure (almost always perfect competition), which generates the deadweight loss associated with taxes; and (2) a social welfare function, which captures equity concerns. While these models have offered numer- ous theoretical insights into the design of a tax system, their level of abstraction limits practical implementation.3 Measur- ing the full efficiency losses associated with taxes requires a large amount of information on preferences and technology and empirical estimates of how people respond to taxes. Moreover, although the social welfare function suc-

cinctly models fairness, its usefulness depends on the analyst’s ability to specify the concavity of society’s welfare function.

Compared to the optimal tax models, the portfolio approach requires less information and puts less emphasis on economic efficiency. Instead of requiring a full specification of behavioral responses to taxes and the parameters of the social welfare function, the portfolio approach can be based on the historical interaction of different taxes with the state’s economy and simple measures of progressivity to capture equity considerations. Although additional information on behavioral responses to taxes could beneficially be incorporated into the portfolio model, its absence does not prevent the implementation of the model. The reduced attention to efficiency is justified by the challenges of measuring deadweight losses, the fact that policymakers appear to put less emphasis on minimizing deadweight losses than do economists, and the observation that other considerations such as the stability of the tax system, which are not incorporated into static optimal taxation models, are important to policymakers.

We incorporate some elements of efficiency by including the competitiveness of a state’s tax structure as one of a state’s policy goals. To maintain a competitive tax structure, a state must avoid imposing taxes at rates that greatly ex- ceed those in other states, thereby minimizing tax-driven economic distortions associated with location decisions. How- ever, our approach ignores distortions not associated with differential tax rates across states. For example, by not explicitly measuring deadweight loss, we fail to capture the advice from economic theory that source-based taxes are unde- sirable on efficiency grounds (see Dixit (1985) and references therein).

In contrast to the explicit statement of a social welfare function in the optimal tax approach, the objective function of state policymakers is less well-specified in the portfolio approach. Nonetheless, an opti- mizing framework is implicit in that the policymaker is assumed to be trying to maximize an objective function defined across several policy goals. In particular, the policymaker is assumed to be striv- ing to design a tax system that provides growth in revenue that corresponds to the predicted growth in expenditures, provides a stable source of revenue, and satisfies other goals such as equity and competitiveness. Specifying how the policymaker wetghs one goal relative to another would be arbitrary. Hence, we leave the preference function unspecified and focus instead on the nature of the trade-offs among policy goals.4

Our analysis also departs from the purely positive, predictive models of state tax behavior developed by Hettich and Wi- ner (1984, 1985, and 1988). These models are predicated on the assumption that state officials rninimize the political costs of raising revenues. Their work is intriguing and has served as the basis for empincal work by themselves and others (see, for example, Chernick (1991); Alm and McCallin, 1992). How- ever, the purely positive focus of their approach limits its usefulness as a tool for evaluating state tax structures and providing policy guidar~ce.5

CHARACTERISTICS OF THE TAX STRUCTURES OF NORTH CAROLlNA AND MASSACHUSETTS

We analyze North Carolina and Massa- chusetts partly because of our familiarity with both states, but also because they have certain similarities and differences that are relevant for this study. The two states have approximately the same pop- Oulation. Despite more rapid population growth in North Carolina, taxes have

grown at similar rates in the two states during the past two decades.” Moreover, neither state is an outlier with respect to the mix of taxes. In particular, both states have income and general sales taxes and neither relies on severance taxes, heavy reliance on which would complicate the analysis because of the potential for exporting the burden to nonresidents. In 1990, per capita state and local tax revenues were $2,360 in Massachusetts, about 40 percent higher than the $1,675 level in North Carolina. However, because per capita income in Massachusetts exceeds that in North Carolina also by about 40 percent, taxes as a percent of income are almost iden- tical---l 0.8 percent in Massachusetts and 10.9 percent in North Carolina.7

In this paper, we focus on state, rather than state and local, tax revenues. This focus is (sensible because state policymakers have full control over state tax revenues but much less control over local taxes. However, because state and local tax decisions are closely inter- twined, a case can also be made for fo- cusing on the combined state and local sector. While \~e apprdciate the argu- ments for examining stste and local gov- ernments together, the logic underlying our estimates of growth, instability, and equity cannot be readilb applied to local property taxes.8

We exclude from the analysis federal aid to states because, unlike taxes, it is not directly controlled by sltate government officials. In addition, we exclude charges and fees because reliance on them across states varies with a state’s decisions about expenditures, such as whether to have a large public university system.

Table 1 reports the 1991 mix of state taxes in each state. Three differences emerge: compared to North Carolina, Massachusetts relies more heavily on in-

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ACTUAL TAX TABLE 1

PORTFOLIO SHARES FOR 1991

Income 0.564 0.489 Sales 0.213 0.233 Corporate 0.068 0.068 Insurance 0.029 0.027 Energy 0.059 0.139 Wealth 0.028 0.012 Other 0.039 0.033

Notes: Revenues from each tax as a fraction of total state revenues. See Appendix A for data sources and details about tax categories.

dividual income taxes and wealth taxes (defined as estate, gift, and inheritance taxes) but less on energy taxes (defined as motor fuel taxes and utility taxes). Re- liance on general sales taxes, corporate income taxes, insurance taxes and other taxes does not vary much between the two states. However, as elaborated further below, the differences between the tax structures in the two states are substantially greater than this table suggests. This conclusion follows because of variation in the way each state defines its tax bases, as most graphically illus- trated by the sales tax: Massachusetts’ narrow base excludes food and most clothing, while the North Carolina tax base includes food and clothing. (See Appendix A for definitions of tax bases.)

An alternative, and in our view more useful, way to classify tax structures is in terms of their characteristics. Table 2 presents data on four main characteristics: revenue growth, instability, equity, and competitiveness. As elaborated be- Jaw, the estimates of revenue growth and instability are based on historical data in each state and reflect the combi- nation of the characteristics of each tax, changes in the state economy, and small discretionary changes in tax rates and tax bases. The measures of equity and competitiveness are calculated for 199 1. The table shows that the two states’ tax structures differ along these four dimensions.

The first characteristic, revenue growth, primarily reflects growth in demand for spending. The expected rates of real revenue growth reported in Table 2 are weighted averages of tax-specific growth rates estimated over a 21-year period, with the weights equal to the 1991 portfolio shares. (Details on the calculation of this and the other characteristics by tax are discussed below in the context of the derivation of the efficiency frontier). For 1991, the expected real growth rate was about 3.6 percent per year for North Carolina and 2.85 percent per year for Massachusetts.

Instability refers to the short run variabil- ity of the tax portfolio around its expected growth rate and accounts for both the variance of the trend-adjusted residuals of individual taxes and their covariances. To make the units compara- ble, we report instability as a standard deviation rather than as a variance. Be- cause states are required to balance their budgets and because they find it hard to maintain sufficient reserves in the form of “rainy day funds” to offset unanticipated revenue shortfalls, we assume that unstable tax systems are less desirable than stable ones, all else held constant. The table shows that the Mas- sachusetts tax structure has greater instability than the North Carolina tax structure.

Our measure of equity is intended to capture the progressivity of the tax

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TABLE 2 CHARACTERISTICS OF STATE TAX STRUCTURES FOR 1991 ---- ---____c_---

Characteristic Massachusetts North Carolina ----~ --- Real growth rate 2.85 percent Instability

3.63 percent .-

(percentage points) 4.99 3.81 Equity 1.65 1.08 Competitiveness

Income 1.31 1.47 Sales 0.65 0.90” Corporate 1.43 1.18 Insurance 1.03 1.18 Energy 0.59 1.02 Wealth 2.56 1.05 ----- ---__ -.-

Notes: The calculations of growth, instability, and equity are discussed in the text. Competitivfness is based on the average effective tax rates relative to averages for all states (ACIR data for 1988). ?ncludes local sales taxes Without local two percent tax, the North Caroliina value would be d.60.

structure. In particular, we use one of several standard measures of tax progressivity, namely, the elasticity of tax payments with respect to annual income.’ As applied to discrete inc:ome spans, this measure is calculated as the percentage change in tax revenues divided by the percentage change in income. An elasticity greater than one indicates a progressive tax system, while an elasticity less than one indicates a regressive system. We apply the measure to relatively high-income households (those with income in the $40,000 and $50,000 range) and to relatively low-income households (those with incomes between $10,000 and $ZO,OOO), lo with the calculation based only on those taxes that are intended to be borne by residents. This measure, it should be noted, is based on burdens in relation to annual income rather than the alternative of permanent income. While annual income may be a reasonable measure of ability to pay for middle-income households, it is probably a poor measure for many people in the lowest and the highest income classes. By avoiding the very lowest and the highest income classes, our selection of income classes minimizes the limitations of using annual income.”

<Along this equity dimension, Massachu-

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setts and North Carolirla have m,ade significantly different choices. The index value of 1.65 Indicates ~that Massachu- setts’ state tax structure is highly progressive, while the value of 1.08 indicates that North Carolitia’s is only slightly progressive. However, the reader should note that both $tates appear to have regressive structuFs when local taxes are added.‘*

Finally, we c:haracterize the competitiveness of a state’s tax str cture in terms of effective tax rates 1 re ative to the national average for each ~of several taxes. At this point, we simply: report measures for each tax for each siate. Below, we introduce competitivenc/ss into the model as a constraint oin the effective tax rates that states cari impose. The state’s effective tax rate is calculated as the tax collections from~ the tax divided by the potential tax bade, as measured In a consistent way across states by the U.S. Advisory Commissi$n on Intergov- ernmental Relations (1982). Because states vary in how they define tax bases, the use of nominal tax rates would be misleading. A ratio grealter than one implies that the state impqses an average effective Irate greater thbn the national average. To the extent t/hat individuals or firms evaluate the effective tax rate in


their own state by comparing it with tax rates in other states, the higher is a state’s tax rate relative to the national average, the less competitive by defini- tion is that state in terms of that tax.13 The bottom part of Table 2 shows that both states tax personal income, corporate income, insurance, and wealth at above-average effective rates. In contrast, both states tax sales at below- average effective rates. The relative effective sales tax rate of 0.90 for North Carolina is based on the sum of state and local sales taxes, rather than on state taxes alone. Because firms and individuals do not distinguish between state and local taxes as they compare rates across states, the relevant effective rate is based on revenue generated by the uniform two percent local rate as well as that by the four percent state rate.14 Compared to Massachusetts, the effective tax rates in North Carolina are somewhat higher for income, sales, insurance, and energy.

THE EFFICIENCY FRONTIER

A major purpose of this paper is to un- derstand and evaluate the decisions that the two states have made about these four dimensions, especially the latter three. Central to this analysis is the con- cept of an efficiency frontier, namely, the boundary of the set of characteristics that are feasible given the nature of the state economy and the values of state residents. One set of questions revolves around the position and shape of this frontier. A second set involves the rela- tionship between the state’s actual choices and the frontier.

Following portfolio theory from finance, we begin by describing the frontier for the tax portfolio in terms of revenue growth and instability. These two characteristics of a state’s tax portfolio are the most similar to the relevant characteristics of asset portfolios in the finance

literature, namely, the rate of return on assets and the riskiness of the portfolio. However, in contrast to asset models for which it is reasonable to assume that the investor cares about only the mean and the standard deviation of portfolio returns, models of the state tax decision must incorporate other policy objectives. Specifically, the models must, at a minimum, incorporate considerations of equity and competitiveness. Following Har- mon and Mallick (1994), we incorporate these other considerations into the con- struction of the frontier in the form of constraints.

Revenue Growth and Instability

The expected growth rate of revenue generated by a tax system can be calculated as a weighted average of the expected real growth rates of each tax, where the weights are the shares of total tax revenue attributable to each tax. For both Massachusetts and North Caro- lina, we estimate tax-specific growth rates using annual data for the past 21 years.

One issue that arises in estimating growth rates is whether to adjust annual revenues for discretionary changes in tax rates and tax bases to assure that the dependent variable represents revenue from a tax that is defined uniformly over time. For major, infrequent discretionary changes, such an adjustment is clearly desirable. If the adjustment were not made, the resulting estimates of growth rates would confound the effects of legislated changes with growth in the tax base. Stated differently, the estimated growth rates would represent biased estimates of the expected growth in revenue that would be generated from growth in the tax base alone. However, the case for adjusting revenues for discretionary changes is much less compel- ling when such changes are frequent and relatively small. In this situation, one

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might appropriately view the expected growth in a revenue source as the com- bination of growth arising from a uniformly defined tax augmented (or dimin- ished) by legislated changes. Thus, this approach explicitly accounts for growth due to systematic legislative activity as well as for growth due to economy-re- lated changes in the tax base.

The preferred approach for each tax category depends on each state’s legislative history.” Our criteria for determining which changes required adjustment were that the growth rate in a year was substantially greater or smaller than the average growth rate over the period and that the outller could be matched with a clearly specified policy change. Based on these criteria, we did not adjust the North Carolina data. A close examina- tion suggests that legislated changes in that state were, in general, relatively frequent and relatively small.‘6 For some of the minor taxes, such as cigarette taxes, the changes were more significant. However, because we group several small taxes together, legislated changes that may appear large for an individual tax are often small in the context of the larger category.

Using the same methodology, we identi- fied and adjusted for four significant policy changes in Massachusetts. These were an increase iin the state sales tax rate from three to five percent, which affected revenues in 1976; changes that lowered corporate tax revenue in 1975 (an increase In the investment tax credit and a reduction in the rate on tangible property); a 50 percent increase in the gasoline tax rate that affected energy taxes in 1991; and a change in the structure and rates of the income tax in 1972. In each case, we adjusted the data by setting the growth rate for the relevant year at the average for the sam- ple period.’ 7

We estimate growth rates for using the following eqdation:

each tax

d log R,, == b, + e,,

where d log R,, is the change in the nat- ural logarithm of real r4venue (deflated using the implicit price ,deflator for state and local services) from1 the ith tax between year t -- 1 and t, 6, is the estimated growth rate, an4 e,, is a random error term, which we a+ume is station- ary. <According to this s ecification, the expected growth rate f 1 r each tax is simply the geometric a rate of actual revenue riod.”

The instability of a tax efers to the variation in revenue growt

1 around rts aver-

age. Hence, tax-specific measures of instability can be calculat

e d as the

standard deviation of the error term, e,,, or, equivalently, as the standard deviation of the dependent variable. The greater the variation ar und the average growth rate, the great t r the instability of

of the covariances bet

Table 3 presents tax-sp cific measures of growth and instability f

B r the seven tax

categories for each stat . In both states, the income tax clearly i xhibits the fast- est real growth (3.8 pe cent per year in Massachusetts and 6.0 1 percent in North Carolina). The fact that revenue from these taxes grows faster than real income in both states cat? be explained both by the progressivi y of each tax t and the accumulation df small legislated changes in rates and b&es. The table also shows that sales tqx revenue grows faster in Massachusettslthan in North Carolina both absolute1 Y and relative to

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Tax

TABLE 3 REAL EXPECTED GROWTH AND INSTABILITY BY TAX FOR 1991

Massachusetts North Carolina

Growth Instability Growth Instability (Percent) (Percentage Points) (Percent) (Percentage Points)

Income Sales Corporate Insurance Energy Wealth Other

Addendum Real income

3.8 3.2 0.4 2.9

-1.2 1.9

-2.2

2.2

5.7 6.0 5.0 8.0 2.6 5.7

10.6 0.9 10.7 13.0 2.7 6.8 8.3 -0.1 7.5

14.8 0.9 15.5 6.1 -1.5 6.2

2.4 3.0 1.7

Note: See the text for details on these calculations.

income growth, a finding which is consistent with the differing definitions of the tax base. The narrow base in Massa- chusetts makes the tax into a tax on consumer durables, spending on which grows faster than personal income. In North Carolina, the broader base, which includes food and all clothing, grows more slowly than personal income. In both states, the lowest growth rates arise for the corporation income tax, energy taxes, and other taxes.

The differences between the two states reflect both differences in how each tax is defined and how it interacts with the state economy. The most striking finding is the greater instability of most of the Massachusetts taxes relative to the North Carolina taxes. The largest differences appear for the general sales tax (with a standard deviation of 8.0 percentage points in Massachusetts versus 5.7 percentage points in North Carolina), the taxes on insurance (13.0 versus 6.8) and the energy taxes, which include motor fuel and utility taxes (8.3 versus 7.5). Part of this greater instability reflects the greater instability in state real income in Massachusetts. As shown in the addendum to the table, the Massachusetts economy was approximately 50 percent more unstable than North Carolina’s during the period, despite its lower average growth rate.

Equity

Regardless of the statutory placement of taxes, the burden ultimately falls on individuals. Hence, equity refers to the pat- tern, usually by income class, of tax burdens on individuals. The distributional effects of taxes by income class depend first on which functional groups-e.g., people in their capacity as consumers, wage earners, or landowners-bear the ultimate burden of the tax and second on the patterns of spending or earnings by income class. The incidence of taxes on state residents is complicated further by the possibility that some of the tax burden may be shifted to taxpayers out- side the state. To allocate taxes among income classes, we assume that policymakers believe that taxes on income are not shifted at all and that taxes on consumer goods are fully shifted forward to consumers.

For the purposes of this analysis, we assume that state policymakers care only about perceived burdens on state residents from taxes intended to be borne by state residents such as the personal income tax, general sales taxes, and selective sales taxes. For business taxes for which the ultimate incidence is unclear (to economists as well as to policymakers and residents), we assume that in making their equity calculations, state

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policymakers either perceive no burden on state residents (or that they ignore such burdens. Thus, our equity analysis ignores business taxes.

Using data from the most recent regional Consumer E.xpenditure Survey (1988), we calculated the incidence by income class of the following taxes: income, general sales, tobacco, alcohol, gasoline, and utilities.‘” Appendix 6 details our methodology for estimating progressivity. Tobacco and alcohol taxes are part of the category of taxes labeled “other.” Taxes on gasoline and utilities together make up the energy category. Given our assumptions about incidence, burdens for the income tax were distributed among income classes in line with actual tax payments (adjusted for de- ductibility against the federal income tax), and burdens for both general and selective sales taxes were distributed in line with consumption of taxed items. The resulting burdens by tax by state for two types of households are shown in Table 4. The third column of the table for each state indicates our summary measure of progressivity, the elasticity of the tax burden between the two income classes.”

Differences In state taxirates and bases, plus some v(ariation in qpending patterns in the Northeast and tde Southeast, ac- count for the different ~relative burdens on high- and low-incot$e households. The iincome tax is highly progressive in both states. Although Massachusetts does not have progressve tax rates, the

i rate on unearned income, which dispro- portionately accrues to ‘higher-income households, exceeds thbt on earned income. North Carolina Has a relatively flat rate schedule but mini izes the burden r(l on low-income househ&ds by using a tax base that mimics q&ite closely the federal tax code. The s

t les tax is regres-

sive in both states, butImore so in North Carolina, which includes food in the tax base. Similarly the gasc/line tax is regressive in both states. Its

i reater absolute

burden iI1 North Caroli, a reflects the state’s slightly higher tax rate and much heavier reliance on travel by automobile, especially arnong low-ivcome households. As indic:ated at he bottom of the

1 table, thle Massachuset s state tax structure In 1989 was signifficantly more progressive than the Nortq Carolina structure “I Of interest is progressrvity in Massac

TABLE 4 EQUITY MEASURES BY TAX FOR 1989 ---~~ ----

Massachusetts --~- $1 o,ooo-$ZO,OOO $40,000-$50,000

Tax (Percent) (Percent) ____---- Income 1.53 3.79 Sales 1.95 1.62 Tobacco 0.37 0.19 0.27 0.02 Alcohol 0.12 0.11 0.86 0.24 Gasoline 0.31 0.24 0.64 ‘I.25 Utilities 0.11 0.05 0.21 0.51

Total 4.39 6.00 1.55 6.08 ----- -----_ Addendum

Average income $14,867 $44,443 $14,752

-..-

-0.04 IO.01 0.12

IO.74 0.26 0.39

0.25 0.23

~6.15 1.02 --.- ,

$44,493 Notes: This information IS based on revenue data for 1988-89 and Consumer Expenditure Su ey expenditure patterns for 1988. The elasticity is, defined as the percentage change in tax payments divided by the p rcentage change in in-

----7---- cqme. See Appendix 8 and the text for details about the derivation of equity measure. The a erage income refers to the average income within the income bracket from the regional Consumer Expenditure Surv$y.

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achieved not through significantly higher tax burdens on high-income households but rather through substantially lower burdens on low-income households. The higher average income in Massachusetts and smaller percentage of low-income households apparently make it easier for Massachusetts than for North Carolina to afford to be generous to its low-income households.

As explained further below, we incorporate equity into the frontier of efficient tax portfolios in the form of a constraint. Specifically, we allow the degree of progressivity to vary around its 1991 level within a limited range. The basic range is plus or minus 0.15, a range that roughly approximates the historical variation in the progressivity of taxes over time in these two states.”

Competitiveness

Competitive pressures across states may limit policymakers’ tax structure choices and their ability to reach desired levels of growth, stability, or fairness in the tax system. Competitive pressures can come either from the threat of relocation by businesses or individuals or through “yardstick” competition by which voters compare their state’s performance with that of other states (see Besley and Case, forthcoming). This competitive pressure might also push states toward choosing tax structures that reduce economic inefficiency. We interpret these competitive pressures as putting limits on a state’s maximum reliance on each of the following six types of taxes: personal income, general sales, corporate income, insurance, energy, and wealth.

As a measure of the limits imposed by competing with other states, we compare each state’s reliance on each of these taxes with the hypothetical revenues it would receive if it relied heavily on the tax. For interstate comparisons, we turn to ACIR data on tax effort for

each tax in each state for 1988 (the lat- est year for which data are available). A state’s tax-specific effort index is calculated as the ratio of its actual revenue from the tax to its tax capacity, where capacity is defined as the national average tax rate multiplied by the state’s tax base assuming it used the ACIR’s uniform tax base. A tax effort index greater than one implies that the state imposes an above-average effective tax rate on that revenue source.

To construct the competitiveness constraint, we limit the effective tax rate on each tax to the tax effort of the state at the 95th percentile of tax effort.23 We use the 95th percentile instead of the state with the highest tax effort, because each tax typically has some out- liers in terms of tax effort.24 For each tax, we define each state’s maximum potential revenue as the competitive limit on tax effort multiplied by each state’s own tax capacity. Since we for- mulate the tax structure choice problem in terms of portfolio shares, we divide the state’s maximum potential revenue from each tax by the state’s total 1988 tax revenue to measure the state’s maximum potential reliance on each tax.

Table 5 lists the resulting maximum shares for the corporate, insurance, energy, personal income, and general sales taxes for Massachusetts and North Caro- lina. The limits differ across the two states because of differences in the size of the tax bases of the different states and differences in total revenues. A comparison of these maximum shares with the actual choices in Table 1 shows that both states could double their reliance on corporate and sales taxes and could substantially increase insurance taxes without the competitiveness constraint binding. In contrast, neither state could substantially increase reliance on the income tax without the constraint binding.25

TABLE 5 COMPETITIVENESS CONSTRAINT MAXIMUM SHARES

Tax Massachusetts North Carolina

Income 0.604 0.492 Sales 0.589 o.447a Corporate 0.137 0.170 Insurance 0.054 0.043 Energy 0.074 0.161 Wealth 0.032 0.027

Notes: The competitiveness constraints are based on ACIR data for 1988. See the text for detalils on the derivation of the maximums aTwo-thirds of maximum sales tax revenue allocated to the state.

The Frontier

We initially summarize the options facing each state in the form of a trade-off between growth and instability. For any specified growth rate, the frontier indicates the minimum amount of instability that can be achieved by changing the mix of taxes given the equity and competitiveness constraints. While the optimization problem can be set up either in terms of maximizing revenue growth or minimizing instability, we prefer the latter approach because it is more consistent with the reality that demand for spending growth determines expected growth rates of revenue. Thus, for any growth rate, the challenge for the state policymaker is to choose a portfolio of taxes that minimizes instability consistent with other tax goals.

Policymakers minimize instability by choosing the portfolio weights for different taxes. Their constrained minimization problem for the frontier can be ex- Ipressed as follows:

subject to

q -7 r~ w,g, = constant >

q w, 5 c, where i = corporate, insurance, income, sales, energy, and wealth.

q > ; w,K;10 - 2 w,K;’ 1 1 --

c w, K;’

E 1 <-

ml” -- 140 /JO 5 Ll‘>X - --

/ 10

where i == income, saleF, energy, and other.

q w,rO Vi q c w=l

where w, is the portfoli$ weight for each tax, a,, is the covaiiance between the percentage changes in the tax revenues (when i = i, this term is the variance of tax i), g, is the expected growth rate for each tax, c, is the competitiveness constraint for carp rate,

1 insurance,

Income, sales, energy, a d wealth taxes described above, KY is jhe percentage of tax i borne by a houqehold in income class m, and E,,, and Edax are the mini-

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mum and maximum levels of acceptable progressivity. The objective in equation 2 is the instability of the portfolio of taxes. Equation 3 specifies the expected growth rate for the portfolio. Changing the growth rate generates points along the frontier. Equation 4 is the set of competitiveness constraints for the personal income, corporate income, insurance, sales, energy, and wealth taxes described above. In equation 5, the expression between the inequality signs reduces to the elasticity expression with the portfolio weights included. Hence, the equation places limits on the degree of progressivity for the set of taxes with an intended incidence on state residents. Equation 6 is a set of non-negativity constraints for the portfolio shares. Equation 7 specifies that the portfolio shares sum to one, which ensures that the state receives the appropriate level of revenue.

This approach summarizes the options facing each state in growth-instability space. By setting up alternative constrained optimization problems, we can also characterize the trade-off between other characteristics, such as progressivity and instability. We refer to these alternative characterizations below in the discussion of policy implications.

figure 1 illustrates two growth-instability frontiers for each state. The top line for each state depicts the results of the minimization problem just described. The lower line for each state depicts the results of a modified minimization problem, namely, one which incorporates neither the equity nor the competitiveness constraint. The difference between the two frontiers illustrates how considerations of equity and competitiveness influence the trade-offs available to each state. Because instability is viewed as un- desirable and growth is desirable, movements in a southeasterly direction represent improvements and movements in a

northwesterly direction represent less desirable outcomes.

Emerging from the graph are four insights about tax policy options and choices in the two states. First, the Mas- sachusetts frontiers indicate that Massa- chusetts faces much higher levels of instability than North Carolina for any expected growth rate. This finding is not surprising in light of the greater instability associated with most of the individual taxes shown in Table 3. Second, equity and competitiveness considerations are more constraining in North Carolina than in Massachusetts. Such considerations raise the amount of instability in the efficient portfolio by 12.0 percent (a 0.4 percentage point increase) in North Carolina at its 1991 expected growth rate of 3.6 percent, but hardly at all in Massachusetts at its 2.85 percent expected growth rate.

Third, after accounting for equity and competitiveness considerations, North Carolina faces a trade-off between growth and instability in the relevant range. That is, to get more revenue growth, the state must accept more instability. For example, an increase in the growth rate from 3.6 to 3.9 percent requires that North Carolina accept 6.3 percent (0.21 percentage points) more instability, and an increase in the growth rate from 3.9 to 4.2 percent requires 13.2 percent more instability. Massachu- setts faces much less of a trade-off between growth and stability. An increase in the expected growth rate from 2.85 percent (the 1991 value) to 3.3 percent requires an increase in instability of only 2.5 percent (0.12 percentage points). The less favorable trade-off in North Carolina is associated in large part with equity and competitiveness considerations. In the absence of such considerations, greater growth would require very limited increases in instability in that state.

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state tax structure and multiple policy objectives - national tax journal

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