The Role of State Fiscal Policy in State Economic Growth

Abstract

Do state policy makers have the ability to affect a state's rate of economic growth? This article examines one possible source of growth and per capita output level disparities by studying the role that state taxation and public expenditure decisions play in fostering economic development. Using pooled annual U.S. state-level data from 1972 to 1998, a fixed-effects model is employed to examine the effects of changing tax rates on both state per capita output levels and growth rates. The results indicate that higher tax rates negatively influence short-run state economic growth, which lowers state output levels. However, long-run growth is unaffected by changes in state tax rates, even after adjusting for the effects of initial per capita output levels, state expenditures, and aid from the federal government. Nor do changes in state public spending rates and federal aid permanently alter state growth rates, implying that state fiscal policies have only transitory effects on state growth. (JEL H71, O40, R11)

The Robust Relationship between Taxes and U.S. State Income Growth

“…The second channel is via the terms DLNK, DLNL, and DLNN, which incorporate the effects of taxes on investment, employment, and 12 Many empirical growth studies follow Helms (1985) and include expenditures along with tax variables, with welfare expenditures as the omitted category. In contrast, my study-along with several others (e.g., Chernick, 1997;Tomljanovich, 2004)-does not. This affects the interpretation of the estimated tax effect.…”

“…A few studies have analyzed the effects of fi scal policy using multiple-year interval data. These include Garcia-Milá et al (1996), Aschauer (2000), Shioji (2001), Chernick (1997), Tomljanovich (2004), and Bania, Gray, and Stone (2007), though only the latter three directly study taxes. My analysis estimates tax effects over 30 years using fi ve-year interval data.…”

“…1 The subsequent discussion of previous research restricts itself to state-level analyses in which the dependent variable is income or income growth, where income is measured either by Personal Income or Gross State Product in either total or per capita terms. 2 Tomljanovich (2004) also allows for dynamic tax effects, but his study only includes state taxes, not state and local. The practical implication of this is that it ignores property taxes, among others, and locally fi nanced public expenditures.…”

“…Despite this, many studies of tax effects include no, or only a few, non-fi scal variables other than initial/lagged income, time, and/or state-fi xed effects (cf. Becsi, 1996;Tomljanovich, 2004;Yamarik, 2000). Helms (1985) includes variables for state wages, percent unionization, and population density.…”

“…Panel data are potentially characterized by complex error structures. Most previous research on fi scal policy uses Ordinary Least Squares (OLS) (e.g., Garcia-Milá and McGuire, 1992;Chernick, 1997;Crain and Lee, 1999), or OLS with standard errors corrected for general heteroscedasticity (e.g., Aschauer, 2000;Tomljanovich, 2004) or serial correlation (Evans and Karras, 1994). A few studies employ feasible Generalized Least Squares (FGLS) to address random effects (Garcia-Milá et al, 1996;Helms, 1985;Holtz-Eakin, 1994), though this procedure is usually rejected in favor of OLS with fi xed effects.…”