Harvey S. Rosen

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Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: Fiscal Federalism: Quantitative Studies
Volume Author/Editor: Harvey S. Rosen, ed.
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-72619-3
Volume URL: http://www.nber.org/books/rose88-1
Publication Date: 1988
Chapter Title: Introduction to "Fiscal Federalism: Quantitative Studies"
Chapter Author: Harvey S. Rosen
Chapter URL: http://www.nber.org/chapters/c7881
Chapter pages in book: (p. 1 - 4)Introduction 
Harvey S. Rosen 
Discussions of public finance in the United  States often refer to the 
role of “the” government. While for many purposes it is useful to  think 
of fiscal decisions as being made by a single government, the reality is 
that in the United States, an astounding number of entities have the 
power to tax and  spend. Including  states, countries, municipalities, 
townships, school districts, and special districts, there are over 82,000 
governmental jurisdictions.  The interaction of state, local, and federal 
governments plays a crucial role in the U.S. fiscal system. In recog- 
nition of this fact, the National  Bureau of Economic Research spon- 
sored a conference on Fiscal Federalism in April  of  1987. The seven 
papers presented at that conference, and the comments of the discus- 
sants, are contained in this volume. Although the papers cover a diverse 
array of subjects, they share a quantitative orientation and a concern 
with policy issues. 
The first three papers, by John Joseph Wallis and Wallace E. Oates, 
Robert P.  Inman, and Jeffrey S. Zax, examine the distribution of power 
and responsibilities among  the various levels of government.  The Wallis- 
Oates paper provides a broad historical perspective on the extent and 
evolution of fiscal decentralization in the state and local sector. They be- 
gin by noting that in 1902 local governments accounted for 82 percent of 
the tax revenues of the state and local sector; by 1981 this had fallen to 
42 percent. The major part of this centralizing trend occurred in the first 
half of the century. Similarly, at any given point in time, there are wide 
variations in the  extent of fiscal decentralizationamong  states.  Wallis and 
Oates  discuss several theories  that might help explain differences in fiscal 
Harvey S. Rosen is  professor of economics at Princeton University and a research 
associate at the National  Bureau of Economic Research. 
1 2  Harvey S. Rosen 
decentralization, and then test these theories econometrically. They find 
that a state’s share in state and local spending is inversely related to both 
population size and urbanization, and in some specifications of the model, 
it is directly related to the level of per capita income. While noting that 
it is very difficult to make predictions about the future course of cen- 
tralization, on the basis of their results Wallis and Oates conjecture that 
in the future the tendency toward centralization  (which has already slowed 
in recent decades) is likely to stop altogether. 
While the Wallis-Oates paper focuses on economic explanations for 
the development of the federal structure, Inrnan concentrates on po- 
litical issues.  He observes that the federal fiscal structure has been 
evolving steadily toward the centralization of the financing of govern- 
ment spending. Revenues are raised centrally and then transferred, via 
grants-in-aid, to state and local governments. Inman explores two dif- 
ferent hypotheses to explain this trend. In the first, federal aid is al- 
located  to  correct  for  the  presence  of  market  failures  such  as 
externalities.  In  the  second, aid is  allocated  only  when  it is in  the 
political interests of congressional representatives.  Inman’s examina- 
tion of  the relationship between the level and composition of federal 
grants and the structure of congressional decision-making suggests that 
the political theory provides a better explanation of the facts. 
The paper by  Zax investigates the effects of the number and types 
of government jurisdictions on aggregate local public debt and expen- 
ditures. From a theoretical  point of  view, it is unclear whether more 
jurisdictions will  lead to greater or less spending. On the one hand, 
when there are fewer governments they may be able to capture econ- 
omies of scale in  the production and distribution of  local public ser- 
vices. On the other hand, political and bureaucratic tendencies toward 
excess public spending may be reduced by competition among a large 
number of jurisdictions. Zax examines county-wide data and finds that 
aggregate debt and expenditures are positive functions of jurisdictions 
per capita, suggesting that small jurisdictions are inefficient. However, 
the data also suggest that when jurisdictions have large average “market 
shares,” they use their market power to expand the size of the local 
public sector. 
The next three papers, by  Douglas Holtz-Eakin and Harvey S. Ro- 
sen, Lawrence B. Lindsey, and George R. Zodrow examine the rela- 
tionship between the deductibility of  state and local taxes on federal 
tax returns and the structure of subfederal public finance. This question 
has assumed great importance in light of the recent public debate about 
the merits of partially or totally eliminating deductibility. Holtz-Eakin 
and Rosen focus on how changes in  the tax  price of local spending 
induced by  deductibility affect the mix between deductible and non- 
deductible revenue sources, and the level of expenditures. Their econ- 3  Introduction 
ometric analysis  is based  on a panel  data  set that  tracks  the fiscal 
behavior of  172 local governments from  1978 to 1980. They estimate 
that the elasticity of  deductible taxes with respect to the tax price is 
in the range -  1.2 to -  1.6; the tax price has no statistically significant 
effect on the use of nondeductible revenue sources; and the elasticity 
of local expenditures with respect to the tax price is about -  1.8. Hence, 
their estimates imply that if deductibility were eliminated, there would 
be a substantial decline in local government spending. 
Like Inman’s paper on the growth  of  grants, Lindsey’s paper on 
deductibility emphasizes political issues.  He emphasizes that unlike 
conventional price changes, changes in the price of  local taxation do 
not translate directly through consumer optimization into changes in 
the equilibrium quantity of services demanded. The response depends 
on how the political mechanism translates the price change into a public 
decision. Lindsey examines the implications of several different the- 
ories for the appropriate measure of  the tax price of  state and local 
spending. Like Holtz-Eakin and Rosen, Lindsey finds that the level of 
state and local spending is significantly affected by  deductibility. He 
also finds that voter-based measures (e.g., the median tax price among 
voters) does better at predicting state and local spending than aggregate 
measures  of  cost  such as the  average  tax price  measured  over all 
individuals. 
Both the Holtz-Eakin/Rosen and Lindsey papers examine deducti- 
bility in a partial equilibrium context. A potential problem with this 
approach is that the state and local sector is  “large”  relative to the 
economy as a whole. Thus, predictions  regarding (say) the revenue 
effects of deductibility may be affected by feedbacks from other sectors 
of the economy. Zodrow constructs a two-sector general equilibrium 
model to investigate such effects. The model permits the allocation of 
capital to respond to changes in state and local capital taxes and the 
associated changes in the net return to capital, wages, and income. 
These in turn permit an explicit calculation of the impact of eliminating 
deductibility on both personal and corporate federal tax revenues. Zod- 
row’s results indicate that the increase in federal revenue from elimi- 
nating deductibility is likely to be less than that predicted  by  partial 
equilibrium techniques. The amounts involved are substantial; the rev- 
enue shortfall is 25  to 58 percent of  the partial equilibrium estimate. 
The final paper, by Charles R. Hulten and Robert M. Schwab, tackles 
the problem of  developing a set of income and product accounts for 
the state and local sector. Hulten and Schwab note that conventional 
estimates of  the production of  the state and local sector assume that 
its capital income is zero, despite the fact that the state and local sector 
is one of the most capital intensive in  the U.S. economy. In addition 
to  leading to a downward  bias in  the income of  the state and local 4  Harvey S. Rosen 
sector, this assumption obscures the existence of an important implicit 
subsidy in the federal fiscal system-under  the federal tax code, state 
and local capital is treated like owner-occupied housing in the sense 
that the noninterest portion of  income accruing to capital is excluded 
from the tax base. Hulten and Schwab’s empirical results indicate that 
conventional accounting procedures underestimate the amount of in- 
come generated by the state and local sector by about $100 billion. 

Fiscal Federalism: Quantitative Studies

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