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: Studies in State and Local Public Finance
Volume Author/Editor: Harvey S. Rosen, ed.
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-72621-5
Volume URL: http://www.nber.org/books/rose86-1
Publication Date: 1986
Chapter Title: Introduction to "Studies in State and Local Public Finance"
Chapter Author: Harvey S. Rosen
Chapter URL: http://www.nber.org/chapters/c8895
Chapter pages in book: (p. 1 - 4)1  Introduction 
Harvey S. Rosen 
In  fiscal year  1981-82,  the federal government’s nondefense  direct 
expenditures were $450 billion. In comparison, state and local govern- 
ment expenditures were $485 billion (Tax Foundation, Inc., 1983, 18). 
It’s a small difference, not what one would have guessed in light of the 
relatively small amount of  attention given by  academics to state and 
local public finance. Given its  size, the  state and local government 
sector is clearly deserving of  serious and sustained study. 
Another reason for studying state and local public finance systems 
is their tremendous diversity. This diversity provides a set of “natural 
experiments” that can be exploited to discern the effects of government 
policy upon the private sector, and how government behavior itself is 
determined. Justice Brandeis once observed: “It is one of the happy 
incidents of  the Federal system that a single courageous state may, if 
its citizens choose, serve as a laboratory, and try moral, social and 
economic experiments without risk to the rest of the country.” These 
experiments provide grist for the economist’s mill. 
In light of these considerations, several years ago the National Bu- 
reau of  Economic Research established  a project on state and local 
public finance. A conference was held in June of 1984. Six of the papers 
presented at that conference, and the comments of the discussants, are 
contained in this volume. Although the papers cover a diverse array 
of topics, they share an empirical orientation and a concern with policy 
issues. 
The first two papers, by James Poterba and by Roger Gordon and 
Joel Slemrod, focus on the role of tax-exempt bonds in local public 
Harvey S. Rosen is professor of  economics at Princeton University, and a research 
associate of  the National Bureau of Economic Research. 
1 2  Harvey S. Rosen 
finance. Poterba examines the yield differential between taxable and 
municipal securities. He considers alternative theories of how the dif- 
ferential is determined, and describes their implications for how changes 
in federal tax policy would affect the differential. His econometric work 
suggests that expected tax changes have an important effect on the 
yield spread between taxable and tax-exempt securities. On the basis 
of these results, he discusses the likely effects of several changes in 
municipal borrowing practices, and concludes that  increased use of 
short-term borrowing instruments would reduce the cost of debt finance 
to state and local governments. 
Roger Gordon and Joel Slemrod examine the arbitrage opportunities 
created by the differences between (1) the tax-exempt rate that a com- 
munity faces when it borrows; (2) the taxable rate that a community 
can earn, free of tax, when it invests; and (3) the after-tax rate of return 
that the residents of the community can receive on their savings. Do 
community financial managers take advantage of such wedges to benefit 
their residents? Gordon and Slemrod provide a careful discussion of 
the economic and institutional considerations that might affect a com- 
munity’s propensity to do so. Their econometric results suggest that 
communities do actively engage in tax arbitrage. 
The  next  three  papers,  by  Michelle  White,  Kenneth  Small and 
Clifford Winston, and Daniel Feenberg and Harvey Rosen, concern 
several different aspects of state and local tax  policy. White is con- 
cerned  with  the  important  controversy  concerning whether or not 
local  taxation  affects firms’ location  decisions.  She begins  by  dis- 
cussing alternative theories of property taxation, and the implications 
of each for the controversy. Her empirical work takes advantage of 
California data collected about the time that Proposition  13 was en- 
acted. Proposition  13 generated exogenous (to the localities) changes 
in  property  tax  levels, making them  uniform  throughout  the  state. 
However, other attributes  of  the business climate  stayed about the 
same.  Therefore,  by  examining location  decisions before  and  after 
Proposition  13, one can study firm location decisions without having 
to correct for things like differential production costs. White’s econ- 
ometric results suggest that property taxes are a significant influence 
on  decisions by  retailing and  service firms,  but  not  manufacturing 
firms. 
The paper by Small and Winston is concerned with a quite different 
tax problem: efficient road-use charges for trucks. Currently, neither 
federal nor state policy seriously attempts to align motor vehicle taxes 
with the damage the vehicles inflict on highways. Small and Winston 
estimate the welfare effects of  instituting  nationwide  marginal cost 
pricing for heavy  highway vehicles. Their analysis recognizes that a 3  Introduction 
change in the current tax regime to one in which rates are based on 
weight per axle would induce trucking firms to use different types of 
trucks, and in some cases induce shippers to switch to other forms of 
transportation (e.g., rail). They find as a conservative estimate that by 
moving to marginal cost pricing, a welfare gain of $1.2 billion per year 
could be realized accompanied by a  17% reduction in highway main- 
tenance and repair expenditures. 
The purpose of the paper by Feenberg and Rosen is to provide con- 
sistent characterizations of state income and general sales-tax systems 
over time. For the period  1977-83,  they compute revenue elasticities 
with respect to income, and marginal and average tax rates at various 
income levels. Such measures, which have not heretofore been avail- 
able, should provide policymakers and academics with a basis for mak- 
ing interstate and intertemporal comparisons of tax structures. One of 
their findings is that if  the income and general sales taxes are viewed 
as a single system, the average income elasticity of the revenue across 
states is about 1.1. This figure has not changed much over the period 
1977-83.  However, averages tend to mask considerable heterogeneity, 
both with respect to progressivity of the systems in a given year and 
how they have evolved over time. 
The last paper in the volume, by Steven Craig and Robert Inman, 
examines some issues  concerning  the  structure of  U.S. federalism. 
They study the ramifications of the structure of federal to state grants 
in aid, and examine the possible allocative consequences of the “new 
federalism”  program suggested by the Reagan administration in  1982. 
Craig and Inman specify and estimate a four-equation budgetary model 
of state spending for education, welfare, other expenditures, and rev- 
enues. An  important  result  is that federal  dollars which  flow into a 
state via grants in aid are allocated disproportionately  away from ed- 
ucation and welfare, and toward other expenditures. When the grants 
come in the form of matching aid, this tendency is mitigated, but not 
as much  as might  be expected. Craig and Inman predict  that if  the 
Reagan plan were implemented, spending on welfare would be reduced, 
as would the size of the public sector as a whole. 
Taken  as a group, the papers in  this  volume raise  important  and 
difficult problems in state and local public finance, and make consid- 
erable progress in solving them. One is nevertheless impressed by the 
number of questions that are introduced and not answered in the essays. 
What is the optimal subsidy for locally provided capital? Can agency 
theory be used to explain local managers’ responses to the arbitrage 
possibilities created by the tax treatment of municipal debt? What is 
the dynamic pattern of firms’ responses to changes in local tax systems? 
What is the relation between a state’s tax structure and the size of its 4  Harvey S. Rosen 
public sector? It is hoped that this volume will stimulate research on 
these and related questions. 
References 
Tax Foundation, Inc. 1983. Facts and figures on government finance 
22nd biennial edition 1983. Washington, D.C. 

Studies in State and Local Public Finance

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