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FISCAL CAPACITY, FISCAL
NEED, AND FISCAL COMFORT:
NEW EVIDENCE AND ITS RELEVANCE TO DEVOLUTION
- Robert Tannenwald,
- Federal Reserve Bank of Boston
Since the founding of the
Republic, Americans have continuously debated the proper division of fiscal and regulatory
responsibilities among levels of government. The controversy has often involved the
concomitant question of the optimal size of government as a whole. Policymakers have
quarreled not only over which level of government should do what but also about what
government should do.
The most recent chapter of this long-standing dispute—the "devolution"
debate—is no exception. The size of government is currently an issue largely because
some question the ability and will of state and local governments to assume devolved
responsibilities. These doubts are especially troublesome to those who believe that states
and their municipalities should pick up where the federal government leaves off. They fear
that many states will fail to take on devolved responsibilities in part because they
suffer from chronic fiscal stress. They argue that states subject to the most fiscal
stress are forced to cut public services to compete in the short run, eroding their
long-run competitive position and drawing them into a vicious cycle.
Proponents of devolution note that governments' reluctance to assume new responsibilities
is precisely the reason why government should be smaller and more decentralized. In their
view, federal spending has bloated government beyond what citizens in many areas of the
country want. If states are given more fiscal independence and responsibility, they will
be freer to respond to the preferences of their citizens. As for the problems raised by
interstate fiscal disparities, many proponents of devolution believe that, even when the
playing field is uneven, interjursidictional competition induces efficient, responsive,
innovative, and self-reliant government. Given political and administrative realities, any
federal aid, no matter how well designed to narrow interstate differences in fiscal
stress, would weaken these desirable incentives.
If devolution were to proceed as extensively as its most avid supporters would like, which
states would have the most difficulty expanding their fiscal domain, should they choose
to? How disparate would be the capacity of states to respond?
In order to address this issue, I estimated the fiscal comfort level of each state, using
methodologies originally developed by the now-defunct U.S. Advisory Commission on
Intergovernmental Relations (ACIR). My estimates are for 1994, the latest year for which
all relevant data are available.
SOME KEY CONCEPTS
Every state, along with its municipal
governments, must provide vital public services to those who reside, work, travel, and
vacation within its borders. Many states, through no fault of their own, must work
relatively hard to meet their fiscal responsibilities, compelled to cope with difficult
problems that require costly solutions. For example, some have a high proportion of
low-income residents who need cash assistance, special education, and extensive health
care. Others may have a large percentage of their population in the school-age bracket of
6 to 18 years, compelling them to spend large per capita amounts on primary and secondary
education. Still others, with a large geographic area and widely dispersed population,
must spend high per capita amounts on road construction and maintenance. Such conditions
intensify fiscal need, that is, they increase the cost of delivering services or augment
the scope of programs that a state must deliver.
On the revenue side, some states are endowed with rich potential tax bases, for example,
large income and property tax bases attributable to residents' high average income and
wealth, a large potential sales tax base due to physical beauty and man-made attractions
that draw visitors, or a rich severance tax base because of high concentrations of
extractable minerals or lumber. These conditions augment fiscal capacity. Fiscal comfort
is fiscal capacity relative to fiscal need.
Fiscal Capacity
It is tempting to use personal income to measure a state's fiscal capacity, since
we pay our taxes, on whatever base, out of our income. However, personal income fails to
take into account the degree to which a state can "export" its tax burden to
nonresidents. For example, states endowed with large deposits of extractable fossil fuels
have a greater revenue-raising capacity than their per capita personal incomes would
suggest because they can impose severance and property taxes on oil, gas, and coal
companies. These companies can often shift much of the burden of these taxes onto their
customers, who are located throughout the world. If not, the owners of these companies,
many of whom are not residents, bear the burden. Similarly, Nevada's revenue-raising
ability is augmented by its large tourist and gambling industry.
The most sophisticated in-depth analyses of interstate differences in fiscal capacity that
attempted to address the limits of the personal income measure were last performed by
ACIR. Between 1962 and 1991, ACIR periodically published an index that gauges each state's
relative fiscal capacity. The methodology used to construct this index, known as the
representative tax system approach (RTS), evaluates tax capacity by estimating the per
capita tax yield that a uniform, hypothetical, representative tax system would produce in
each state. The resulting yield provides an indicator of the relative richness of the
state's potential tax bases. The rather involved methodological details can be found in
ACIR (1993) and Tannenwald (1997). Following the ACIR approach, I indexed these relative
yields to the national average (set equal to 100). The results for FY1994, along with
those for FY1987, estimated by the ACIR, are presented in Table 1.
As the table shows, tax capacity has varied widely among the states, exhibiting a degree
of dispersion that supports the anti-devolutionary concerns discussed above. In FY1994,
the values of the RTS tax capacity index ranged from a high of 141 in Nevada to a low of
71 in Mississippi. States with extraordinarily high tax capacity include those with large
potential income and/or property tax bases (such as Connecticut, Delaware, the District of
Columbia, Hawaii, and New Jersey), those blessed with an abundance of extractable minerals
(such as Alaska and Wyoming), and those with an unusually high sales tax capacity by
virtue of their large tourist industry (such as Hawaii and Nevada). States with the lowest
tax capacity tend to be concentrated in the South and have low capacity indices for all
three major state and local broad-based taxes: property, personal income, and general
sales.
A related concept to tax capacity is "revenue capacity," measured with the
representative revenue system approach (RRS), which is the same as RTS but also takes into
account a state's relative capacity to raise revenues from user charges, rents and
royalties, and lotteries. A state's relative revenue capacity is generally similar to its
relative tax capacity.
Has Tax Capacity Dispersion
Increased or Decreased over Time?
A narrowing of interstate differences in fiscal disparity over time would dispel
some of the concerns of devolution's opponents about the undesirable consequences of
interstate competition pursued on a slanted playing field. Chart 1 reports mean absolute
deviations in tax capacity (as measured by RTS approach) from 100 (the value for the
nation as a whole) for selected years between FY1975 and FY1994. By this measure,
dispersion in tax capacity climbed steadily from FY1975 to FY1977 and quite steeply from
FY1977 to FY1981. Between FY1981 and FY1988 dispersion narrowed gradually. From FY1991 to
FY1994 it decreased sharply, returning almost to its FY1975 level.
Fluctuations in dispersion between FY1977 and FY1988 were influenced most heavily by
movements in energy prices. The pronounced widening of dispersion between FY1977 and
FY1981 was attributable in part to oil shock-induced spikes in these prices, which in turn
dramatically raised the fiscal capacities of states whose economies depend heavily on
fossil fuel extraction. During the four-year period, Alaska's tax capacity index, already
high, increased from 158 to 324 and Wyoming's from 154 to 216. The swings in these two
states' fiscal capacity were so large that they exerted a significant effect on the
numbers. From FY1981 to FY1989, dispersion in tax capacity declined even though many
states in the Northeast, generally enjoying perennially high tax capacities, prospered
economically and widened their advantage. This dispersion-enhancing development was
overpowered by the effects of the "bust" in energy prices during the mid-1980s,
causing a precipitous decline in the tax capacities of the energy-producing states.
From FY1988 to FY1991, the relative fortunes of the nation's various regions reversed. The
states in the Northeast, which had enjoyed high fiscal capacity during much of the 1980s,
saw their RTS index values drop substantially, while a mild rebound in oil prices boosted
the tax capacities of the energy-producing states. As a result, dispersion further
narrowed. Between FY1991 and FY1994, a 10-point decline in California's tax capacity
index, along with smaller declines in other traditionally high-capacity states like New
York, Texas, Florida, Ohio, and Washington, produced a sharp narrowing in dispersion.
(Declining oil prices were a contributing factor—Alaska's index declined 44 points.)
The large effect of swings in oil prices on dispersion in tax capacity is evident when one
removes Alaska and Wyoming from the computations (dotted line in Chart 1). In every year,
dispersion is narrower, especially between FY1979 and FY1985 when fluctuations in oil
prices were especially pronounced. Year-to-year variation in dispersion is also much
smaller. Finally, dispersion in the 49-state sample exhibited a generally upward trend
through FY1988, a reflection of the relatively robust growth of California and states with
traditionally high fiscal capacity in the Northeast. The dotted line indicates that the
narrowing in dispersion since FY1988 is a reversal in trend, not the continuation of one
that began earlier.
Fiscal Need
ACIR's methodology for evaluating fiscal need, the "representative expenditure"
approach (RES) was developed by Robert Rafuse (1990). Analogous to the representative tax
system methodology, analysts implementing RES pose the following questions: (1) What are
the characteristics of a representative bundle of state and local spending functions? (2)
What constitutes a standard level of services for each function? and (3) What would each
state and its municipalities have to spend, in per capita terms, to provide this standard
bundle and level of services? The amount for each state is divided by that for the nation
as a whole and multiplied by 100 to construct a fiscal need index. The only year for which
ACIR constructed this index was 1987.
In that year and in 1994, states with high fiscal need (Table 2) tended to be those with a
high incidence of poverty and/or a large proportion of their population in the school-age
range. These factors are the primary determinants of need for primary and secondary
education and public welfare, the two largest functions of state and local governments,
and an important determinant of the need for health and hospitals. (Together, these three
functions accounted for 49 percent of all state and local direct spending in FY1994.)
Certain states, such as the California, the District of Columbia, Louisiana, and New York
also ranked high in terms of fiscal need in part because of unusually high crime rates, an
important determinant of the need for police and corrections. States exhibiting low fiscal
need tended to have small populations, such as Maine, Vermont, Nebraska, New Hampshire,
Hawaii, Delaware, and Rhode Island.
In both years, dispersion in fiscal need is narrower than in fiscal capacity. In addition,
there have been dramatic changes in the fiscal needs of many states. Over the seven-year
period, the index of fiscal need rose in California and the Northeast states, where rates
of economic growth lagged that of the nation as a whole. At the same time, the index fell
in many states located in the South, Rocky Mountains, and Great Plains, where economic
growth was relatively rapid.
Correlation between Fiscal
Capacity and Need
Devolution's opponents would be less concerned if states facing the most severe
fiscal need enjoyed the most fiscal capacity. As the scatter plot in Chart 2 shows, the
opposite was true in FY1994. Only Alaska, California, and the District of Columbia ranked
high on both measures (upper right quadrant). Several southern states, as well as New
Mexico, Oklahoma, and Texas, suffered from both low capacity and high need (lower right
quadrant). However, several states with weak fiscal capacities faced relatively mild need,
such as Maine, Nebraska, North Dakota, South Carolina, and Vermont (lower left quadrant).
The most fortunate states, enjoying both ample capacity and little need, included
Colorado, Delaware, Hawaii, Maryland, Massachusetts, New Hampshire, New Jersey, Nevada,
and Wyoming (upper left quadrant). Overall, there was a slightly negative correlation
between capacity and need (-0.11), not statistically different from zero. The negative
correlation between the two was stronger in FY1987 (-0.21), although still statistically
insignificant.
Fiscal Comfort
An index of fiscal comfort for FY1994 and FY1987 was created for each state by
dividing its index of fiscal capacity by its index of fiscal need and multiplying by 100
(Table 3). The least fiscally comfortable (most fiscally stressed) states are concentrated
in the South. The most fiscally comfortable states tend to be those with the highest
fiscal capacity, although Maine, Montana, Rhode Island, Vermont, and Wisconsin are
exceptions. Given the slightly negative correlation between fiscal capacity and fiscal
need, the dispersion in fiscal comfort exceeds the dispersion in fiscal capacity, a fact
that reinforces the concerns of devolution's detractors. However, variation in fiscal
comfort was lower in FY1994 than in FY1987.
Fiscal Comfort, Tax
Effort Indices, and Interstate Differences in Preferences for Levels of Public Services
As noted in the introduction, diversity across states in preferences for the size
of state and local government is a key issue in the debate over devolution. Both
supporters and detractors worry that such diversity is substantial, but they disagree over
what to do about it. Proponents of decentralization contend that the nation would be
better off giving citizens an opportunity to realize their diverse preferences rather than
have the central government suppress differences. Opponents fear that states with
preferences for limited government would fail to provide levels of service consistent with
the national interest.
The extent of diversity in preferences can be estimated roughly from the measures of
fiscal capacity and fiscal comfort presented in this section. Other things equal, states
with low capacity relative to need (low comfort) are compelled to spend a relatively high
fraction of their tax bases to provide a given level of public services. Consequently, if
preferences for levels of state and local public services were similar across states, one
would expect states with low levels of fiscal comfort to tax their revenue bases
relatively intensively, that is, to exert a relatively high tax effort. A lack of
correlation, or a negative one, between fiscal comfort and tax effort would imply that
fiscally uncomfortable states prefer lower levels of government than their fiscally
comfortable partners.
Following ACIR's methodology, each state's tax effort was computed by dividing its total
tax (or own-source revenue) collections by the amount that it would raise under RTS (RRS).
This ratio was then multiplied by 100 to create an index of tax (revenue) effort for which
the value of the nationwide average is set equal to 100. As shown in
Table 4, New York and the District of Columbia exert the most tax effort by far.
As shown in Chart 3, there is no correlation between fiscal comfort and tax effort. Only a
handful of states, including Michigan, Mississippi, New York, and South Carolina, have low
fiscal comfort and medium-to-high tax effort (upper left quadrant). Several states have
either low fiscal comfort and low tax effort (lower left quadrant) or high comfort and
high effort (upper right quadrant)—just the opposite of what one would expect if
preferences were similar. However, there is a number of states—most notably Nevada
and New Hampshire—with high comfort and low effort (lower right quadrant). The
correlation coefficient between effort and comfort was -0.01 in FY1994, indicating no
significant correlation between comfort and the level of public services preferred.
SUMMARY AND CONCLUSIONS
As a resident of New England, the
region enjoying the highest degree of fiscal comfort in the nation but whose political
clout in the Congress has diminished, I find myself asking: why shouldn't I be an ardent
devolutionist? Compared to the rest of the nation, we New Englanders are generally in the
best position to provide for ourselves. Why should we subsidize other states? The
disadvantaged residing within our own borders deserve our attention more than those in
Mississippi or Alabama. Let Mississippians or Alabamans take care of their own problems.
Frankly, for all their fiscal stress, they seem to be competing with us pretty well.
Should we help those who are luring our companies with their cheap land and labor and warm
climate? Besides, people in the South, however fiscally stressed their states may be, like
small government. They may lack fiscal resources and have to contend with some difficult
problems, but they just don't believe that it's the business of state and local government
to resolve them.
Before anyone adopts such a position, however, one must ask: is it in the national
interest to ensure that all Americans have access to some minimum level of public services
that at least some states and municipalities will not provide on their own? If so, should
state and local governments nevertheless play some role in delivering these services
because they know best how to implement national goals within their own borders? If the
answer to both of these questions is yes, then the federal government should provide aid
to the states in magnitude and under conditions sufficient to ensure that these services
are delivered. The devolution movement is evidence that Americans are questioning whether
such national standards enjoy widespread support. The limited progress of the movement to
date suggests that many citizens still cling to such standards.
References
Rafuse, Robert W., Jr. Representative Expenditures: Addressing the Neglected Dimension of
Fiscal Capacity. Washington, DC: U.S. Advisory Commission on Intergovernmental Relations,
1990.
Tannenwald, Robert. "Come the Devolution, Will States be Able to Respond?"
Presented at "Devolution: the New Federalism," Federal Reserve Bank of Boston,
September 12, 1997.
U.S. Advisory Commission on Intergovernmental Relations. State Fiscal Capacity and Effort
1991.Washington, DC, 1993. |