Tax policy colloquium, week 3: Andrew Hayashi's "Countercyclical Tax Bases"

Yesterday at the colloquium, Andrew Hayashi presented an early draft of an interesting project that brings together two recently burgeoning (but still on balance underpopulated) sub-genres in tax policy scholarship. The first is looking at macroeconomic, or more specifically, Keynesian, policy considerations - in particular, the design of fiscal policy instruments to be automatically countercyclical (or at least not procyclical). The second is state and local taxation, which gets less attention in the literature (despite some excellent scholars) than its overall importance deserves, in part because it's harder to look at all 50 states than simply at the federal level.

Hayashi is interested in examining, from both a theoretical and an empirical perspective, the question of how the choice of tax base by local governments could affect the depth of recessions and speed of recovery within their borders.

In recent years, we have of course learned that serious recessions actually can and do still happen. Plus, they may be inadequately addressed at the federal level, despite the multiple tools of monetary policy, automatic fiscal policy adjustments, and discretionary fiscal policy responses. Plus, recessions may vary significantly in severity as between localities, even if geographical mobility within the United States is not quite so low as, say, that between distinctive parts of the EU.

So, even if one is skeptical of the potential of discretionary fiscal policy at the state and local level - if only due to balanced budget constraints on state and local governments - one might like to ask what automatic fiscal policy can do. Only, when one thinks about this, balanced budget constraints remain relevant.

State and local governments may face balanced budget legal requirements with varying degrees of rigor. But even if the legal constraints aren't binding, the governments may face market constraints since, their credit ratings can plummet if they don't take care (reflecting a long history of sub-federal defaults).

If a locality's balanced budget constraint is sufficiently binding, then a countercyclical reduction in tax revenues may be promptly (or even verging on simultaneously) offset by a procyclical reduction in government outlays. So then the question becomes, from the standpoint of countercyclical fiscal policy, which of these two sets of opposite changes is likely to have a greater business cycle effect.

Joseph Stiglitz and Peter Orszag have apparently argued that marginal changes in state and local government spending, amid a recession, tend to affect consumption levels more than marginal changes in state and local tax levels - reflecting that taxes may tend to be paid by higher-income households that respond to the tax changes via their savings levels.  If and insofar as this is true, one gets a seemingly paradoxical reversal of the standard wisdom regarding automatic fiscal policy.

If the tax side changed by itself, then the Keynesian macro standpoint would counsel the use by state and local governments of tax instruments that are relatively volatile and correlated with the business cycle. State and local income taxes are the classic example. By contrast, real property tax revenues tend to be extremely stable, even if home values are fluctuating. For example, property tax reassessments may be sporadic, may lean in practice against reducing the assessed value, and have enough discretion in the joints to permit keeping revenues steady. (Recent research by John Mikesell confirms that real property tax revenues were extremely stable during the Great Recession.)

So one has the paradigmatic choice between state and local taxes - income taxes, which fluctuate countercyclically but thereby draw procyclical spending changes, and real property taxes, which may fail to boost consumption in a recession, since they remain about the same, but have the virtue of not similarly drawing procyclical spending cuts.

A question of central interest in Hayashi's paper is whether one can find an empirical correlation between (a) the use of income taxation versus property taxation at the county level and (b) the severity of and speed of recovery from recessions. Then a second question is whether one can draw a causal arrow from (a) to (b), based on the above scenario in which volatile income taxes, but not stable property taxes, draw matching spending cuts. Early work, reflected in the draft discussed yesterday, suggests that there may indeed be some positive correlation between using property taxes and doing better in recessions, but much work remains to be done before any causal interpretation of the data can be confidently advanced.