Tax Reform: Implications for the State-Local Public Sector
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Description
The Tax Reform Act of 1986 should provide valuable information which will allow economists to distinguish among competing models of determinants of state and local spending and taxes. This paper outlines the implications of current public finance theory and empirical work for the direction and (where possible) likely magnitudes of the effects of the tax bill after it is fully in effect in 1988. We analyze separately the effects of the bill on the level and distribution of state and local spending, and on the mix of revenue sources employed by the state and local governments. The effects of the tax reform in this area will be fairly small; we expect state and local spending to fall by between 0.9 percent and 1.9 percent, with the lower end of the range the more plausible. A reduction in the number of itemizers – taxpayers who will be unable to deduct their state and local income and property taxes – will account for about half of this change. The elimination of sales tax deductibility, which also makes citizens pay more for state and local government, accounts for slightly more than a third of the decrease in spending. Finally, reductions in marginal tax rates, which make the deductions for income and property taxes worth less to taxpayers who continue to itemize, accounts for the rest. Moreover, states will probably shift away from sales taxes toward deductible sources of revenue, thereby making the effect of the tax reform on state spending smaller still. The conclusion that aggregate spending is unlikely to change very much does not imply that the Tax Reform Act is unimportant to the state and local public sector. The fiscal and economic circumstances of state and local governments vary enormously, and the federal tax reform will therefore affect them very differently. Local governments with relatively large numbers of high income homeowners can be expected to reduce their expenditures substantially and to expand their reliance on user charges. The relative fiscal attractiveness of localities within metropolitan areas will be altered, leading to changes in population distribution and house values, and increasing the incentives for higher income households to segregate themselves from lower income households. From both an efficiency and an equity perspective, these effects on local governments are likely to be much more important than the aggregate effect on either state or local spending. The Tax Reform Act has the immediate effect of changing state revenues; most states will enjoy an increase at current rates, while some will lose revenue. Over the longer run, apart from the obvious incentive to move away from the non-deductible sales tax to other deductible taxes, the effect of tax reform on the mix of revenue instruments is difficult to predict. The new tax bill also has major implications for bond financing: it limits the use of the tax-exempt bond instruments (since industrial development bonds have been cut back and regulations regarding the use of tax-exempt bonds generally have been tightened), and may also change the relative attractiveness of the instrument in financial markets.
Source Publication
Readings in Public Sector Economics
Source Editors/Authors
Samuel H. Baker, Catherine S. Elliott
Publication Date
1990
Recommended Citation
Courant, Paul N. and Rubinfeld, Daniel L., "Tax Reform: Implications for the State-Local Public Sector" (1990). Faculty Chapters. 1864.
https://gretchen.law.nyu.edu/fac-chapt/1864
