Tax policy.
Metcalf, Gilbert E.
My research on taxation has focused on three areas: taxes and
government financing in a federal system; measuring tax incidence; and
energy-related taxation. What is striking in many of the projects that I
describe here is the range of effects that taxes can have on behavior,
many of which are surprising.
Financing Government in a Federal System
Taxes at the national level interact with the financing of state
and local governments in a variety of ways. Many state and local taxes
are deductible at the federal level, thereby reducing the cost of
raising a dollar of state or local tax revenue for federal itemizers.
Income from municipal debt in large part is untaxed at the national
level. Equally important, income earned by the state and local sector is
not subject to taxation. This provides a variety of arbitrage
opportunities that can help explain the financial behavior of state and
local governments.
Deductibility of state and local taxes became an important issue
during the debate leading up to the Tax Reform Act of 1986 (TRA86). The
elimination of this deduction was a major source of revenue to pay for
lower marginal tax rates in the Treasury I plan. However, my research
with Martin Feldstein called into question the revenue response
predicted in Treasury 1.(1) We argued that eliminating the personal
deduction for state and local taxes would lead to a shift away from
these taxes toward others that continue to be deductible at the
corporate and business level. Using the NBER TAXSIM model to construct
state-level average tax prices for state and local taxes, we found large
price elasticities for tax shares.
One implication of this finding is that eliminating deductibility
for state and local taxes would not necessarily increase federal tax
receipts. Interestingly, we also found that changes in deductibility
have large effects on the share of different tax instruments, but little
effect on the overall level of spending at the state and local level.
While there is still some controversy over the effect of changing tax
prices on the overall level of state and local spending, subsequent
research has found substantial price effects for tax shares in a variety
of models.(2)
Ultimately, TRA86 eliminated deductibility of only state and local
general sales taxes. Based on the research just cited, economists
predicted that the use of general sales taxes would decline. Instead, it
appears that state and local governments relied more heavily on sales
taxes after 1986 than before. I rationalize this behavior with the
strong price effects found in the previous literature,(3) because TRA86
increased the tax price for all state and local taxes, not just for the
sales tax. For an itemizer at the federal level, the tax price of a
deductible tax is one minus the federal marginal tax rate. Decreases in
marginal tax rates at the federal level thus increase the tax price for
deductible taxes. While it might appear that the tax price for sales
taxes would increase by more than the tax price for deductible taxes,
this will not be true if there is not complete deductibility of sales
taxes at the margin prior to 1986. Evidence suggests that the sales tax
"look-up" tables used by most taxpayers to compute their
deduction underestimated at the margin the sales tax liability actually
incurred.(4)
TRA86 provided a natural experiment for studying the incentive
effects of federal deductibility on the state and local tax structure
and on state and local spending. Using data on state governments over a
nine-year period and the Bureau's TAXSIM model, I find that state
income taxes are sensitive to changes in their tax price.(5) There is
also evidence in the data that high-income groups are more concerned
about income taxes and middle-income groups are more concerned about
sales taxes.
In addition to affecting the choice of tax instruments, federal
taxation affects saving and borrowing decisions by state and local
governments. Roger H. Gordon and Joel B. Slemrod have noted several
arbitrage opportunities available to state and local governments because
of the failure to tax their earned income and the failure to tax income
on bonds they issued.(6)
In a series of papers, I have used panel datasets on state and
local governments to study these different arbitrage opportunities. The
simplest arbitrage opportunity available to state and local governments
is to borrow funds at the tax-exempt rate and invest them in taxable
(higher-yielding) securities. Although federal regulation attempts to
prohibit this activity, I find strong evidence that this form of
arbitrage was occurring prior to TRA86.(7) Arbitrage possibilities can
be used to build a model of the supply of municipal bonds. In effect,
communities must decide how to raise funds; they can do so by borrowing
publicly (issuing municipal debt) or by borrowing privately (taxing).
This suggests that the spread between the aftertax rate of return
available to residents in a community and the municipal borrowing rate
for bonds issued by that community affects the supply of municipal debt.
I find strong support for this model using data on both state and local
governments.(8)
In another paper, Gordon and I explore the implications of these
arbitrage opportunities for the size of the subsidy for municipal
capital arising from tax-exempt municipal debt.(9) We argue, that the
exemption provides little in the way of subsidies to municipal capital,
but rather provides subsidies to individuals in high and low tax
brackets. it subsidizes high-income people to the extent that tax-exempt
interest rates are lower than the aftertax rates of return they can earn
on equivalent taxable securities. It subsidizes low-income people by
allowing them to borrow funds at lower rates of interest (through their
community) than through private markets. In addition, the tax revenue
that the federal treasury would obtain by eliminating this tax exemption would be small, given the decline in municipal borrowing that would
occur if the tax exemption were eliminated.
Tax Incidence
So far I have considered how governments choose to allocate their
revenue requirements among different tax and borrowing instruments. Once
that decision is made, it is important to understand its distributional
effects. There has been considerable interest recently in measuring the
incidence of taxes over the lifetime of taxpayers.(10) I find that the
system of state and local taxes is significantly more progressive over
individuals' lifetimes than over a year.(11) In fact, using data
from the Consumer Expenditure Survey, I find that general sales taxes
are progressive over the life cycle, and as progressive as state and
local income taxes. Moving from annual to lifetime measure shifts sales
taxes toward proportionality. Exempting necessities, as most states do,
then moves the tax to progressivity.
If we ignore bequests, the lifetime budget constraint suggests that
a flat tax on consumption should be proportional over the lifetime.
Since bequests are small for the bulk of the population, this suggests
that a value-added tax (VAT) with exemptions for necessities easily
could be progressive over the lifetime. This is borne out in research
that Erik Caspersen and I are conducting using data from the Consumer
Expenditure Survey and the Panel Study of income Dynamics.(12) Using two
different measures of lifetime income, we find that a VAT that excludes
housing, health, and food costs is moderately progressive over the
lifetime. This contrasts sharply from the results using an annual
framework, in which the tax appears distinctly regressive.
Taxes and Investments in Energy Efficiency
Do people respond to tax incentives for energy conservation
investment by increasing their rate of investment in energy-efficient
capital? While one might expect a clear-cut affirmative response, in
fact there has been little evidence to support such a claim. Studies of
tax incentives for conservation investment typically have used variation
in state programs to identify the effects of tax incentives. Kevin A.
Hassett and I argue that a major reason for the lack of a response is
the endogeneity of state tax incentive programs.(13) If residents of a
particular state are inclined to make investments in energy-efficient
capital, then the states may feel less need to create a tax incentive to
induce further investment. Using data from a panel of tax returns, we
are able to construct a consistent measure of the effect of tax
incentives on the probability to invest in conservation capital. We find
this effect to be puzzlingly small. We argue that this is probably
because these investments are both irreversible and risky. We then apply
the models of Dixit and Pindyck to explain investment in
energy-efficient capital.(14) This helps to explain the findings by
Hausman and others of very high discount rates for investment in
energy-efficient capital.(15)
(1) M. Feldstein and G. E. Metcalf, "The Effect of Federal Tax
Deductibility on State and Local Taxes and Spending," NBER Reprint
No. 911, September 1987, and Journal of Political Economy 95 (1987), pp.
710-736. (2) D. Holtz-Eakin and H. S. Rosen, "Tax Deductibility and
Municipal Budget Structure," NBER Working Paper No. 2224, April
1987; L. B. Lindsey, "Federal Deductibility of State and Local
Taxes: A Test of Public Choice by Representative Government," NBER
Working Paper No. 2292, June 1987; and G. Zodrow, "Eliminating
State and Local Tax Deductibility: A General Equilibrium Model of
Revenue of Effects"; and all three papers in Fiscal Federalism:
Quantitative Studies, H. S. Rosen, ed. Chicago: University of Chicago
Press, 1988. See also R. P. Inman, "The Local Decision to Tax:
Evidence from Large U.S. Cities," NBER Reprint No. 1406, May 1990,
and Regional Science and Urban Economics 19 (1989), pp. 455-491. (3) G.
E. Metacalf, "Deductibility and Optimal State and Local Fiscal
Policy," Economics Letters 39 (1992), pp. 217-221. (4) R. Ebel,
"Comment on |Tax Exporting, Federal Deductibility, and State Tax
Structure,'" Journal of Policy Analysis and Management 12
(1993), pp. 127-130. (5) G. E. Metcalf, "Tax Exporting, Federal
Deductibility, and State Tax Structure," Journal of Policy Analysis
and Management 12 (1993), pp. 109-126. (6) R. H. Gordon and J. B.
Slemrod, "An Empirical Examination of Municipal Financial
Policy," in Studies in State and Local Public Finance, H. S. Rosen,
ed. Chicago: University of Chicago Press, 1986. (7) G. E. Metcalf,
"Arbitrage and the Savings Behavior of State Governments,"
Review of Economics and Statistics 72 (1990), pp. 390-396. (8) G. E.
Metcalf, "Federal Taxation and the Supply of State Debt,"
Journal of Public Economics, forthcoming, and "The Role of Federal
Taxation in the Supply of Municipal Bonds: Evidence from Municipal
Governments," National Tax Journal 44 (1991), pp. 57-70. (9) R. H.
Gordon and G. E. Metcalf, "Do Tax-Exempt Bonds Really Subsidize Municipal Capital?" NBER Working Paper No. 3835, September 1991,
and National Tax Journal 44 (1991), pp. 71-80. (10) D. Fullerton and D.
L. Rogers, "Lifetime Versus Annual Perspectives on Tax
Incidence," NBER Working Paper No. 3750, June 1991, and J. M.
Poterba, "Is the Gasoline Tax Regressive?" NBER Working Paper
No. 3578, January 1991, and Tax Policy and the Economy 5 (1991), pp.
145-164. (11) G. E. Metcalf, "The Lifetime Incidence of State and
Local Taxes: Measuring Changes During the 1980s," NBER Working
Paper No. 4252, January 1993. (12) E. Caspersen and G. E. Metcalf,
"Is a Value-Added Tax Progressive? Annual Versus Lifetime Incidence
Measures," mimeo, Department of Economics, Princeton University,
February 1993. (13) K. A. Hassett and G. E. Metcalf, "Energy Tax
Credits and Residential Conservation Investment," NBER Working
Paper No. 4020, March 1992. (14) A. K. Dixit, "Investment and
Hysteresis," Journal of Economic Perspectives 6 (1992), pp.
107-132, and R. S. Pindyck, "Irreversible Investment, Capacity
Choice, and the Value of the Firm," NBER Working Paper No. 1980,
July 1986, and American Economic Review 78 (1988), pp. 969-985. (15) J.
A. Hausman, "Individual Discount Rates and the Purchase and
Utilization of Energy-Using Durable," Bell Journal of Economics 10
(1979), pp. 33-54.