Tax policy.

• Author: Metcalf, Gilbert E.
• Position: Research Summary

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...