Tax Competition among U.S. States: Racing to the Bottom or Riding on a Seesaw?

Government of the Italian Republic (Italy), Ministry of Economy and Finance, Department of the Treasury Working Paper No. 3

86 Pages Posted: 6 Oct 2017

See all articles by Robert S. Chirinko

Robert S. Chirinko

University of Illinois at Chicago, Department of Finance; CESifo (Center for Economic Studies and Ifo Institute)

Daniel J. Wilson

Federal Reserve Bank of San Francisco

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2017

Abstract

Dramatic declines in capital tax rates among U.S. states and European countries have been linked by many commentators to tax competition, an inevitable “race to the bottom,” and underprovision of local public goods. This paper analyzes the reaction of capital tax policy in a given U.S. state to changes in capital tax policy by other states. Our study is undertaken with a novel panel data set covering the 48 contiguous U.S. states for the period 1965 to 2006 and is guided by the theory of strategic tax competition. The latter suggests that capital tax policy is a function of “foreign” (out-of-state) tax policy, preferences for government services, home state and foreign state economic and demographic conditions. The slope of the reaction function – the equilibrium response of home state to foreign state tax policy – is negative, contrary to casual evidence and many prior empirical studies of fiscal reaction functions. This result, which stands in contrast to most published findings, is due to two critical elements – allowing for delayed responses to foreign tax changes and for heterogeneous responses to aggregate shocks. Omitting either of these elements leads to a misspecified model and a positively sloped reaction function.

Our results suggest that the secular decline in capital tax rates, at least among U.S. states, reflects synchronous responses among states to common shocks rather than competitive responses to foreign state tax policy. While striking given prior empirical findings, these results are fully consistent with the qualitative and quantitative implications of the theoretical model developed in this paper and presented elsewhere in the literature. Rather than “racing to the bottom,” our findings suggest that states are “riding on a seesaw.” Consequently, tax competition may lead to an increase in the provision of local public goods, and policies aimed at restricting tax competition to stem the tide of declining capital taxation are likely to be ineffective.

Keywords: Tax Competition, State Taxation, Reaction Functions, Capital Taxation

JEL Classification: H71, H77, H25, H32

Suggested Citation

Chirinko, Robert S. and Wilson, Daniel J., Tax Competition among U.S. States: Racing to the Bottom or Riding on a Seesaw? (August 1, 2017). Government of the Italian Republic (Italy), Ministry of Economy and Finance, Department of the Treasury Working Paper No. 3. Available at SSRN: https://ssrn.com/abstract=3048236

Robert S. Chirinko (Contact Author)

University of Illinois at Chicago, Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States

HOME PAGE: http://tigger.uic.edu/~chirinko/

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Daniel J. Wilson

Federal Reserve Bank of San Francisco ( email )

101 Market Street
Mail Stop 1130
San Francisco, CA 94105
United States

HOME PAGE: http://www.frbsf.org/economics/economists/dwilson.html

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