The tax-spending nexus: Evidence from a panel of US state–local governments

a r t i c l e i n f o JEL classification: H71 H72 C33 Keywords: Tax-spend State and local government Public finance Panel unit root Panel cointegration We reexamine the tax-spending nexus using a panel of 50 US state–local government units between 1963 and 1997. We find that, unlike tax revenues, expenditures adjust to revert back to a long-term equilibrium relationship. The evidence on the short-term dynamics is also consistent with the tax-and-spend hypothesis. One implication of this finding is that the size of the government at the state–local level is not determined by expenditure demand, but rather by resource supply. This is consistent with the fact that many US state and local governments operate under constitutional or legislative limitations that seek to constrain deficits. Persistently large public sector budget deficits have to be eventually corrected through fiscal adjustments in the form of government expenditure cuts and/or tax revenue increases. In practice, however, addressing the deficit problem may be complicated by the several issues. One issue is the division of the burden of adjustment between the expenditure and revenue sides of the budget during periods of fiscal retrenchment. A related issue is the temporal causality between taxes and expenditures which is typically discussed in terms of the following four competing hypotheses in the literature. According to the " tax-and-spend " hypothesis championed by Friedman (1978), the level of spending adjusts to the level of tax revenues available. Thus, an increase in tax will not lead to lower budget deficits. Friedman therefore, favors a reduction in taxes to force subsequent spending cuts. Buchanan and Wegner's (1977) version of this hypothesis states that tax reductions will lead to higher spending through lowering the perceived price of government provided goods and services by the public. To reduce expenditures, the authors suggest limiting the ability of the government to resort to deficit financing. The " spend-and-tax " hypothesis maintains that the level of spending is first determined by the government and then tax policy and revenues are adjusted to accommodate the desired level of spending. In this connection, Peacock and Wiseman (1979) argue that temporary increases in expenditures due to a crisis situation are used to justify higher taxes which may then become permanent. Another version of this hypothesis is based on the work of Barro (1979). In his tax smoothing hypothesis, government spending is considered as an exogenous variable to which …