Thursday, March 4, 2010

What Does Aid to States Do To Marginal Tax Rates?

Suppose that the federal government gives $ to the states in a way that give states incentives to match the federal spending with more of their own spending. Then the federal grant would increase state-level taxation (presumably some combination of present and future taxation), and thereby raise nationwide marginal tax rates beyond that occurring due to the fact that the federal government eventually has to pay for federal spending with federal taxes. And this does not even could "implicit" marginal tax rates created by any tendency of states to spend more on low income persons and businesses.

If the federal government gives fungible $ to states, then the states could react either by cutting current state taxes (or increasing them less), cutting future state taxes (even states with balanced budget amendments could do this by adjusting their capital expenditures), or increasing spending.

The Obama White House estimated that 1/3 of fungible federal $ to states goes to state tax cuts, and the other 2/3 to increased spending -- a pretty good estimate IMO. The tax cuts do not necessarily have to be in the present, and do not necessarily have to reduce marginal tax rates (e.g., some of the recent federal "tax cuts" increased income-weighted marginal tax rates). The increased spending itself is very likely to raise marginal tax rates.

Thus, the effect of aid to states is probably a lot like the average federal stimulus dollar spent on other things, which raises marginal tax rates and thereby reduces GDP.

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