Redistribution at the State and Local Level: Consequences for Economic Growth

Abstract

Fiscal redistribution varies substantially across U.S. states, both on the tax and spending side. A compensating differential framework is used to show that greater redistribution will tend to increase the gross wage of skilled workers but that any increase could be offset by stronger preferences for redistribution. An increase in gross wages raises the cost of output in the more redistributive state, leading to a predicted decline in income and output. To test the model, five- and ten-year per capita and aggregate growth rates are estimated as a function of initial measures of tax and expenditure incidence. Data are a four-period panel of U.S. states from 1977 to 1995. Tax progressivity is measured both overall and for the income tax alone. Expenditure progressivity is measured by spending on welfare and higher education, and the state share of elementary and secondary education spending. Tax structure and welfare spending are instrumented. State tax progressivity shows no effect on growth. Welfare spending has a negative effect on aggregate income growth but not on per capita income. Higher education spending is unrelated to growth. Fiscal spillovers within regions are asymmetric. Progressive taxation and more higher education spending by a state’s geographic neighbors have positive effects on own-state growth. The asymmetry in tax effects explains why interstate tax competition does not lead to geographic convergence in fiscal structures. The results suggest that interstate differences in fiscal redistribution are welfare enhancing in the Pareto sense.