AN ALTERNATIVE APPROACH TO THE MEASUREMENT OF STATE AND LOCAL FISCAL CAPACITY AND FISCAL NEED

MICHAEL ARNOLD NELSON, Purdue University

Abstract

A generally recognized object of fiscal federalism is the equalization of the fiscal position of subnational governments. Fiscal position refers to the relationship between a jurisdiction's relative ability to generate revenues from own sources (its fiscal capacity) and the expenditures required to provide certain levels of publically provided goods and services (its fiscal need). The existence of variations in fiscal position among subnational governments will result in variations in the tax effort of States required to finance any given service levels, consequently violating the principle of horizontal equity (i.e., people in equal positions should be treated equally).^ In the pursuit of equalization objectives in the U.S. Federal-State fiscal relations, income is most frequently used to measure fiscal capacity and population or some subset of population is most frequently used to measure need for services in grant allocation formulae. Yet income and population may have substantial shortcomings as measures of fiscal capacity and fiscal need. If indeed these measures do prove to lack precision in assessing a State's fiscal position, there may be a misallocation of Federal grants among the States. The principle objectives of this research are to examine the current role of equalization in Federal-State fiscal relations and to evaluate how well population and income measure a State's needs and capacity to finance those needs. An alternative approach to the measurement of State and local fiscal capacity and fiscal need, based on positive economic theory, is presented in this research. The alternative measures are intended to be normative and not necessarily designed for employment in actual policy situations. Rather, the measures developed in the research are used to appraise the income and population measures presently used in Federal-State fiscal relations and other measures suggested in the literature in the past.^ The alternative approach to fiscal capacity and fiscal need measurement developed in this thesis is based on a simultaneous equation financial model to explain interstate variations in nonFederal public spending decisions by major expenditure functions (ie., local education and highways). The model considers the interaction between demand factors (aggregated at the State level) and the role of perceived tax price in State and local expenditure determination. Two-stage least square regression techniques are employed to estimate the model using 1972 cross-sectional data for the State and local governments.^ The principle conclusion of this research is that income and population are not adequate proxies for State and local fiscal capacity and fiscal need (nor are the other approaches suggested in the literature). In particular, it was found that in the Northeast and North Central States, population tends to underestimate fiscal need and income tends to overestimate fiscal capacity. In most low income States, the reverse is true. That is, population overestimates fiscal need and income underestimates fiscal capacity. ^

Degree

Ph.D.

Subject Area

Finance

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