Vertical fiscal balance and horizontal fiscal diversity in the U.S. federal system: what might common shared taxes do?

The 50 state governments in the American federal system enjoy considerable fiscal freedom as each seeks to provide government services for its own constituency. This freedom allows states to adjust both types and levels of government services to the preferences of a heterogeneous population. Because states have considerable responsibility for raising their own revenue, states can and do differ considerably in the size of their state-local public sectors relative to their economies, and states reach dramatically different decisions in regard to how the revenue is obtained, in other words, what sectors of their economies will bear the cost of state-local government service. Such diversity of service and finance would be impossible without fiscal independence that encompasses both revenue raising and decisions about spending.

Independent revenue systems allow state independence and the capacity for fiscal response. Without the ability to raise their own revenue, state governments (and their included localities) would remain dependents of the central government,(1) Furthermore, without the need to raise that revenue, these subordinate units would recognize only the rewards from their expenditures--they need not be conscious of the cost of that activity, as another unit's revenue system would extract the resources from private use. Indeed, Wallace Oates argues that if these governments "are to have real and effective fiscal discretion, they must raise a significant portion of their funds from their own revenue sources" (Oates, 1993, p. 241). That is because central funds almost certainly bring intrusion (strings) into spending choices and because funding from above reduces incentive for responsible recipient choice. In a geographically, socially, and economically diverse country, a federal structure with, state revenue responsibility would produce substantial differences in states' fundamental fiscal choices--how much revenue they raise and spend, how they raise that revenue, and how they spend those funds.

Not all federal systems use such assignment of revenue responsibility. Alice Rivlin recently suggested a different approach, a system of "common shared taxes for the states" (Rivlin, 1992, p. 152), This mechanism, not unlike that used in the German federal system, would simplify compliance for multistate operations, allow tax enforcement economies, reduce state concerns about competitive reaction when rates increase (assuming rates on the shared base move in unison), and would provide states with another revenue option, usable either to reduce existing taxes or to increase quality or quantity of state-local services. Depending on the nature of the scheme, it could also allow fiscal equalization among the states. This structure would mark a significant change in American fiscal federalism. It could be reasonable if American subnational governments were characterized by common preferences for services and for financing those services, in other words, if states came to roughly the same fiscal conclusions. But that is not the case in regard to either spending or taxing.

Vertical Balance and Horizontal Diversity

A federal fiscal system can provide states great options in service delivery and in finance. A system of high vertical fiscal balance, one in which the level of government with overall expenditure responsibility is similarly the level that must use its revenue system to finance that expenditure (Herber, 1969), allows states to reach divergent fiscal choices and finance those choices. The American fiscal system is one of considerable vertical balance: in 1989-1990, the federal government made almost 51 percent of total direct general expenditure (total general expenditure less intergovernmental payments); it raised from its own taxes and charges slightly more than 52 percent of all such revenue. When we take a broader view (including social insurance, state-local utilities and monopolies, and deficits), balance is somewhat less: the federal government raised 62 percent of funds and spent 56 percent, largely because of the deficit, but balance is still high (U.S. Bureau of Census, 1992). Since 1960, vertical fiscal balance here has been high and is generally increasing.(2)

Do the actual choices differ much from one state to another? Some answers may be found in Tables 1 and 2, displays of the expenditure and revenue choices made by states in the …