In recent years, revenue diversification has emerged as an important trend in public finance. One important consequence of increased revenue diversification is less volatility and more predictable revenue streams which collectively increase the capacity for governments to provide services during an economic downturn and reduce the need to cut public services at a time when they are needed the most. This paper aims to examine another implication of a diversified tax base; its impact on credit quality and ultimately borrowing cost.
While a number of previous studies have developed models to identify factors that impact credit quality and borrowing costs, an important consideration that is often ignored in these studies is the impact of a diversified tax base. The idea that “a rent seeking state will attempt to diversify the tax base, raising its tax revenues as a result of the advantages of portfolio diversification and fiscal illusion on the part of taxpayers” resulting in improved fiscal performance has been around for a number of years (Conybeare[1], 1982). It is plausible that these positive effects of revenue diversification can translate to increased credit quality and ultimately lower borrowing costs for state governments.
Data/Methods
This study analyzes bond market data from 1980 – 2006. The first econometric extension in this analysis is to account for self-selection. A selectivity problem may arise in this analysis from the practice of considering only observations in a sample for which a bond rating has been obtained rather than from considering all observations with outstanding debt in the sample. The second part of this paper estimates the influence of revenue diversification on credit ratings by employing an ordered probit model using maximum likelihood estimation (MLE). Finally, the estimated direct and indirect effects of diversification on the true interest cost (TIC) holding underlying credit rating constant are estimated.
Results
Preliminary results show that states with a more diversified tax base are estimated to have lower true interest cost by 20 basis points, half of which is direct effect on TIC and half is indirect effect on credit rating. The estimated total effect is a large percentage of the difference of about 43 basis points between AAA and BBB rated bonds. These results are robust to controls for credit ratings and other measures of state’s economic performance and the impact appears strongest among states with the weakest ratings.
Conclusion
Earlier research has shown that a stable and diverse revenue base is a long-term tactic that can be employed by governments to help improve overall fiscal performance. This study adds to the current literature and finds that a diversified tax base can directly reduce borrowing cost and indirectly increase credit quality thus reducing the cost of providing public services and infrastructure in the long run.
[1] John A. C. Conybeare (1982). “The Rent-Seeking State and Revenue Diversification,” World Politics 35 (1): 25-42.