Are Diversified Revenues More Regressive? State and Local Governments in the U.S

It is well known that state and local governments in the U.S. have diversified their revenue structures, largely instigated by the tax revolts beginning in the late 1970s. State governments have decreased their reliance on property and income taxes and shifted toward greater use of motor fuels taxes, general sales taxes, and user charges and fees. Local governments have reduced their use of property taxes and increased reliance on local option sales taxes, license taxes, and user charges and fees. Research on these trends has primarily focused on two implications: 1) the positive effect of diversification on reducing revenue volatility, and 2) the negative effect of diversification on increasing revenue complexity and fiscal illusion. However, little attention has been paid to the implications of diversification in terms of horizontal or vertical equity.

Both state income taxes and local property taxes are potentially progressive tax systems reflecting citizens’ abilities to pay. Shifting revenue structures away from these sources toward greater use of the taxes noted above as well as user charges and fees might reduce the overall progressivity of government revenue structures because the flat-rate nature of statutory rates associated with these alternate revenues results in more regressive effective tax rates. On the other hand, lack of indexing state income tax brackets and lags between revaluation of local property values diminish the progressivity of some state income tax and local property tax systems. In such cases, diversification might have no impact on the overall regressivity of a jurisdiction’s revenue structure because it already lacks vertical equity.

This paper examines the extent to which diversification affects the regressivity of state and local government revenue structures. Using data from the U.S. Census Bureau and Institute on Taxation and Economic Policy, this paper analyzes state and local tax systems in all fifty U.S. states for three separate years. Using fixed effects regression, the regressivity of state and local tax systems is modeled as a function of various measures of revenue diversification along with a series of control variables. The results of analysis will help to inform policy makers of the implications of revenue diversification beyond extant research focusing on revenue stability and fiscal illusion.