State Government Tax Revenue, Tax Revenue Composition and Tax Effort Index: An Assessment of the 1978-97 period

Fiscal deficit concerns, especially during sever downturns, and uncertainties regarding future federal grants have underscored the importance of relying on state own-revenues including taxes. In this paper, we derive an equation for state total tax revenue-output ratio and estimate it using a panel of forty-nine states over the period 1078-97 (the sample period reflects a break in some key series after 1997). The predicted values from the estimated model are used as a measure of “tax capacity.” We then construct period averages of an index of “tax effort” defined as actual tax collection divided by the tax capacity to assess the extent to which states exploited their tax capacity. The regression based approach adopted here may serve as an efficient alternative to the highly data intensive “representative tax system approach” in estimating state tax capacity and tax effort indices. We also examine the tax revenue composition by estimating equations for the relative share of six tax types in total state tax revenue and use the predicated and actual values to assess whether a particular tax type was “overused” or “underused.” In view of the effects of tax revenue level and mix on growth, employment, income distribution, and the importance of stability and growth potential of tax revenues, the results of our analysis may have implications regarding the need for tax portfolio reshuffling in some states.