Heterogeneous Vertical Tax Externalities, Capital Mobility, and the Fiscal Advantage of Natural Resources

Abstract

How do state tax rates respond to federal tax shocks? This paper presents a novel mechanism of heterogeneous vertical tax externalities across levels of fiscal advantage, showing that tax increases can be expansionary -- even without their reinvestment. States rich in natural resources have a fiscal advantage in the inter-state competition over production factors which allows them to respond better to increases in federal taxes and, consequently, attract capital from other parts of the nation. We add heterogeneity in fiscal advantage levels to an otherwise standard model of vertical tax externalities and horizontal tax competition. The model shows that, irrespective of federal redistribution, the contractionary effect of a federal tax increase can be overturned in resource-abundant states, through an increase in their tax base. Using the case of the U.S., and narrative-based measured federal tax shocks a-la Romer and Romer (2010), we provide empirical evidence for the various aspects of this mechanism. Specifically, our lower-bound estimates indicate that, controlling for federal transfers, a 1% increase in the GDP share of federal taxes at the beginning of a year increases the growth rate of the per capita tax base by approximately 16% in high fiscal advantage states at the end of it.