Tax Limitations and Revenue Shifting Strategies in Local Government

Abstract

The literature on tax and expenditure limitations (TELs) shows how limiting the freedom of local governments to levy taxes may have considerable unexpected effects. Entities subjected to such limitations may, as their proponents hope, react by cutting expenditures and revenue, but they may also strategically change their revenue structure and increase reliance on income sources not subjected to limitations. However, these findings are overwhelmingly based on studies of state and local governments in the United States. Their relevance outside this empirical setting remains unclear. A study of Denmark, where the central government imposed tax limitations on municipalities in 2009, makes two contributions. First, it probes the empirical domain of the U.S. findings. Second, it constitutes an empirical testing ground where endogeneity is not a pressing concern. In the United States, TELs are often self‐imposed either by local legislatures or by citizens through voter initiatives, which may bias the correlation between TELs and tax rates. We analyze a dataset of all Danish municipalities from 2007 to 2011 and demonstrate that TELs do indeed stop taxes from increasing but also confirm the findings from the TEL literature that entities subjected to tax limitations employ revenue‐shifting strategies. In Denmark, however, these strategies are contingent on the specifics of the Danish intergovernmental system, which render central government grants an attractive object of revenue‐shifting strategies. Our analysis thus helps identify the scope conditions of core findings within the literature.