Tax Reform: Implications for the State-Local Public Sector

Abstract

We analyze the effects of the Tax Reform Act of 1986 on the level and distribution of state and local spending, and on the mix of revenue sources employed by state and local governments. We expect state and local spending to fall by between 0.9 percent and 1.9 percent, with the lower end of the range the more plausible. The conclusion that aggregate spending is unlikely to change very much does not imply that the Tax Reform Act is unimportant to the state and local public sector. The fiscal and economic circumstances of state and local governments vary enormously, and the federal tax reform will therefore affect them very differently. The relative fiscal attractiveness of localities within metropolitan areas will be altered. From both efficiency and equity perspectives, these effects on local governments are likely to be much more important than the aggregate effect on either state or local spending. Over the longer run, apart from the obvious incentive to move away from the nondeductible sales tax to other deductible taxes, the effect of tax reform on the mix of revenue instruments is difficult to predict. The new tax bill also has major implications for bond financing as it it limits the use of the tax-exempt bond instrument.