The Effect of State Fiscal Policy on State Relative Economic Performance

Abstract

The relative performance of different state economies has been a matter of much interest to both policymakers and the public in general. In a neoclassical world where factors are free to move across political boundaries, one would not expect to observe the existence of persistent product price or factor income differentials. Such differentials would disappear either through the trading of goods or factor migration. Yet in seeming violation of neoclassical economic theory, apparent persistent differences in factor incomes have been repeatedly observed among states or regions in the U.S.' The intent of this paper is to develop and empirically examine a neoclassical model which explicitly incorporates both state and federal fiscal policies in order to explain persistent differences in the levels of market income of the states' economies.2 In section ii, a simple neoclassical model of an integrated economy is developed. Within this framework, we show that trade in market goods and migration of the mobile factor may result in factor price equalization across states on a before tax basis. Our model differs from others [6; 16] in that the assumption of factor price equalization does not necessarily imply equality in per capita market income across states. This result may be traced to our assumption that each factor has the choice of working in either the market or household sector. Consequently, although full incomes may be equated, market incomes