The effect of tax elasticity on government spending

Abstract

Elasticity measures the extent to which a tax structure generates revenue in response to increases in taxpayer income without a change in statutory tax rates. While elasticity depends in part on propensities to engage in taxable activity, its main dependency across political units in the United States is on the progressivity of the income tax. States with highly progressive income taxes tend to have elastic tax structures. It has been proposed that greater elasticity in the tax structure generates a greater volume of public spending [3, 5, 12]. This proposal generally rests on the concept of 'fiscal illusion', the illusion being that if the legislature does not enact a statute raising tax rates, taxes have not increased. It follows that states with elastic tax structures experience greater increases in tax revenues without having to go through the throes of a tax increase, and those states will spend more. We admit to being supportive of the idea that elasticity drives spending. We also admit to the usual discomfort that economists feel when they lean on notions conflicting with the assumptions of 'rationality' that undergird the conventional utilitarian analysis. But, we proceed with the hope that there will be a reconciliation of this conflict. One could build a competing theory based on public choice notions to explain the hypothesis that elasticity breeds spending. Assuming that the median voter prevails, it is obvious that we could specify individual demand functions for public goods such that if cost allocation were made progressive to income, spending increases would result. But, there is difficulty in propping up such a notion in the face of Tiebout mobility [11 ]. Similarly, if we assumed that tax sharing arrangements were prescribed