Tax Policy Conference 2015

1. FISCAL STIMULUS IN ECONOMIC UNIONS:
WHAT ROLE FOR STATES
by
Gerald Carlino
Federal Reserve Bank of Philadelphia
Robert Inman
University of Pennsylvania

2. MOTIVATION
FISCAL POLICY IN ECONOMIC UNIONS
The Great Recession and US Fiscal Policy (ARRA)
$797 Billion
$381 B in Tax Relief + $98 B in Federal Purchases + $318 B in State Transfers
(48%) (12%) (40%)
LONG RECOGNIZED THAT STATES MIGHT BE IMPORTANT:
BUT HOW?

3. On Their Own?
When confronted by severe depression state-local governments as a whole have not had and
cannot be expected to develop the fiscal ability to expand countercyclical spending. The few
that are strong enough tend to hold back because expansion or contraction by them can affect
the level of income and employment within their own area to only a limited degree.
As Agents for Coordinated Action by the Federal Government?
Financial assistance from the federal government by grants and loans has been suggested as
a technique for getting concerted action by all levels of government.
James Maxwell, Federal Grants and the Business Cycle, p. 100, NBER Fiscal Studies, No. 4, 1952
This Is The Received Wisdom as Delivered by:
Richard Musgrave (Theory of Public Finance)
Wallace Oates (Fiscal Federalism)
THE AGENDA HERE: IS MUSGRAVE-OATES CONJECTURE CORRECT?

4. OUR CONCLUSIONS
1. From an analysis of state budgets and state economies for the years1973-2009, we find that
state deficits can improve job growth in the deficit state, but that there are also significant
spillovers to “economically neighboring” states.
2. The deficit cost per job created in the deficit state is (on average) about $71,800/job.
Including jobs created in economically neighboring states lowers the cost per job to (on
average) $50,000 per job. Spillovers are significant, statistically and economically.
Coordinated fiscal policies are more cost-effective.
3. Intergovernmental fiscal assistance (A) is the most plausible means for a coordinated policy.
Current federal assistance is paid to states either as unconstrained (“fungible”) project aid
(AP) or as targeted, matching (“price incentive”) aid (AW): A = AP + AW.
4. From an analysis of the impact of A, AP and AW on national income, we find that aggregate
aid does positively impact income growth, and that AW assistance is more effective than AP
assistance. For two reasons. AW aid is a price incentive so money is spent and AW aid is
targeted for income and services provided to credit constrained lower income households.
5. The ARRA policy mix might have been 30 percent more effective (or 30% less expensive) in
stimulating the aggregate economy had only AW assistance been used to stimulate the
economy.

5. STEP 1: CAN STATES IMPACT THEIR OWN ECONOMIES?
Estimation of:
( ) = f(OwnD(-1), AP(-1), Spillovers; Controls) + υst, where:N H
OwnD(-1) = State own “cash-flow” deficit lagged one year.
AP(-1) = Federal “unconstrained” aid lagged one year.
Spillovers = Job (or Population Growth) of “Economic Neighbors” lagged one year.
Controls = Changes in world energy prices; changes in state productivity; lagged weather disasters
υst = vt + vs + vst
Estimated for the years, 1973-2009.

6. OVERVIEW OF ESTIMATES FOR A TYPICAL STATE:
FOR A 1 SD INCREASE IN OwnD(-1) = $390/person will:
L Increase job growth by 1.2% one year later or by 34,000 jobs;
L Increase in-migration implies 7,000 of those jobs filled by in-migrants;
L Increase the aggregate state deficit by $2.44 billion;
L Imply the average cost per job created within the state will be $71,800/job.
BUT IMPACTS ARE SHORT-LIVED
Figure 2

7. -6
-5
-4
-3
-2
-1
0
1
2
3
1 2 3 4 5 6 7 8 9 10 11
% Change in Job Growth
Years
Figure 2: Responses of State Job Growth to an Increase in State Own Deficits*
Source: Carlino and Inman (2013)
* The solid line represents the time path for changes in the rate of state job growth in response to a 1 percent change in the state's own
deficit introduced at the start of year 0. The dashed lines represent the 95 percent confidence band for each year's projected change in
job growth.
0

8. SPILLOVER EFFECTS ARE IMPORTANT, SO FREE-RIDING A RISK
Table 2
REGION FAR WEST
LARGEST JOBS STATE
(ΔDeficit/Own Rev)
California
(.10)
LARGE STATE’S OWN JOBS
(Deficit Cost/Job)
158,483
($90,956)
JOB SPILLOVERS TO OTHER STATES
(Deficit Cost/Job)
108,561
($0)
REGION’S TOTAL JOBS
(Deficit Cost/Job)
267,043
($53,980)
OTHER STATES’ OWN JOBS
(Deficit Cost/Job)
90.301
($84,234)
JOB SPILLOVERS TO LARGE STATE
(Deficit Cost/Job)
43,836
($0)
REGION’S TOTAL JOBS
(Deficit Cost/Job)
152,158
($49,990)
REGIONAL POLICY JOBS
(Deficit Cost/Job)
419,201
($52,532)
Source: Carlino and Inman (2013)

9. THEREFORE:
COORDINATE FISCAL POLICIES THROUGH STATE GOVERNMENTS
USING INTERGOVERNMENTAL AID
AP = Project Aid (Education, Highways, GRS, Model Cities, TANF, Tobacco
Settlement)
AW = Welfare Aid (AFDC, Medicaid)
AID = AP + AW
HISTORICAL ALLOCATIONS TO AID
Figure 3
ARRA ALLOCATIONS:
AID = $318 B = $217 B + $101 B = AP + AW

10. 0
500
1,000
1,500
2,000
2,500
1950 1960 1970 1980 1990 2000 2010
$/person
Figure 3
Total Aid, Welfare Aid, and Project Aid
Total Aid (A)
Project Aid (AP)
Welfare Aid (AW)
0
1,000
2,000
3,000
4,000
5,000
6,000
1950 1960 1970 1980 1990 2000 2010
$/person
Federal Purchases (G)
Fed Net Revenues (R)
Figure 4
Federal Purchases and Federal Net Revenue
Federal Aid, Federal Purchases, and Federal Net Revenue: 1947 - 2010*
(Per Capita, 2005 Dollars)
* Recession years shown as shaded bands
* Recession years shown as shaded bands

11. ESTIMATING THE EFFECTS OF A, AP, and AW on GDP
Impact Estimates:
Wilson (2012)
Feyrer-Sacerdote (2011)
Chodorow-Reich, et. al. (2012)
Dynamic Estimates:
Our Approach using Structural VAR
Tables 3 and 4

12. TABLE 3:
SVAR Estimates: GDP Responses to Fiscal Shocks for Blanchard-Perotti and Aid Specifications
Specification
Sample Period
Blanchard-
Perotti
1947:1 to 2010:3
(1)
Blanchard-
Perotti
1947:1 to 2010:3
(2)
Blanchard-
Perotti
1960:1 to 2010:3
(3)
Blanchard-
Perotti
1960:1 to 2010:3
(4)
Aid
Specification
1960:1 to 2010:3
(5)
Aid
Specification
1960:1 to 2010:3
(6)
Aid
Specification
1960:1 to 2010:3
(7)
Fiscal Policy (R - A) G (R - A) G R G A
IMPACT -1.603*
(-1.72, -1.47)
.944*
(.94, .947)
-1.683*
(-1.98, -1.55)
.959*
(.95, .96)
-2.804*
(-2.84, -2.77)
.564*
(.56, .57)
.528*
(.52, .53)
4 Qtrs -1.943*
( -2.24, -1.65)
.772*
(.46, 1.08)
-2.089*
( -2.45, -1.72)
1.000*
(.59, 1.40)
-3.287*
( -3.90, -2.67)
.447
(-.24, 1.13)
.713*
(.56, .86)
8 Qtrs -1.222*
(-1.57, -.87)
.294
(-.07, .66)
-1.223*
(-1.70, -.75)
.619
(.20, 1.03)
-2.186*
(-2.96, -1.41)
.404
(-.30, 1.11)
.499*
(.33, .67)
12 Qtrs -.698
(-1.06, -.34)
.023
(-.36, .41)
-.578
(-1.05, -.11)
.340
(-.11, .75)
-1.503*
(-2.26, -.74)
.309
(-.44, 1.06)
.360*
(.18, .54)
20 Qtrs -.235
(-.47, .06)
-.071
(-.38, .24)
-.0962
(-.34, .16)
.058
(-.38, .50)
-.920
(-1.61, -.23)
.165
(-.64, .98)
.234
(.04, .43)
Peak -2.105* (Q2)
(-2.35, -1.86)
.963* (Q2)
(.77, 1.17)
-2.267* (Q2)
(-2.55, -1.99)
1.078* (Q2)
(.67, 1.41)
-3.755* (Q2)
(-4.22, -3.29)
.564* (Q1)
(.56, .57)
.802* (Q2)
(.68, .93)

13. TABLE 4:
SVAR Estimates: GDP Response to Fiscal Shocks With Disaggregated Aid Specification
Sample Period 1960:1 to 2010:3
(1)
1960:1 to 2010:3
(2)
1960:1 to 2010:3
(3)
1960:1 to 2010:3
(4)
Identification Strategy SVAR SVAR SVAR SVAR
Fiscal Policy R G AP AW
IMPACT -2.955*
(-3.06, -2.91)
.807*
(.80, .82)
-.108*
(-.11, -.11)
1.637*
(1.61, 1.66)
4 Qtrs -3.189*
(-3.71, -2.67)
.884
(.27, 1.51)
.919
(.02, 1.78)
2.108*
(1.80, 2.42)
8 Qtrs -2.067*
(-2.73, -1.40)
.677
(.07, 1.28)
.908
(.05, 1.77)
1.453*
(1.07, 1.83)
12 Qtrs -1.312*
(-1.97, -.067)
.498
(-.15, 1.15)
.886
(-.03, 1.80)
.988*
(.58, 1.40)
20 Qtrs -.647
(-1.15, -.14)
.301
(-.40, 1.01)
.843
(-.16, 1.84)
.548
(.15, .95)
Peak -3.604* (Q2)
(-3.98, -3.23)
.884 (Q4)
(.27, 1.50)
1.005 (Q2)
(.19, 1.82)
2.315* (Q2)
(2.08, 2.55)

14. INSIDE THE MACRO ECONOMIC BLACK BOX:
RATIONALIZING MACRO MULTIPLIERS WITH STATE FISCAL
BEHAVIOR
STEP 1: HOW DOES FEDERAL AID IMPACT STATE BUDGETS?
BUDGET IDENTITY:
AP + (rs - b) - (gs + k) / SURPLUS = Δc - Δd + Δf
($504) + ($3063 - $276) - ($3003 + $312) / (-$24) = ($81) - ($55) + (-$50),
b = BC(1 - m)
STATE FISCAL BEHAVIOR
(rs, b, gs, k, Δc, Δd, Δf) = f(AP,1 - m; I, é; c-1; X) + (vt + vs + vst),
(Results in Table 6)

15. STEP 2: IMPLIED 4-QUARTER MULTIPLIERS FOR FEDERAL AID
For a $1 Increase in Federal Project Aid: ΔAP = 1*
Δrs/ΔAP • .00 ΔB/ΔAP • .02 ΔG/ΔAP • .50 ΔW/ΔAP • .48
Simulated Four Quarter Project Aid (AP) Multiplier
dGDP/dAP = (dGDP/drs)C[Δrs/ΔAP] + (dGDP/dB)C[ΔB/ΔAP] + (dGDP/dG)C[ΔG/ΔAP] + (dGDP/dW)C[ΔW/ΔAP],
.52 = (-3.19)C[.000] + (1.59)C[.02] + (.88)C[.50] + (.10)C[.48]
For a $1 Increase in Federal Welfare Aid: ΔAW = 1 from a small increase in Δm
Δrs/ΔAW = (-52.58)/(135.50) = -.39 ΔB/ΔAW = (95)/(135.50) = .70 ΔG/ΔAW = (-53.30)/(135.50) = -.39 ΔW/ΔAW = (41.30)/(135.50) = .30
Simulated Four Quarter Welfare Aid (AW) Multiplier
dGDP/dAW = (dGDP/drs)C[Δrs/ΔAW] + (dGDP/dB)C[ΔB/ΔAW] + (dGDP/dG)C[ΔG/ΔAW] + [dGDP/dW)C[ΔW/ΔAW],
2.04 = (-3.19)C[-.39] + (1.59)C[.70] + (.88)C[-.39] + (.10)C[.30]

16. LOOKING FOR THE COST-EFFECTIVE POLICY MIX
ARRA Policy Mix:
ΔR = $45.2 B in 2009:2
ΔG = $11.8 B in 2010:1
ΔAP = $8.7B in 2009:2 and $18.75 B in 2010:1
ΔAW = $37.03 B in 2009:2
GDP Growth Over Benchmark With ARRA Policy Mix: 1.95%
Targeted Policy Mix:
ΔR = $57 B in 2009:2
ΔAW = $64.5 B in 2009:2
GDP Growth Over Benchmark With “Targeted” Policy Mix: 2.60%

17. A LINGERING (Last) QUESTION:
WHY, THEN, USE AP AID?
L TO BE QUICK, LEVERAGE EXISTING UNION POLICIES
L FOR PASSAGE, GIVE STATE POLITICIANS WHAT THEY WANT
Grunwald, The New, New Deal
Boone, Dube, Kaplan, “The Political Economy of ARRA” Brookings Papers

18. LESSON NO. 1: Musgrave and Oates Were Right,
BECAUSE OF SPILLOVERS, COORDINATED FISCAL POLICIES IN
ECONOMIC UNIONS ARE MOST COST-EFFECTIVE
AN EU FISCAL UNION?
LESSON NO. 2: In Designing Stimulus Fiscal Policy,
IF USING STATES, PRICE INCENTIVES AIMED AT STATE LOWER
INCOME ASSISTANCE ARE MOST COST-EFFECTIVE
EU-WIDE SOCIAL INSURANCE?
LESSON NO. 3: But Remember, in a Union Democracy
UNION POLITICS WILL SET UNION POLICIES
EU PARLIAMENT or COUNCIL OF MINISTERS?