Fiscal decentralization – A cautious tale

Abstract

Many subnational economies are facing severe fiscal stress often generated by the devolution of responsibilities that have been accompanied by little devolution of fiscal resources. In 2011, the Illinois state government raised individual and corporate income taxes as one contribution to easing the problem of short term and longer‐term fiscal deficits; opponents of the tax increase were concerned about the impacts on labor mobility and the overall state economy, as well as the policy's effectiveness in addressing the state's financial situation. These concerns provide the foci of the present paper. Comparison of simulation results with and without the tax increase finds that although the policy increases the state government's income, it also negatively impacts the state economy in terms of greater outmigration, lower employment and Gross Regional Product, and a smaller tax base in the long run. Moreover, simulation results show that the tax increase will expedite the state's debt clearance only if the state government significantly increases its share of income spent on debt payment, at the price of enhanced negative economic impacts. The results provide a cautionary tale for subnational authorities to consider more carefully the implications of unilateral changes in tax rates.