Decline in US states' capital tax rates is due to synchronous responses to common shocks rather than competitive responses to other state's tax policy

Tax competition among U.S. states: Racing to the bottom or riding on a seesaw? Robert Chirinko and Daniel Wilson. Journal of Public Economics, Volume 155, November 2017, Pages 147-163. https://doi.org/10.1016/j.jpubeco.2017.10.001

Highlights
•    The reaction in a given U.S. state to capital tax changes in other states is analyzed.
•    The reaction function slope is negative, contrary to casual evidence and many prior studies.
•    Allowing for delayed reactions and heterogeneous responses to aggregate shocks is crucial.
•    Our empirical results suggest frequently-used static tax competition models are misspecified.
•    Rather than “racing to the bottom,” our findings suggest states are “riding on a seesaw”.


Abstract: Dramatic declines in capital tax rates among U.S. states and European countries have been linked by many commentators to tax competition, an inevitable "race to the bottom," and underprovision of local public goods. This paper analyzes the reaction of capital tax policy in a given U.S. state to changes in capital tax policy by other states. Our study is undertaken with a novel panel data set covering the 48 contiguous U.S. states for the period 1965 to 2006 and is guided by the theory of strategic tax competition. The latter suggests that capital tax policy is a function of "foreign" (out-of-state) tax policy, preferences for government services, home state and foreign state economic and demographic conditions. The slope of the reaction function - the equilibrium response of home state to foreign state tax policy - is negative, contrary to casual evidence and many prior empirical studies of fiscal reaction functions. This result, which stands in contrast to most published findings, is due to two critical elements that allow for delayed responses to foreign tax changes and responses to aggregate shocks. Omitting either of these elements leads to a misspecified model and a positively sloped reaction function. Our results suggest that the secular decline in capital tax rates, at least among U.S. states, reflects synchronous responses among states to common shocks rather than competitive responses to foreign state tax policy. While striking given prior empirical findings, these results are fully consistent with the implications of the theoretical model developed in this paper and presented elsewhere in the literature. Rather than "racing to the bottom," our findings suggest that states are "riding on a seesaw." Consequently, tax competition may lead to an increase in the provision of local public goods, and policies aimed at restricting tax competition to stem the tide of declining capital taxation are likely to be ineffective.