Show and TEL: Are Tax and Expenditure Limitations Effective?

Local-Level TELs

Currently, 41 states in the United States impose some kind of TELs on their respective local governments. The restrictions may fall on the county, municipal, or school district budgets. The table summarizes the types of TELs that typically apply to local governments. The most common form of TELs at the local level is a property tax rate limitation imposed on specific types of local governments.

As with state-level TELs, some of the limitations imposed on local governments are more restrictive than others depending on how easy it becomes for governments to circumvent or override the constraints. For instance, consider a limit on the property tax rate. In this case, the restriction operates only when the rate reaches the ceiling. At this point, tax revenue may still increase, but it will be driven solely by the growth of the tax base. In other words, this limit by itself may not constrain tax revenues. To avoid this kind of outcome, most TELs at the local level combine a property tax rate limit with a limit on property assessment increases. The most restrictive limitations are those that apply to increases in total tax revenue (property taxes and other types of local tax revenue) or aggregate spending. Generally, the limit allows a given annual percentage increase in tax revenue or spending determined by population growth, inflation, or local income.

Full disclosure laws, which require taxpayers to receive notice of anticipated tax rate increases, do not directly restrict or limit revenues or expenditures and are there­fore not considered potentially binding. Such laws exist in three states in the District; Maryland, South Carolina, and Virginia each enacted full disclosure legislation around the same time period — between 1975 and 1977. In Maryland and Virginia, the full disclosure laws extend to counties and municipalities, while in South Carolina the measure also includes school districts.

Measuring Outcomes of TELs: Challenges

Evaluating the effectiveness of TELs is not easy for several reasons. First, the empirical analysis is subject to significant methodological challenges. Second, rules and limitations are very heterogeneous across states and local governments. Not only are some rules more restrictive than others, as highlighted earlier, but they have changed over time as well. Finally, when assessing the effectiveness of these constraints on fiscal policies, the evaluation should be performed in relation to their intended objectives.

For instance, do TELs aim to restrict the overall size of government? Do they intend to limit the growth of certain specific taxes or expenditures or alter the composition of government spending and tax revenue?

One of the methodological challenges in research on the effect of TELs is the problem of endogeneity or reverse causality. The problem becomes more significant when examining the impact of TELs on spending or taxes. It may be, for instance, that jurisdictions with relatively high long-run growth rates of taxes and spending would more likely adopt TELs as a tool to achieve stronger fiscal discipline. Ronald Shadbegian, an economist at the National Center for Environmental Economics, noted that "if voters in states with bigger governments are more likely to vote for a TEL and government spending patterns persist over time, then I would expect to find a positive rela­tionship between a TEL and government size, even though a causal relationship does not exist." Hence, failure to acknowledge the fact that the decision to adopt TELs by a government may be endogenous would seriously bias the conclusions of the analysis.

Second, the presence of unobservable factors, such as voters' preferences, which differ systematically across jurisdictions, may bias the results if they are not controlled for, as pointed out by the public choice view. The latter is commonly known as omitted variable bias. The main problem is that preferences are not observable. In order to address this issue and differentiate the effect of TELs on government taxes and expenditures from the corresponding effect of voters' preferences, some research work has relied on panel data regression models.

Measuring Outcomes of TELs: Results

Ideally, as when conducting any kind of policy evaluation, the effectiveness of TELs should be assessed by comparing the fiscal outcome with TELs to the counterfactual outcome that would have occurred in the absence of the limitations. Since it is not possible to carry out such an ideal experiment, the impact of TELs is assessed by comparing the outcomes of the treatment group (TEL states) to those of the control group (non-TEL states). For instance, the work by Poterba examines the different responses of TEL and non-TEL states to negative economic shocks that generate unex­pected budget deficits (in his work, he considers the late 1980s and early 1990s).

Research has shown, however, that the robustness of the results and conclusions of such analysis depend on the choice of the control group. To overcome some of the weak­nesses explained above, recent work by Paul Eliason of Duke University and Byron Lutz of the Federal Reserve Board of Governors relies on a novel approach known as the "syn­thetic control method" to construct the control group. The objective of their study is to examine the extent to which one of the most stringent TELs in the United States, Colorado's Taxpayer Bill of Rights (TABOR), constrains government size. Specifically, the synthetic control method relies on observed data to construct an artificial control group based on a weighted combination of non-TEL states. The weights for each state are chosen so that taxes and spending in the control group match taxes and spending in the treatment group prior to the implementation of the limitations.

The earlier literature on TELs focused on how fiscal limits affect government growth. The findings of this research are mixed. For instance, while the work by Poterba concludes that when faced with fiscal distress, TEL states tend to increase taxes by less than non-TEL states, the work by Eliason and Lutz indicates that TABOR does not have any effect on government taxes or spending. To the extent that the institutional irrelevance view correctly assesses the effectiveness of budgetary rules, the absence of a strong relationship between TELs and fiscal policy outcomes should not be surprising. In fact, TELs, according to this view, should not be effective because they are essentially nonbinding.

The lack of association between TELs and government growth may also be attributed to other factors, however. Many researchers highlight the fact that earlier studies did not account for the rich institutional differences across TELs. As noted earlier, TELs are very heterogeneous. For instance, some TELs are more restrictive than others, and it is plausible that the ability of TELs to constrain government size depends precisely on their stringency. In an effort to account for this heterogeneity, Barry Poulson, distinguished scholar at the Americans for Prosperity Foundation, constructed an index of TEL restrictiveness for each of the 50 states. This methodology was later adopted and extended by other researchers. For instance, Lindsay Amiel and Steven Deller, both at the University of Wisconsin, and Judith Stallmann of the University of Missouri conducted several studies using indices like the one developed by Paulson and provide conclusive evidence in favor of following such an approach.

Even when TELs are effective at controlling the growth of specific tax revenues or expenditures, the implementation of TELs in a context where voters cannot fully monitor government actions ends up having numerous unintended effects not fully anticipated or envisioned by their proponents. These effects usually take place when governments take actions to avoid or circumvent the rules established by the legislation.

One way governments may circumvent the restrictions imposed by TELs is by issuing debt. Such a hypothesis is studied by Deller, Amiel, and Stallmann jointly with Craig Maher of the University of Nebraska Omaha. Specifically, they claim that when the limits are imposed only on revenues or only on expenditures, governments would be induced to issue debt. Unlike previous work, which was unsuccessful at documenting such a relationship, their work accounts for the heterogeneity of TELs. Specifically, they found that more restrictive revenue TELs and expenditure TELs are associated with higher levels of government debt. Only TELs that limit revenue and expenditure at the same time restrict the use of debt.

States may still find ways to operate within the limits imposed by TELs by shifting some of their fiscal responsibilities to local governments. James Cox of California State University, Sacramento and David Lowery of Penn State University study such a possibility. They empirically test this hypothesis by comparing the behavior of pairs of TEL and non-TEL states. Their findings do not generally show that states decentralize responsibilities, with the exception of South Carolina. When comparing state revenue as a fraction of total state and local revenue in North Carolina, a non-TEL state at the time of the study, and the corresponding proportion in South Carolina, a TEL state, they found that the latter was remarkably lower. The authors also underscore that South Carolina did not explicitly prohibit the decentralization of fiscal responsibilities to local governments.

Costs of TELs

Even if TELs are successful at achieving their intended goal of restricting government growth, they may do so at the expense of generating other negative effects. It has been claimed, for instance, that TELs might negatively affect the financial stability of the states. A study by Tucker Staley of the University of Central Arkansas found that more restrictive TELs are strongly associated with higher levels of state revenue volatility. At the local level, work by Mathew McCubbins of Duke University and Ellen Moule, then at the University of South Carolina, indicates that the enforcement of property tax limits have induced state and local governments to rely on a system of revenues is generally more income-dependent, such as income taxes, charges, and fees. This means revenues would be subject to even greater fluctuations during the business cycle.

TELs may also affect the quality of services provided by governments. The relationship between TELs, particularly limitations imposed on property tax growth and school quality, has received a lot of attention in the literature. A few studies have found that reduced funding as a result of TELs negatively affects student achievement in public K-12 schools. The work of Thomas Downes of Tufts University and David Figlio of Northwestern University suggests that TELs "lead to reductions in student outcomes that are far larger than might be expected given the changes in spending." Possible explanations for this result include disproportionate cuts in instructional rather than administrative expenditures, higher student-teacher ratios, and a shift especially of the more talented students to private schools. Matt Davis, Andrea Vedder, and Joe Stone of the University of Oregon claim that, in fact, the lower levels of education funding could have been compensated with school-finance equalization and other alternative revenues. They argue, however, that TELs may still have a negative impact on student achievement if these constraints make school funding more unpredictable and volatile, as suggested earlier.

The use of tax and expenditure limitations has spread since first implemented almost 40 years ago; however, the effectiveness of TELs in fulfilling their objectives is still in question. Recent research has led to inconclusive and, at times, contradictory results. Due to the heterogeneity and complexity of TELs, significant methodological challenges remain in answering the question of the effectiveness of these fiscal rules.