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DOI: 10.1177/109114219902700203

1999 27: 160Public Finance ReviewKaren Smith Conway

Are Workers ''Ricardian''? Estimating the Labor Supply Effects of State Fiscal Policy

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PUBLIC FINANCE REVIEWConway / ARE WORKERS RICARDIAN?

This research investigates whether workers perceive current deficits as implied

future taxes ( la Ricardian equivalence) and therefore consider current deficits

when formulating their expectations about future net wages. A life cycle model of

labor supply thatpermitsworkersto be aware of thegovernmentsbudgetconstraint

over time is constructed and then estimated using microlevel data and state fiscal

policy variables. The results reveal that state government budget deficits tend to

increase male labor supply more (or decrease it less) the more the state relies on

individual income taxes. Suchan effect is whatwouldbe predicted withRicardian

workers.

AREWORKERS RICARDIAN?

ESTIMATING THE LABOR SUPPLY

EFFECTS OF STATE FISCALPOLICY

KAREN SMITH CONWAYUniversity of New Hampshire

Under Ricardian equivalence, the private sector is aware ofthe governments intertemporal budget constraint and cor-

rectly perceives debt-financed spending as implied future taxes; thus,under certain restrictive conditions, a reduction in taxes, holdingspending constant, will have no real effect on the economy (Barro

1974). The Ricardian equivalence result typically requires that alltaxes be lump-sum taxes. However, the basic assumption underlyingRicardian equivalence has broad implications for intertemporal laborsupply behavior when taxes are instead distortionary. Specifically, ifworkers perceive current deficits as implied future taxes, they shouldconsider them when formulating their expectations about future netwages.1 And if they expect their future taxes to be higher (and there-fore their future net wages to be lower), they may work more now and

Abstract

AUTHORS NOTE: I am grateful to Michael DeSimone for his invaluable research assistance

and to Jim Ziliak, David Bradford, and participants in the UNH Economics Seminar for their

helpful comments. I also thank the numerous state tax officials who assisted me in my calcula-

tion of state income tax rates.

PUBLIC FINANCE REVIEW, Vol. 27 No. 2, March 1999 160-193

1999 Sage Publications, Inc.

160

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work less in the future (or intertemporally substitute their labor sup-ply). Postponing taxes on labor income via deficit finance could be adesirable policy because it increases current labor supply, whichshould also boost current savings (Hansson and Stuart 1987). If work-ers are Ricardian, their current labor supply depends not only oncurrent wages, income taxes, and perhaps government spending butalso on the level of the deficit and their expectations about how thegovernment will pay it off (Conway 1994).

A life cycle model of labor supply that permits workers to be awareof the governments intertemporal budget constraint is constructedand then estimated using microeconomic labor supply data from the

Panel Study of Income Dynamics (PSID) for prime-aged men. To esti-mate such a model, there must be information on workers whopay dif-ferent amounts of taxes, receive different amounts of public-sectorspending, and face different levels of government budget deficits orsurpluses. State government policy provides this necessary dimensionand is an interesting laboratory for testing the underlying assumptionsof Ricardian equivalence because most state constitutions mandate abalanced budget in the intermediate run. Thus, if a state has a budgetdeficit one year, taxpayers know that the deficit must be paid off in thenear future.

2In addition, states cannot resort to printing money to

finance a deficit and may not have the same access to credit markets asthe federal government (Poterba 1997). Individuals may also be more

aware of and affected by the fiscal policies that occur closest to home.On the other hand, taxpayers can avoid repaying a current state deficitby moving to another state. Also, unlike the federal government, manystate governments have budget surpluses that may arguably have aweaker effect than a budget deficit. These latter two differences sug-gest that the labor supply effects of the budget balance is smaller at thestate level than the federal level. However, state laws that require bal-anced budgets may make workers more Ricardian if and when a statebudget deficit/surplus appears.

3

This research contributes to our understanding of the full impact offiscal policy on labor supply behavior by first deriving the theoreticallabor supply effects of a budget deficit and showing how they depend

on thetax structure. I then investigate empirically whether workers areaware of the governments budget constraint and use it in makingwork decisions. In so doing, this article adds a new kind of empirical

Conway / ARE WORKERS RICARDIAN? 161



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evidence to the current debate over whether Ricardian equivalencebest represents reality.

4Given the sensitivity of the existing evidence,

which uses macroeconomic time-series data (e.g., Barth et al. 1991), anew approach using different data should be useful. The results pre-sented here suggest that state budget deficits/surpluses, when com-bined with information about the states current tax structure, have aneffect on the labor supply of prime-aged men consistent withRicardian behavior.

A THEORETICAL MODELOF INTERTEMPORAL

LABOR SUPPLY ANDRICARDIAN BEHAVIOR

Are workers aware of the governments budget constraint overtime? Quintieri and Rosati (1988) explore the theoretical labor supplyeffects of several policy changes, including deficit-financed ones,when workers are Ricardian. Hansson and Stuart (1987) analyze thewelfare costs of deficit finance in a general equilibrium model withRicardian agents and show that postponing taxes on labor via deficitfinance may be a desirablepolicy. Fremling andLott (1989) show howa deficit alters the current labor supply and savings of Ricardian work-ers when the deadweight losses from distortionary taxes are consid-ered, and they demonstrate that only a fraction of taxpayers must be

Ricardian in order for Ricardian equivalence to result. All of thesestudies emphasize the importance of knowing whether workers areRicardian or Keynesian in determining the outcome of governmentpolicies.

Although many theoretical studies make the assumption ofRicardian agents, empirical labor supplystudies have failed to exploreit. To undertake such an empirical investigation, one must first con-struct a theoretical framework that allows for more complicated taxstructures than those typically considered. In this section, I considerthe effects of deficit finance on current labor supply under a variety ofpossible tax structures and methods of repayment.

For simplicity, I consider a two-period perfect foresight model,

similar to Hansson and Stuart (1987) and Blomquist (1985), in whichthe individual maximizes utility over two periods,

162 PUBLIC FINANCE REVIEW



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Quintieri and Rosati (1988) make the assumption of a proportionalwage tax in their derivation of balanced-budget, labor supply effectsof different government policies. It appears implicitly in the argumentput forth by Fremling and Lott (1989), although they also discuss pos-sible distortions in the capital market. I begin with this simple casebecause it lays the groundwork for the more complicated ones.

If the tax system consists only of a proportional wage tax, the work-ers problem described in equations (1) and (2) becomes much sim-pler. Specifically, andfequal zero, and t[]= tWh. The relevant wagefor optimization is the net wage, or w = (1 t)W. Deficit financeincreasescurrent labor supply, as seen by thecomparativestaticresult,

=+

++

>

h

H rt W H

t W h

rH

1

1 10

, (3)

where |H| > 0 is the determinant of the bordered Hessian, |Hij| is thedeterminant of theijth minor ofH, andis the Lagrange multiplier.Both |H31| and |H51| are positive, so that h1/ is positive. The firstterm is the intertemporal substitution effectcurrent leisure is rela-tively more expensive than future leisure, so the individual worksmore in the present period. The second term is the income effect of thetax increase on current labor supply, which is also positive. Intuitively,a budget deficit increases the Ricardian individuals predicted future

tax, thereby decreasing the future net wage. This reduction in futurewages makes the individual feel poorer and makes current labor sup-ply more financially rewarding than future labor supply. Thus, a defi-cit increases a Ricardian workers current labor supply when the taxsystem consists only of a proportional wage tax.

A progressive wage taxis onein which t[]= t[Wh],andthefirstandsecond derivatives oft, t and t, respectively, are bothpositive. Allow-ing the tax rate on labor income to increase with income does not sub-stantively alter the predictions of the model. The comparative staticresult for h

1/ is the same as in equation (3), except that in the first

term,t2is nowt2 , and in the second term, t2W2h2is equal to t2[W2h2].

Increasing a future progressive wage tax has the same effect as

increasing a future proportional onefuture wages decrease, and theindividual feels poorer. Including exogenous income, Y, in the pro-gressive tax function (i.e., t[] = t[Wh + Y]) does not substantively




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change how a deficit affects a Ricardian workers current labor sup-ply.

6Thus, allowing for a progressive wage tax and/or including

exogenous income in the tax function does not change the result that adeficit increases a Ricardian workers current labor supply.

A TAXONALL INCOME

Blomquist (1985) shows how a nonlinear tax function that includesall sources of income, including asset income, greatly complicates theanalysis and overturns much of the conventional wisdom regardingintertemporal labor supply behavior. Blomquist discusses the labor

supply response to changes in present or future gross wages (i.e., h W1 1

/ and h W1 2

/ ) in the presence of a nonlinear income tax.Although some of the intuition put forth by Blomquist applies here,my focus is how a proportionate shift in thetax systemaffects currentlabor supply.

Specifying a tax on all income makes the budget constraint non-separable over time, as seen by examining the present and future taxfunctions,

[ ]t t W h Y rA

[]= + + , (4)

and

[ ] ( )t t W h Y r W h Y A t Wh Y rA C f 1[] = + + + + + + + ( )[ ] . (5)

For instance, how much a worker earns and saves in the present periodinfluences his future tax bill and, in a progressive tax system, hisfuture marginal tax rate. The decision to work in this period versus thefuture depends not only on the two wages but on the cost of saving cur-rent income to be consumed later. This can best be seen through thefirst-order conditions for current labor supply and consumption,respectively,

( ) + +

=U W t

t r

r

1 11

0(6)

and




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The model simplifies somewhat if the tax function is proportional,or t = t. As Blomquist (1985) notes, the budget constraint can berewritten in terms of the after-tax wages,w; exogenous income,Y=(1 t)Y; and interest rate, r= (1 t2)rand is no longer nonseparableover time. A deficit paid off with future income taxes now has theeffect of reducing these three variables, the first two of which have anunambiguously positive effect on current labor supply. The compara-tive static result for this model appears likely positive but unfortu-nately remains ambiguous unless an additional assumption is imposed(see the appendix). A deficit paid off by increasing a future propor-tional income tax will not necessarily increase current labor supply,

although such an effect appears likely. This is an important distinctionbecause many states have income tax systems in which the marginaltax rate is constant (t = 0) for most taxpayers.7 In addition, theassumption that a future change in the tax system will come as a pro-portionate increase (> 1) is much more realistic if the tax system isproportional.

Given that I cannot derive unambiguous results for a proportionaltax, it is not surprising that a progressive tax structure yields compara-tive static results that are impossible to simplify in a meaningful way.Now, current labor supply and consumption decisions affect not onlythefuture income taxbill but thefuture marginal taxrate as well. How-ever, recall that it is not the progressivity of the tax structure, per se,

that makes the current labor supply effect of an increase in the futuretax system (h1 ) difficult to predict. Rather, it is the taxation ofasset income. When asset income is taxed, increasing future incometax rates make the worker feel poorer and reduce the price of futurelabor supply, as before, but they now also reduce the price of currentlabor supply and consumption. With a proportional tax system, theseeffects can be manipulated such thath1 appears likely positive.With a progressive tax system, such manipulation is much moreinvolved and shows little promise.

WHAT EFFECTDOTHE OTHER ELEMENTS OF

THEGOVERNMENTS BUDGET CONSTRAINTHAVE?

State governments are not known for their reliance on incometaxes. Unlike the federal government, state governments obtain a




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contain future prices. The second method, however, remains empiri-cally useful and has the additional advantage that it can use cross-sectional data. By viewing the individuals problem as a two-stagebudgeting process, Blundell and Walker derive household labor sup-plies that condition on the current period allocation out of life cyclewealth. This methods sufficient statistics are the beginning-of-periodassets (henceforth denotedA

t 1 ) and end-of-period assets (At).8

The ability to use cross-sectional as opposed to panel data hasadvantages beyond reduced data requirements. My two-period modelis more applicable to cross-sectional data; I observe the present periodwith my cross-sectional data, and the future period is simply the

future. Likewise, I do not have to specify when the deficit will be paidoff, only that it will be paid off in the future. If one were to use paneldata, numerous other complicationssuch as dealing with individu-als who move across states,

9controlling for changing federal govern-

ment policy, and modeling individual or time effectswould have tobe addressed. Estimating this model with panel data, properlyaccounting for the above-mentioned complications, and exploring themigration effects of fiscal policy are worthwhile extensions of thisresearch but beyond the scope of this study. I therefore choose to use across section from the PSID to study whether workers appear to beRicardian in their labor supply response to state government policy.

EMPIRICAL SPECIFICATION

I specify the simplest empirical labor supply equation as

h w Y A A G B Z

= + + + + + + , (11)

where B is the state governments budget balance (revenues minusexpenditures) per capita,Zis a vector of variables affecting tastes, andall other terms are as previously defined.10 Notice that a deficit (ordebt) means thatB < 0. To explore whether the deficit adequately cap-tures the expectations process so that the sufficient statistics areunnecessary, I also estimate all specifications without the assetvariables.

A nonlinear income tax complicates the empirical model by mak-ing w endogenous and because the marginal wage no longer equals the




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average wage. I control for the latter problem by making a virtualincome adjustment toY(which results from linearizing the budgetconstraint), as discussed in Killingsworth (1983). However, this vir-tual income adjustment is also endogenous. I therefore estimate themodel by two-stage least squares, treating the observed net wage (w),virtual income (Y), and end-of-period assets (A

t) as endogenous.

11(A

t

is a choice variable because it is the assets accumulated by the end ofthe period.) I explore whether beginning-of-period assets are endoge-nous as well. Note that by treatingwas endogenous, I am controllingfor the well-known division bias associated with imputed wagemeasures that are calculated as earnings divided by hours worked.

12

Likewise, treating Yas endogenous controls for the possibility that thespouses labor income is simultaneously determined and that anytransfer income is work conditioned. In other words, even without thenonlinear tax, the wage and nonlabor income are likely endogenous.

The effect of the states budget balance,B, on current labor supplydepends on how workers think future fiscal policy will be affected,and current state policyseems a reasonable guide. Theinformationtheworker uses is specified here as the states current reliance on incometaxes, which is measured by the proportion of the states revenues(excluding intergovernmental grants) that come from individualincome taxes, or. The states budget balance is multiplied by thisproportion (and 1 ) to approximate theamount of the deficit/surplus

that workers believe will be paid/rebated in theform of income taxes.13

Of course, other factors might influence how an individual predicts hisfuture taxes will be affected, such as the workers age, asset income,the health of the state economy, and the stringency of the statesbalanced-budget rules. These factors are explored in the empiricalsection.

A final implication of Ricardian equivalence is that workers inter-nalize government debt/assets. To test for this aspect of Ricardianbehavior, state government net assets are included in one of the speci-fications. The most general labor supply equation estimated istherefore

h w Y A A G B B N Z = + + + + + + + + 1( ) , (12)




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whereNis per capita state net assets. Several hypotheses emerge fromthis specification. An obvious test is whether thes andGare zero.Rejecting this hypothesis suggests that workers use the governmentsbudget constraint and are behaving in a Ricardian manner. If is rele-vant as workers form their expectations about future wages, then 1 2.In addition,1should be negative. This occurs because a state budgetdeficit (B < 0) that workers believe will be paid off with future incometaxes shouldincrease current labor supply. Finally, if workers view thestate governments assets/debt as their own,Gshould equal0.

DESCRIPTIONOF THEDATA

The survey data used in the empirical analysis are from the Univer-sity of Michigans PSID for 1980. Poterba (1994) notes that in theearly 1980s, states and localities were in near fiscal balance andreports that total year-end balances as a percentage of expendituresduring 1978-1993 were highest in 1980. He also finds that unexpectedstate budget surpluses lead to much smaller fiscal policy changes thanunexpected deficits. These two results combine to suggest that byusing 1980, I am perhaps less likely to find evidence of Ricardianbehavior than if a year exhibiting more fiscal stress had been chosen.Any bias associated by choosing 1980 as the year to study shouldtherefore work against finding Ricardian behavior.

I restrict my sample to males between the ages of 25 and 55 to cre-ate a more homogeneous sample and limit my study to (potential) full-time labor force participants. Due to both data limitations and the dif-ficulties in correctly modeling the labor supply behavior of moon-lighters and self-employed workers, such individuals were deletedfrom the sample. I also limited the sample to those who were eitherpaid hourly or were salaried.

14Less than 5% of the men in the sample

had annual hours worked of zero; therefore, a self-selection modelappeared infeasible, and such observations were dropped. Individualswho lived in more than one state during the survey year were alsodropped. I also eliminate the low-income Survey of Economic Oppor-tunity subsample and use only the random sample.

15Table 1 reports

the variable definitions, means, and standard deviations for thesample.




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TABLE 1: Definitions, Means,and Standard Deviations of the Variables Used in

the Analysis

StandardVariable Definition Mean Deviation

Annual hours worked 2,138.54 502.97

Net hourly wage in dollars 6.40 2.64

Net virtual income in dollars 10,292.50 7,920.04

Beginning-of-period assets in dollars 40,424.06 49,878.77

End-of-period assets, deflated to 1980 dollars 39,806.62 45,606.50

State government spending per capita, Ga 1,130.30 197.72

State capital spending per capita, K 101.18 42.61

State budget balance per capita,Bb 67.21 65.58

NASBO measure of budget balance 33.08 34.23Proportion of state revenue coming from individual

income taxes,c .178 .087State net assets per capita, Nd 643.68 370.49

Education (in years) 13.06 2.61

Age, limited to 25 to 55 36.95 9.18

Health dummy variable equaling 1.0 if a health

condition severely limits work .07 .26

Number of children age 17 or younger 1.26 1.17

Number of children age 6 or younger .78 .98

Dummy variable equaling 1.0 if the person is marr ied .90 .30

Dummy variable equaling 1.0 if the person is white .92 .28

Dummy variable equaling 1.0 if l ives in Northeast region .21 .41

Dummy variable equaling 1.0 if lives in North Central region .33 .47

Dummy variable equaling 1.0 if lives in the Southern region .29 .46Additional state characteristics

Unemployment rate 7.54% 2.16

Change in state personal income 1979-1980 .46% 2.3

Urbanized 71.63% 12.54

With a high school education 68.05% 5.68

Nonwhite 13.38% 6.82

SOURCE:NationalAssociation of StateBudget Officers (NASBO 1981); U.S. Bureau ofthe Census (1981).NOTE: Number of observations = 881.a. Includes all general state expenditures = direct state expenditures + intergovern-mental grants + insurance trust expenditures.b. Defined as state total revenues minus total general state expenditures (defined inNote a).c. Defined as individual income taxes divided by total state revenue, excluding inter-

governmental revenue.d. Defined astotalstategovernment cash andsecurityholdings minustotalstatedebt.



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The labor supply variable used is annual hours worked. Two hourlywage measures are available: an imputed wage (earnings divided byhours worked) and an hourly wage that is reported by the respondent.Because most research uses the imputed wage, for the sake of brevity,I report only the imputed wage estimates and discuss any differencesbetween the two measures. Before-tax nonlabor income includes allnoninterest income of the household minus the husbands laborincome. The PSID does not have much information on consumptionor saving, so the asset variables had to be constructed. I define assetsina manner similar to Ziliak and Kniesner (1996), who also estimate alife cycle labor supply model with nonlinear taxes using the two-stage

budgeting method and data from the PSID.

16

In particular, assets havea liquid and an illiquid component. Liquid assets are derived by divid-ing the husbands and wifes nominal rent, interest, and dividendincome by a nominal interest rate; the passbook savings rate of 5.5% isused for thefirst $400 of income, andthe average 3-month T-bill rate isused for all income exceeding $400.

17The illiquid component is the

value of home equity and is defined as the difference between housevalue and the outstanding principal remaining.

18End-of-period assets,

At(which refer to the beginning of 1981), are deflated into 1980 dol-

lars using the implicit price deflator for total personal consumptionexpenditures.

Estimated federal income taxes and marginal tax rates are available

in the PSID, but it was necessary to calculate federal payroll and stateincome taxes and marginal tax rates.

19These (state + federal) tax rates

and tax bills are then used to construct the net (after-tax) wage, w, andthe linearized or virtual nonhusband labor, noninterest income, Y.

20I

follow Conway (1997), who uses the same data to estimate the effectof government spending on labor supply, in my choice of governmentspending measures. My primary measure ofG (and the only one forwhich results are reported) is total general state government expendi-tures per capita (thereby including both direct expenditures and inter-governmental grants by the state) because it appears to be the leastambiguous or endogenous measure.

21Local government spending is

more likely within the individuals control and is much harder to iden-

tify correctly for each individual. Federal spending also differs by




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state, but it too is a more ambiguous measure because many federalexpenditures may benefit more than one state. However, because Con-way (1997) finds that different categories of spending have differentlabor supply effects (e.g., transfer spending is always strongly nega-tive) and that spending undertaken at different levels of governmenthas a different impact, I explore the sensitivity of my results to themeasure ofGused.

The states budget balance,B, is calculated as the states total reve-nues minus total expenditures, and the states net assets, N, is stateassets minus debt. Both variables are calculated per capita. The statesreliance on income taxation,, is the proportion of the states revenues

(excluding intergovernmental grants, which are arguably out of thestate governments control) that come from individual income taxes.All of the information needed to construct these variables is found inState Government Finances in 1980 (U.S. Bureau of the Census1981), and further details are provided in the notes to Table 1.

This measure of the budget balance may be deficient, however, intwo respects. First, Poterba (1994) argues that social insurance fundsshould be removed from the calculation of the budget balance, and heuses the budget balance as reported by the National Association ofState Budget Officers (NASBO) in their Fiscal Survey of the States1980-81(NASBO 1981). Although this measure is highly correlatedwith mine, it has a lower mean and exhibits less variance across the

states. I therefore also estimate many of the specifications using theNASBO measure.

The other possible deficiency is the treatment of capital expendi-tures. Capital budget balances may have a different effect than operat-ing budget balances on workers expectations because capital expen-ditures by definition yield benefits and possibly even tax revenues inthe future (as in a toll road or, more generally, any public investmentthat increases future economic growth). Thus, a capital budget deficitmay require a smaller increase in future taxes than an operating budgetdeficit. Unfortunately, only 29 states had capital budgets in 1962, andthat number increased to only 34 states by 1986; furthermore, stateshave differing definitions of capital goods (Poterba 1995, 168-69).




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Decomposing the budget balance variable into operating and capitalcomponents is therefore not feasible. Rather, I explore this issue bytreating capital expenditures, for which there are data available, dif-ferently from other kinds of expenditures.

22In particular, the most

general treatment of capital expenditures allows the direct effects ofsuch spending (the coefficient on G) and the budget effects (the coeffi-cient(s) onB) to differ:

h w Y A A G K

K B K

= + + + +

+ + + +

1

( )

( ) ( )(B K Z+ + ) ,

(13)

where Kis capital expenditures, and1

and2

measure the directeffects of noncapital and capital expenditures, respectively, on laborsupply. The differential effects of capital versus operating deficitscomes in through . If there is no difference, then equals zero. If thedirect effects are also the same (1 = 2), then equation (13) reduces tothe usual specification. At the other extreme, if all capital expendi-tures are viewed as generating discounted future tax revenues equal totheir current cost, then they add nothing to the deficit and should beomitted from the expenditure side of the balance calculation; hence, equals 1.0. The model written in equation (13), however, is highlynonlinear in coefficients on variables that vary only over states, andestimating it may be asking too much of the data. I therefore also esti-

mate a linear model in which the direct effects are assumed equal (1 =2), and = 1; this specification essentially redefines the balance to betotal tax revenues minus total noncapital expenditures.23

After all of the exclusionary restrictions mentioned above areimposed, the sample contains 881 observations spanning 43 states.

24

The sample average state balance per capita is $67, indicating a sur-plus, but ranges from a deficit of ()$109.50 to a surplus of $338. Like-wise, most states assets outweighed their debts, yielding a sampleaverage of $644 but ranging from $173 to $2,301.50. The proportionof state revenues coming from individual income taxes ranges fromzero to 34.7%, with a sample average of approximately 18%. Thestates contained in the sample therefore vary widely in their budgetary

situations.




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EMPIRICALRESULTS

Table 2 reports the two-stage least squares estimates of the keyparameters in equations (11) and (12) under a variety of assumptions,including a base model that omits the deficit variables (column 1). Allof the main models are estimated three ways: (1) including both assetvariables and instrumenting end-of-period assets, (2) including andinstrumenting both assetvariables, and (3) omitting the assetvariablesunder the assumption that the deficit adequately captures how futurepredictions are formed. Because the treatment of the asset variablesdoes not substantively affect the results, only a subset of these esti-mated models is presented. In general, instrumenting beginning-of-period assets produces similar coefficients but larger estimated stan-dard errors, a result consistent with using a less efficient estimator(Method 2 above versus Method 1).

25I therefore report those models

that instrument only end-of-period assets.Several results emerge from this table. The wage coefficient is con-

sistently negative and sometimes statistically significant, suggesting awage elasticity ranging from .39 to .18, which is at the low end ofthe range reported by Pencavel (1986, 69) but is very close to theunconstrained estimates produced by MaCurdy, Green, and Paarsch(1990), who also use an IV procedure and a cross section of the PSID.The virtual income coefficient is always positive yet statistically in-

significant. Although it is disconcerting to find a zero or even positiveincome effect (h Y 0), such a result is consistent with other

empirical male labor supply research that deals with progressiveincome taxation and does not implicitly imposeh

Y to be negative

(see Pencavel 1986, 69; Moffitt 1990; MaCurdy, Green, and Paarsch1990; Triest 1990). The two asset variablescoefficients are of similarmagnitude and usually opposite sign, such that the sum is typicallyzero or slightlynegative. Neither coefficient is statistically significant.Thus, the sufficient statistics do not appear to have much empiricalimportance, whether or not the deficit is included. This may be due tothe high collinearity between the two asset variables and the virtualincome variable and the fact that at least two of the three must be

instrumented. Nonetheless, economic theory mandates that all threevariables be included (see Note 8).




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TABLE 2: Summary of Two-Stage Least Squares Results (tstatistics in

parentheses)

Coefficient Base Model 1 Model 2 Model 3 Model 2a Model 3a

The basic models

w 90.19* 87.97* 82.78 77.36 76.38 69.22

(1.89) (1.65) (1.55) (1.43) (1.59) (1.39)

Y .024 .026 .022 .019 .020 .018

(1.06) (1.20) (1.07) (.94) (1.15) (1.02)

A

.0027 .0026 .0019 .0016

(.88) (.84) (.66) (.63)

At .0033 .0032 .0022 .0016

(.65) (.62) (.44) (.38)

G .108 .113 .025 .025 .057 .051

(.96) (1.00) (.19) (.20) (.48) (.43)Balance,B .037

(.11)

B 4.167 3.969 3.828 3.577(1.42) (1.36) (1.39) (1.28)

(1 )B .900 .987* .856 .957*(1.63) (1.71) (1.60) (1.68)

Net assets .026 .030

(.34) (.51)

NASBO NASBO and and Using

Coefficient NASBO Exclude K Exclude K Add K Add K Debt

Alternative Measures

ofBin Model 2b

w 92.86** 67.23 90.51** 61.42 108.50** 98.75**(2.00) (1.33) (2.02) (1.20) (2.30) (2.14)

Y .023 .009 .006 .013 .010 .023

(1.07) (.46) (.30) (.69) (.50) (1.15)

B 11.065** 1.593 2.901* .479 5.728 .789**(2.22) a (1.06) (1.72) a (.12) (1.00) (2.04) a

(1 )B 2.302** .800** 1.175** .427 1.077 .143*(2.14) (2.66) (2.84) (.48) (.82) (1.69)

K 1.648 1.927(.50) (.72)

(1 )K 1.385* 1.362**(1.84) (1.965)



21/35

The effect of state government policy is also fairly stable over the

specifications. As in Conway (1997), the effect of state governmentspending on labor supply is usually negative; however, its magnitudeand statistical significance decrease as Ricardian behavior is permit-ted. This raises the question of whether state government spending,when included in isolation, is actually capturing the budgetary situa-tion of the state, or if trying to identify both a state spending effect anda state budget balance effect is simplyasking toomuch of thedata.

26

Turning to the state budget variables, it is evident that the statescurrent revenue structure is important to the effect of the budget bal-ance on labor supply. In the model that does not include this informa-tion (equation (11) and Model 1 in Table 2), the effect of the budgetbalance is essentially zero. When included (Models 2 and 3), the coef-ficients have signs that are consistent with Ricardian behavior. In par-ticular, the portion of the budget balance predicted to be paid/rebated


TABLE 2 Continued

X=X= X= % Change Including

Asset X = Str ict Rule State State Coefficient Dummy X = Age 1/Age Dummy Income Var iables

Other Variations

on Model 2b

w 85.03 88.26* 84.30 70.25 79.97 129.48**

(1.56) (1.66) (1.62) (1.23) (1.61) (2.26)

Y .026 .022 .023 .026 .027 .032

(1.22) (1.06) (1.08) (1.28) (1.14) (1.15)

B 5.312 9.740 5.235 .236 6.97**(1.62) a (1.45) (1.01) (.08) (2.40) a

(1 )B .916 1.919 2.359 .008 1.65**(1.62) (1.03) (1.34) (.01) (2.21)X B 2.00 .148 148.536* 1.357 213.546

(.95) (.74) (1.68) a (.25) (1.64) a

X(1 )B .028 31.318* 1.533 33.785*(.55) (1.79) (.81) (1.77)

NOTE: NASBO = National Association of State Budget Officers.a. The null hypothesis that theBand (1 )Bcoefficients are equal is rejected at the10% level or better.b. Thecoefficients onthe asset andgovernment spendingvariables arenot reported forthe sake of brevity.* Statistically significant at the 10% level. ** Statistically significant at the 5% level.



22/35

via income taxes (B) has a negative, but not quite statistically signifi-cant, effect. This suggests that a budget deficit (B< 0) in a state thatrelies heavily on income taxes may increase current labor supplyjust what is expected of Ricardian agents. The other portion of thebudget balance is positive and of about one fourththe magnitude of theincome tax part. Although this pattern is quite consistent across speci-fications, the individual coefficients are only marginally significant atbest, and one cannot quite reject the hypothesis that these two coeffi-cients are equal.

Another implication of Ricardian equivalence is that workers treatgovernment debt or assets as if it was their own. Model 3 incorporates

this possibility. The results here are inconclusive; although thehypothesis that government net assets have the same effect as privateassets cannot be rejected, it is likely because both coefficients areapproximately zero. Imposing the restriction that they be equal had noreal impact on the results (results available upon request). Finally,omitting the asset variables (Models 2a and 3a) has no impact on theempirical results. Taken together, the results of Table 2 are weaklyconsistent with Ricardian behavior.

Thelower twopanelsof Table 2 reportseveral variations on Model 2.I do not report the asset and government spending variables coeffi-cients because they are fairly consistent across the specifications andnever statistically significant. The first panel reports results from

models in which alternative measures of B are used. The NASBOmeasure, which Poterba (1994) and others prefer, yields similar butmuch more statistically significant results. In addition, the magni-tudes of the coefficients are greater, and the hypothesis that they areequal is easily rejected at the 5% level. The next four columns addressthe issue of capital versus operating budgets. The nonlinear modelwritten in equation (13) appears to be asking too much of the data;none of the key economic variables is even close to being statisticallysignificant, and the results are therefore not reported. I do report twomore restrictive linear specifications. The first simply excludes capitalexpenditures from the calculation of the budget balance and yieldscoefficients of smaller magnitudes but otherwise similar results,

regardless of the deficit measure used (columns 2 and 3). The secondadds capital expenditures, multiplied by and (1 ), respectively, to




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the model. If these coefficients are equal to their budget balance coun-terparts, then excluding capital expenditures from B is supported. Ifthey are equal to zero, then no special treatment of capital expendi-tures is required (see Note 23). The results support the idea that capitaldeficits have a different effect than operating deficits (i.e., the firsthypothesis is not rejected and the second is) on labor supply. The lastcolumn reports estimates from a model in which state net assets areused instead of the budget balance. Net assets are a more long-runmeasure of a states financial situation andare less prone to temporary,cyclical fluctuations. The results from this model are essentially thesame, if not stronger, as when the budget balance variable is included.

In sum, the second panel reveals that using alternative measures of thestates fiscal situation indeed tends to strengthen the evidence thatworkers are behaving in a Ricardian manner.

The last panel allows the labor supply effects of deficits to dependon other factors and uses the original measure of the budget balance,

B. (The results using the NASBO measure are very similar, unless oth-erwise noted.) The first column allows for a differential effect of defi-cits financed with future income taxes (B) for households that haveasset income. (Recall that it is the taxation of asset income that makesthis variable theoretically ambiguous.) Although the results are con-sistent with theory in that having asset income dampens the effect ofB, the difference is not statistically significant. As discussed earlier,

an individuals age may also affect his future predicted tax burden.The next two columns find some support for allowing the effect of thedeficit variables to depend on the workers age. Column 2s results aretheoretically consistent in that the effects of the deficit grow weaker asan individual ages, but the difference is not statistically significant.

27

The third column allows the size of the coefficients to decrease as aperson ages; this specification improves the statistical significance ofthe balance coefficients but otherwise yields similar results.

The last three columns consider the effect of other state characteris-tics. Poterba (1994) discusses how states vary in their stringency ofrules mandating balanced budgets and finds that such rules matter inpredicting states responses to fiscal crises. One might then expect

workers to be more Ricardian in states with stricter budget rules. Incolumn 4, I employ the same variable as Poterba (1994) and see if itaffects the balance coefficients.

28I find no evidencethat this variable is




24/35

importantthe coefficients are of the wrong sign and are statisticallyinsignificant. Column 5 repeats the same exercise with the percentagechange in state personal income. In this case, the interaction termsbecome more important than the original variables, although theyhave the same sign and general relative magnitude (although the coef-ficient onBis now about six times as big as that on (1 )B). Thus,the stronger a states growthrate, the bigger thelabor supplyeffect of adeficit will be, a rather counterintuitive result because a high rate ofeconomic growth should decrease the workers prediction of hisfuture tax burden. These confounding results could be due to otherstate-specific influences, a possibility I explore shortly. They could

also be due to an unfortunate by-product of this specification thatrequires, by construction, negative state growth to cause a flip in thesigns of the coefficients (e.g., the true coefficient onBis now posi-tive). In addition, using the NASBO measure did not reveal any suchpattern.

Overall, the results provide some support for the notion that work-ers use the deficit (and the states reliance on income taxes) to forecastfuture variables. Although the statistical significance of the budgetbalance variables is marginal, the overall pattern is consistent acrossspecifications: Deficits in states that heavily rely on income taxes aremore likely to increase labor supply. The statistical insignificance ofthe sufficient statistics, the asset variables, is troubling, however. One

might expect them to be unimportant if modeling the expectationsprocess via the deficit is empirically superior. However, they are alsoinsignificant when the deficit variables are omitted. One explanationis that my asset measures, especially when instrumented, are so noisyand collinear as to render the coefficients statistically insignificant.Another explanation is that workers are myopic, and the life cyclemodel is inappropriate; however, that requires the deficit also to haveno effect. Perhaps, as also suggested by the state personal incomeinteraction terms, the deficit variables are instead capturing someother effect. I explore this and other possible explanations next.

A FURTHER EXPLORATION

Could there be an alternative explanation for these results? Onemight suspect that the arithmetic relationship between deficits and




25/35

observed labor supply is responsible. Reduced labor supply decreasesstate tax revenues in states that tax labor income and thereby induce adeficit. Changes in labor supply might be causing changes in the defi-cit, rather than vice versa. Recall, however, that my results suggest thatdeficits in states that rely heavily on income taxation increase laborsupply more (or decrease labor supply less) than states that do not, aresult that is directly counter to the arithmetic relationship betweenlabor supply and deficits.

Another argument is that these results are a peculiarity of my modelspecification choices, especially because the statistical significance ofthe key coefficients fluctuate and are marginal. To explore this possi-

bility, I reestimate the model by alternately (1) using reported wages;(2) expanding my sample to include the low-income subsample, bothwith and without weighting; and (3) breaking government spendinginto categories and including local spending also, as in Conway(1997). Both (1) and (2) tend to further reduce the statistical signifi-cance of the balance coefficients but typically yield estimated coeffi-cients of a similar magnitude. The third exercise tends to strengthenthe results, if anything.

I also reestimate the model omitting the six states with = 0.29 Thisomission greatly reduces both the size and significance of the deficitcoefficients, suggesting that the distinction between states with per-sonal income taxes versus those without is important to the labor sup-

plyeffects of deficit finance. To further explore this, I redefine tobeadummy variable equal to 1.0 if the state has an income tax.

30This also

tends to reduce the size and significance of the deficit coefficients,especially that ofB. These two exercises suggest that the discrete(income tax/no income tax) and continuous aspects of the state taxstructure combine to produce important labor supply effects of deficitfinance.

State deficits also might be picking up any number of state charac-teristics (such as other state taxes or the local economy) that affectlabor supply behavior. The last column in the bottom panel of Table 2reports estimates from a model that includes other state-specific char-acteristicsthe state unemployment rate, the percentage change in

state personal income between 1979 and 1980, the percentage urban-ized, and the percentage of the state population that is high school




26/35

educated and nonwhite. The coefficients actually increase in statisti-cal significance when these variables are included.

31

A less restrictive model specification than the one(s) estimatedabove would permit state-specific random effects. I reestimate themodel, controlling for random state effects using the two-step methodoutlined by Amemiya (1978) and Borjas and Sueyoshi (1994).Amemiya (1978) proves that this method yields coefficients on thestate-level variables that are algebraically identical to the usual GLSrandom effects model, but it is much simpler computationally, espe-cially when the groups are of different sizes as is the case here. (Thatis, I do not have the same number of observations for each state.)

Briefly, the method involves first estimating the model with fixedstate effects (accomplished by includingJstate dummies and exclud-ing the common intercept and all state-specific variables). In the sec-ond stage, the estimated coefficients from these state dummies, , arethen regressed on a vector of state-specific characteristics, X, includ-ing the state government variables, or

= + = + +X X u e, (14)

whereuis the error arising from the fact that only an estimate ofisavailable, and e is the inherent randomness in the state effects that can-not be explained byX. Notice thatuis both heteroskedastic and seri-ally correlated, as the estimated dummy coefficients have differentvariances and are correlated with one another. One way to deal withthis is to adjust the standard errors for the known heteroskedasticityand serial correlation (i.e., Cov Cov() ( ) ( ) ( ) = X X X X X X1 1 ).The other more efficient method, at least asymptotically, is to performGLS. Both require an estimate of the covariance matrix of. Thiscovariance matrix can be written as

Cov Cov Cov( ) ( ) ( ) = + = +u I I

, (15)

whereIis aJ Jidentity matrix. Cov( ) is available from the first-stage estimates, but e

2 must be estimated. Amemiya (1978) suggeststhe simple variance calculated from estimating equation (14) via ordi-

nary least squares (OLS) as a consistent estimator because asymptoti-cally, Cov( ) approaches zero (thereby also negating the need for




27/35

GLS). Borjas and Sueyoshi (1994) suggest an estimate that adjusts forthe fact that the simple variance also includes Cov( ) by subtractingthe mean variance attributable to . Unfortunately, in my model, thisadjustment yields a negative estimate of e

2 , so I must use Amemiyasestimator, which is likely biased upwards.32

Because of this problem and the somewhat dubious practice ofappealing to asymptotic superiority in a model with a (second-stage)sample size of 43 observations, I report both the GLS estimates andthe OLS estimates in Table 3. The other state-specific characteristicsincluded inXare those listed above. The sign and general magnitudeof the budget balance coefficients are unchanged by modeling random

effects, although the statistical significance of these coefficients isdiminished by the asymptotically less efficient OLS method. I alsoestimate these models without the asset variables and again obtain


TABLE 3: Summary of Results From the Two-Stage Procedure Controlling for

Group Effects (tstatistics in parentheses)a

First-stage coefficients:

w= 73.56 (.84), Y= .0043 (.13), A

= .0017 (.40), At= .0017 (.23)

Model 1 Model 2 Model 3

Second-StageCoefficients OLS GLS OLS GLS OLS GLS

G .162 .031 .132 .058 .099 .064

(.59) (.14) (.51) (.26) (.39) (.29)

Balance,B .915 .426

(.91) (.55)

B 5.656 5.816* 5.487 5.811*(1.37) (1.73) (1.33) (1.72)

(1 )B 1.573 1.628* 1.016 1.759(1.22) (1.67) (.63) (1.44)

Net assets .094 .024

(.58) (.18)

NOTE: Tendency of other variables in OLS models: unemployment rate (), % changestate personal income (), urban (+), education (), nonwhite (); no |tstatistic| > 1.19.Tendency of other variables in GLS models: unemployment rate (), % change statepersonal income (), urban (+), education (), nonwhite ();no | tstatistic| > .86. OLS =ordinary least squares; GLS = generalized least squares.a. The OLS standard errors are calculated using the correct standard errors; that is,Cov Cov( ) ( ) ( ) ( )

X X X X X X= .* Statistically significant at the 10% level. ** Statistically significant at the 5% level.



28/35

almost identical results. Thus, the empirical support for Ricardianworkers found in Table 2 also survives the inclusion of random stateeffects.

EVALUATINGTHERESULTS

Theresults of the empirical analysis therefore suggest that althoughthe statistical significance of the budget balance variables is sensitive,the estimated labor supply effects are fairly consistent across differentmodel specifications and measures of the deficit. Deficits in states thatrely heavily on income taxation increase current labor supply,

whereas deficits in states that do not rely on income taxes decreasecurrent labor supply. My results (for the models without interactions)suggest that the proportion () in which deficits will have no effect(the two parts just offset each other) ranges from approximately .153to .232. (If capital expenditures are excluded from the balance, thentheproportion rises to around.3.) For the 22 statesin my samplewith< .153, a deficit reduces labor supply, whereas for the 8 states with> .232, it increases labor supply. The labor supply effect of a deficitcan therefore be positive or negative for the remaining 13 states,depending on which set of estimates are used. Although the coeffi-cients onB and (1 )B suggest rather substantial labor supplyeffects (e.g., a one dollar per capita increase in the income tax

financed deficit results in a 5-hour increase in annual labor supply),the combined effect is likely small for most states.

33However, the fact

that the budget balance, when combined with information about how astate might be expected to finance/rebate that balance, matters at all tocurrent labor supply supports the hypothesis that workers are indeedRicardian.

CONCLUDING REMARKS

This research investigates a model of labor supply that permitsworkers to be Ricardian or aware of the state governments intertem-

poral budget constraint. The theoretical analysis derives the labor sup-ply effects of deficit finance under a variety of possible tax structures.The empirical results suggest that state government budget deficits




29/35

increase male labor supplymore (or decrease it less) the more the staterelies on individual income taxes, suggesting that workers areRicardian and adding a new kind of evidence to the Ricardian equiva-lence debate. For a number of reasons, however, these results are notas definitive as one would hope and thus point to the need for addi-tional empirical studies. First, the key coefficients statistical signifi-cance varies a great deal. Part of this may be due to the conservativechoice of 1980 as the year of study. Choosing 1980, a very good yearfor the states, may very well have resulted in smaller estimatedRicardian effects than if a year was used when more states were in fis-cal distress. The lack of significant income and asset coefficients is

also troublingbut entirely consistentwithother empirical labor supplyresearch.

Finally, the results found here for state government policy shouldnot be directly applied to an analysis of the labor supply effects of fed-eral deficits because of the multitude of differences between federaland state government policy. These differences affect the likelihoodthat the worker will indeed face higher future taxes as a result of a cur-rent deficit, a necessary assumption for Ricardian behavior to be evi-dent. Foremost, unlike most states, the federal government does notmandate a balanced budget and has demonstrated a willingness to rundeficits continually. As noted by Poterba (1997, 79), the federal gov-ernment also likely has better options for financing a deficit, such as

the ability to print money and greater access to credit markets. On theother hand, workers can avoid repaying a current state deficit by mov-ing to another state, an option typically not available at the federallevel. Anticipated future tax increases at the state level are also morelikely to be capitalized (Poterba 1997). And states are much morelikely to run surpluses than the federal government, which have beenfound to cause weaker fiscal reactions by state governments than defi-cits (Poterba 1994). Thus, the extent to which a current deficit isrationally forecasted to cause a future tax increase for the individuallikelydiffers between thestates and thefederal government.

34The evi-

dence presented here suggests that workers are using state govern-ment deficits/surpluses in a manner consistent with Ricardian behav-

ior. In situations in which workers are Ricardian, Hansson and Stuart(1987) show that postponing taxes on labor income via deficit finance




30/35

may actually be a desirable (and not neutral) policy by increasing bothcurrent labor supply and savings. At the very least, this analysis sug-gests that mens work decisions are influenced not only by stateincome taxes but by other aspects of state fiscal policy as well.

APPENDIX

With a proportional tax system, the consumers budget constraintcan be written more simply as

A t W h t Y C f

t W hr

1 1 1

11 1

+ + +

+ +

( ) ( ) ( )

( )(

+

+ +

+

+ tt Y

r tC

r tf

r t

11 1

11 1 1 1)

( )( )

( )( ) (

),

where all terms are as previously defined. The comparative static

result for

=

h h

t

1 1

2

can be simplified as

( )

( ) ( )( )

( ) ( )

h

t

r t

V W rW t

W t V

1 1

1 1

1 1

=

+

+

+ +~

( )( )( )

1

rV

W h Y rC rf V V V

+ + + + +

,

where

( ) ( )( )( )( ) | |

~

= +

+ >

U U t W

r t H

1 1

1 1

10

,

andUijandV

ijare the second partial derivatives of the utility func-

tions, and Uii, V

ii0forall i j. Recall that , t,and rare

all tax or interest rates and therefore are between 0 and 1.0. This infor-mation allows us to determine that all of the terms are positive except

for the one involving V , which is negative. Thus, we must assume




31/35

that ( )12

2+ r V

is outweighed by the rest of the terms in the equa-

tion to conclude that

h

t

h1

2

1or

is positive.

NOTES

1. Hansson and Stuart (1987), Judd (1987), and Quintieri and Rosati (1988) are among

those who discuss the theoretical effects on labor supply of distortionary taxation and deficit

finance.To my knowledge, thereis no accompanying empirical evidenceusing microleveldata.

2. Conway (1994, 215) alsosuggests using statefiscalpolicyand microeconomic dataas

a new avenue for empirically testing the fundamental assumptions underlying Ricardianequivalence.

3. Using time-series, cross-sectional data, Rogers and Rogers (1993) find that although

few states have a balanced budget in any one year, each state obeys its budget constraint over

time. In addition, a growing literature that examines the effects that state budget rules have on

state fiscal policy (e.g., Poterba 1994, 1995, 1997) offers support that theselimitationsdo indeed

matter.

4. See Barro (1989) and Bernheim (1987, 1989) for further discussion of this debate.

5. For instance, Ycould be thelaborincome of thespouse, assumingthat thetwo individu-

als make their labor supply decisions independently. This assumption is explored further in the

third section. Ydoes not include asset income; such income is not exogenous in a life cycle

model.

6. Theonlyadditional alterationto equation (3)is theinclusion ofYin thetax function that

is multiplied against |H51|.

7. For instance, in the year used in the empirical analysis1980the highest tax bracket

formarriedcouplesbeganat a householdincome of$13,000or lessin 19of the41 statesthat hada broad-based income tax.

8. Blomquist (1985)notes that these measures maybe replaced bynet savings over thepe-

riod( ( ( )) )S A r t A

= + 1 1

if the income tax system is proportional. Because all workers

face the nonlinear federal income tax, I must include both measures.

9. As mentioned shortly, individualswho moved across stateswere deletedfrom my cross-

sectional sample. With a longitudinal sample, this omission reduces sample size much more

because the individual is deleted if he moved at any time during the panel.

10. Specifically,Zincludes age, age squared, education,educationsquared, number of chil-

dren younger than age6 inthe household, numberof children younger than age17, healthstatus,

and marital status.Zalso includes a constant. Notice that because all individuals face the same

federal budget balance, its effect cannot be estimated and is instead contained in the common

intercept. This is precisely why state fiscal policy presents an interesting experiment of

Ricardian behaviordifferent individualsface different state budget balances at a given pointin

time.

11. The reduced form wage, virtual income, and ending assets equations also include thecubic polynomial of age and education (as in Mroz 1987), the state unemployment rate, and

dummy variables for the individuals race and region of the country.

12. See Killingsworth (1983) for further discussion of this problem.




32/35

13. An alternative approach is to calculate a person-specificas the proportion of currentstate taxes paid by each individual in income taxes. However, thisis the result of the workersutility maximization problem and is therefore endogenous. Using this measure would add two

more endogenous variables (Band (1 )B) to a system that already has three or four endoge-nous variables (w, Y, and the asset variables). Furthermore, the goal here is to include the

parameters of the workers problem, not the utility-maximizing solution, in the labor supply

equation.

14. These groups of workers were omitted from the sample because it is very difficult to

measure theirtrue marginal wage.For moonlighters, identifyingthe marginal jobis problematic,

whereas for the self-employed, distinguishing the returns to labor from the returns to capital is

difficult. Likewise, it is difficult to theorize the true marginal hourly wage facing a commission

or piecework employee. In addition, these observations also made up a disproportionate number

of the extreme outliers and those with apparently miscoded data.

15. In the empirical section, I estimate the key models using a bigger data set that includes

the low-income subsample,both withand without usingthe weights providedby the Panel Study

of Income Dynamics (PSID) to explore the impact that an increased sample size and the use ofweights has on the results.

16. Ziliak and Kniesner (1996), in turn, draw on Zeldes (1989) and Runkle (1991) in their

construction of the liquid component of assets.

17. The average 3-month T-bill rate was 11.5% in 1980 and 14% in 1981.

18. The latter variable is unfortunately truncated at $99,999; dropping observations with

this truncated value reduces the sample by one observation.

19. The employees share of Social Security and Medicare taxes in 1980 was 6.13% with a

ceilingon taxable earnings of $25,900 (Browning andBrowning1994,408).Statutory tax rates

and brackets, standard deductions, exemptions, and other characteristics of the state personal

incometax systemswere found in Significant Features of Fiscal Federalism 1979-1980 Edition

(Advisory Commission on Intergovernmental Relations 1980) and the State Tax Handbook

(1980). Deductibility of federal income taxes for all taxpayers (including nonitemizers) was

accounted for, as well as any universally applied tax credits. If the two documents contradicted

each other or if necessary information was missing, state tax officials were contacted.

20. Specifically, incometaxes on before-taxnonhusband labor, noninterest income are esti-mated using the householdsaverage taxrate (estimatedtotal taxes paid divided by total taxable

income) and thensubtracted. The virtual income adjustment is calculated by multiplyingthe dif-

ference in the marginal tax rate and the average tax rate by the husbands labor income, or ( tm

ta)Wh, wheretmandtaare the marginal and average tax rates, respectively. See Mroz (1987) or

Killingsworth (1983) for further discussion.

21. State expenditures were found in Table 9 ofState Government Finances in 1980(U.S.

Bureau of the Census 1981).

22. Total state government expenditures on capital outlays are found in Table 12 inState

Government Finances in 1980(U.S. Bureau of the Census 1981).

23. Anintermediatelinear model would beone that restrictsthe directeffectsto be equal but

does notrestrict to equal 1.0. This involves adding Kand (1 )Kas regressors to themodel;their corresponding coefficients equal

and

, respectively.

24. Not surprisingly, the states not included tend to be states with smaller populations (and

hence fewer initial observations)Alaska, Delaware, Hawaii, Idaho, Montana, North Dakota,

and Vermont. Alaska and Hawaii are frequently omitted from studies of the states anywaybecause they are such outliers in so many ways. The remaining five states are somewhat unique

in that they are low-population states, but fortunately in each case, the sample includes similar

states from the same region.




33/35

25. If anything, the coefficients are of a larger magnitude when both asset variables are

included so that the overall significance levels are mostly unchanged.

26. For instance, state government spending and the budget balance are highly correlated;

the Pearson correlation coefficient calculated for these two variables using state-level data (43

observations) is .279, which is statistically significant at the 7.0% level. Likewise, transfer

spending andare very highly correlated.27. Specifically, the coefficientson B and (1 )B arereduced foreach year.For instance,

the coefficient onBis approximately 5.3 for a 30-year-old and 2.34 for a 50-year-old.28. The Advisory Commission on Intergovernmental Relations (1987) cataloged the rules

and assigned an overall score between 1 and 10 to the stringency of a states rules. The dummy

variable, STRICT, is equal to 1.0 if the score is 6 or higher.

29. This omission is notthe same as deleting stateswithout a broad-based incometax. Con-

necticut, New Hampshire, and Tennessee all have narrowly defined taxes on asset income, so

that , although quite small,does notequalzero forthem even thoughthey have no broad-basedincome tax.

30. I define this two ways; one is if the original> 0, and the second is if the state has abroad-based income tax. See Note 25.

31. This result is not confined to this one specification; including the state-level characteris-

tics tendedto increase thestatistical significanceof the deficit variablesin mostspecifications.

32. This likelyarises because several stateshaveonlyone or twoobservations andtherefore

have very large dummy coefficient variances.

33. For example, the labor supply effect of a one dollar per capita increase in the deficit in

the state with the heaviest reliance on income taxes (= .347) would increase annual labor sup-ply by approximately 1 hour.

34. Or, put differently, the assumptions necessary for the individual to internalize the cur-

rent deficit differ between state and federal deficits. For example, the former requires assump-

tions about capitalization and future plans to relocate, and the latter requires assumptions about

infinitely lived consumers or intergenerational altruism.

REFERENCES

Advisory Commission on Intergovernmental Relations. 1980. Significant features of fiscal fed-

eralism 1979-1980 edition. Washington, DC: Advisory Commission on Intergovernmental

Relations.

. 1987. Fiscal discipline inthe federal system: Nationalreformand theexperience of thestates. Washington, DC: Advisory Commission on Intergovernmental Relations.

Amemiya, Takeshi. 1978. A note on a random coefficients model. International Economic

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Karen Smith Conway is an associate professor of economics at the University of New

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and applied econometrics.


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