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We re-examine the tax-spending nexus using a panel of 50 US state–local government units between 1963 and 1997. We find that, unlike tax revenues, expenditures adjust to revert back to a long-term equilibrium relationship. The evidence on the short-term dynamics is also consistent with the tax-and-spend hypothesis. One implication of this finding is that the size of the government at the state–local level is not determined by expenditure demand, but rather by resource supply. This is consistent with the fact that many US state and local governments operate under constitutional or legislative limitations that seek to constrain deficits.

Persistently large public sector budget deficits have to be eventually corrected through fiscal adjustments in the form of government expenditure cuts and/or tax revenue increases. In practice, however, addressing the deficit problem may be complicated by the several issues. One issue is the division of the burden of adjustment between the expenditure and revenue sides of the budget during periods of fiscal retrenchment. A related issue is the temporal causality between taxes and expenditures which is typically discussed in terms of the following four competing hypotheses in the literature. According to the “tax-and-spend” hypothesis championed by Friedman (1978), the level of spending adjusts to the level of tax revenues available. Thus, an increase in tax will not lead to lower budget deficits. Friedman therefore, favors a reduction in taxes to force subsequent spending cuts. Buchanan and Wegner's (1977) version of this hypothesis states that tax reductions will lead to higher spending through lowering the perceived price of government provided goods and services by the public. To reduce expenditures, the authors suggest limiting the ability of the government to resort to deficit financing. The “spend-and-tax” hypothesis maintains that the level of spending is first determined by the government and then tax policy and revenues are adjusted to accommodate the desired level of spending. In this connection, Peacock and Wiseman (1979) argue that temporary increases in expenditures due to a crisis situation are used to justify higher taxes which may then become permanent. Another version of this hypothesis is based on the work of Barro (1979). In his tax smoothing hypothesis, government spending is considered as an exogenous variable to which taxes adjust. Since changes in expenditures drive changes in taxes in this scenario, the preferred approach to fiscal deficit reduction relies on cutting expenditures. Meltzer and Richard (1981), among others, maintain that voters' choices lead to concurrent changes in taxes and expenditures. The implication of this so-called fiscal synchronization hypothesis is that causal relationship between government revenue and spending is bidirectional. In contrast, Wildavsky (1988) and others emphasize that separate institutions participate in the budgetary process and that the collapse of a consensus on fundamentals among them may result in an independent determination of the revenue and expenditure sides of the budget. The implication of this “institutional separation” hypothesis is that taxes and expenditures may be causally independent. Our main objective is to re-examine this issue of causality between taxes and expenditures at the US combined state–local government level. While the direction of causality is an empirical question in the final analysis, the use of state–local data may provide prior expectations in that regard. In particular, it is well known that many states and local governments in the US operate under fiscal constraints in the form of budget requirements and debt limits. These constraints, while not strictly binding, may be effective enough to result in revenue-constrained spending decisions. If so, we would expect to obtain results that are consistent with the tax-and-spend hypothesis. Similarly, to the extent that such constraints create causal dependence between revenues and expenditures in either direction, we do not expect to find empirical support for the institutional separation hypothesis.1 The paper contributes to the existing tax-spending literature in several ways. Firstly, our empirical evidence is based on a panel of 50 combined US state and local government units, henceforth referred to as state–local governments, and covers over 35 years.2 Secondly, our empirical model controls for federal government grants to state–local governments, non-tax revenues, gross state product, and debt stock, for these are some important factors that are likely to affect the relationship between taxes and expenditures. It is also very general in the sense that it accounts not only for the non-stationarity, but also for the panel structure of our data. Thirdly, our approach to causality relies on the fact that if taxes and expenditures are cointegrated, then their levels must be related in the long run with causality running in at least one direction. To exploit this potential channel of causality, we adopt the panel error correction approach of Westerlund (2007a). Fourthly, we use panel tests that account for both the time series and cross-sectional dependencies. This is a crucial feature given a high degree of interdependency among state–local government units. Finally, we employ alternative variable definitions to check the robustness of our results. The rest of the paper proceeds as follows. Section 1 provides a theoretical framework. Section 2 describes the empirical methodology and the data. Section 3 presents the results. Section 4 concludes.

In this paper, we re-examined the tax-spending nexus using, for the first time, a panel of 50 US states–local government units over a period of roughly three and a half decades. The statistical evidence suggests that while taxes are rather exogenously set, expenditures adjust not only to deviations from the long-term equilibrium relationship but also to the short-run changes in taxes, other funding sources and output. Stated differently, expenditures seem to bear the adjustment burden in response to budgetary disequilibria. An implication of this finding is that the size of the government at the state–local level is not primarily determined by expenditure demand, but rather by resource supply, such as taxes and grants. It is hard not to conclude that these results, at least in part, reflect the constitutional or legislative limitations that seek to constrain deficits under which many state and local governments operate in the US. These include submission of balanced budgets, limiting appropriations to estimated revenues, and/or requiring revenue shortfalls to be matched by spending cuts. That expenditures seem to depend on taxes both in the long and short terms underscores the important role of taxes in controlling government deficits at the state–local level. In this connection, reductions in the federal commitment to existing entitlement and mandatory programs and/or introduction of new unfunded mandates will result in fiscal imbalances through cost shifts to state and local governments. To avoid confronting these governments with the unpleasant choices of raising taxes or cutting other expenditures, stricter adherence to provisions of the Federal Unfunded Mandates Reform Act of 1995 is necessary. In relation to the current recessionary environment, continued infusion of federal assistance to fiscally strapped state and local governments in the context of the American Recovery and Reinvestment Act of 2009 seems to be justified to avoid draconian expenditure cuts.