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JA N U A R Y /F E B R U A R Y 1 9 9 6
ECONOMIC PERSPECTIVES
S ta te -lo c a l business ta x a tio n
and th e b e n e fits p rin c ip le
S om e c o m m e n ts on th e
role o f e c o n o m e tric s in
e c o n o m ic th e o ry
FEDERAL RESERVE
OF CHICAGO
Contents
State-local business taxation
and the benefits principle...........................................................................2
W illiam H. O akland
and W illiam A. Testa
This article advances the proposition that general business
taxation should be structured to recover the costs of public
services rendered to the business community. Estimates of
one possible form of such a tax structure are offered for states
of the Seventh District and for other U.S. regions.
1996 Bank Structure Conference
announcement............................................................................................ 20
Some comments on the
role of econometrics in
economic theory........................................................................................ 2 2
M artin Eichenbaum
The basic tension facing econometricians is that structural
models are necessary for addressing monetary policy questions.
But all models are, by their very nature, false. Econometric
programs that focus on testing whether models are true will be
ignored by practicing macroeconomists. The critical task facing
econometricians is to develop diagnostic tools for assessing the
usefulness of models for addressing particular questions. This
article reviews two diagnostic strategies.
ECONOMIC PERSPEC1 I\ ES
January/February 1996 Volum e XX, Issue 1
President
Michael H. Moskow
Senior Vice President and Director of Research
William C. Hunter
ECONOMIC PERSPECTIVES is published by
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R esearch D e p a rtm e n t
Financial Studies
Douglas Evanoff, Assistant Vice President
Macroeconomic Policy
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Microeconomic Policy
Daniel Sullivan, Assistant Vice President
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Editor
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Production
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ISSN 0164-0682
State-local business taxation
and the benefits principle
W illiam H. Oakland
and W illiam A. Testa
in recent years, interest in
economic efficiency by causing the prices of
state and local taxation of
goods and services to reflect their full costs of
business has been fueled by
production. Such prices enable people to
concerns over the possible
make appropriate choices among consumer
goods. Business benefits taxes similarly pro
deleterious effects such taxes
may have on economic development mote
and, in
appropriate choices between private and
particular, on the ability of a jurisdiction
to goods. Without recovery of the costs
public
provide jobs for its residents. Much of
inkbusiness
has
services, voters may not support
been spilled over whether or not fiscal factors
otherwise worthy public services provided to
have a significant effect on firm location deci
business. Alternatively, the voting public and
sions. However, without analyzing why busi
their representatives may believe that business
ness taxes are on the books in the first place, it
taxes can be ratcheted skyward as a way to
may be impossible to properly evaluate the
subsidize those public services provided to
impact of such taxes on business location. In
households.
this article, we advance the proposition that
One objective of this article is to develop a
general business taxation should be structured
comprehensive framework for evaluating the
so as to recover the costs of public services
efficacy of state-local business tax structures.
rendered to the business community.
This framework will then be applied to existing
Economic development may be but one
practices within the U.S., with specific focus
objective of tax policy. Other objectives,
upon the Seventh Federal Reserve District,
which encompasses Iowa and major portions of
such as fairness, economic efficiency, and
sound expenditure policy, are also important.
Illinois, Indiana, Michigan, and Wisconsin.
For example, a local community may want to
We will argue that the primary basis for gener
structure its taxes to discourage business ac
al business taxation is to recover the costs of
tivities which produce noxious side effects;
government services rendered to the business
state government may wish to restrict busi
community. It follows that if general busi
ness activity in such a way as to promote
ness taxes exceed or fall short of the cost of
monopoly power of home enterprise(s) serv
ing an out-of-state clientele. Even in the
W illiam H. Oakland is a professor o f econom ics at
Tulane U niversity. W illia m A. Testa is assistant
absence of such motives for growth controls,
vice president at the Federal Reserve Bank of
business taxation may be desirable to recover
Chicago. The excellent research assistance of
the cost of government services provided to
Jam es Greco is g ra te fu lly acknow ledged. The
authors also thank the Federal Reserve Bank of
businesses within a jurisdiction. Not only
Chicago lib ra ry staff, past and present. Helpful
does this promote fairness, by recouping the
com m ents were con tribu te d by Richard M attoon,
costs of such services from those who ulti
Federal Reserve Bank o f Chicago, and Thom as
Pogue, U n iversity of Iowa.
mately benefit from them, it also enhances
f
2
ECONOMIC PERSPECTIVES
taxes, the incidence of particular taxes con
providing government services to business,
tributes little to a useful definition of business
the business tax structure is not neutral with
taxes.
respect to the location of business activity in
Our approach is to define business taxes to
general. Furthermore, it will not be neutral
include any levy upon a firm’s purchase of
with respect to consumption patterns for con
inputs, its transfer or ownership of assets, its
sumer goods and the composition of spending
earnings, or its right to do business—in short,
on private goods and public goods.
any levy which would, in the absence of price
It should be emphasized that, even where
adjustments, reduce the firm’s bottom line.
there is correspondence between business taxa
Included in this definition are corporate profits
tion and business expenditures, there may
taxes; real and personal property taxes on busi
remain non-neutral location incentives for
ness assets; franchise taxes and business license
specific firms. This will be the case if the
fees; sales and use taxes and gross receipts taxes
business tax structure is not neutral across firm
upon a firm's purchase of equipment, services,
types or if there are wide disparities among
firm types in terms of service benefits received
and materials; and those payroll taxes for which
the firm is the statutory taxpayer.
from government. In effect, what is true on
By this definition, business taxes can be
average may not be true for particular firms.
seen to produce a prodigious flow of revenue
These issues should be considered when de
to state and local governments. Table 1 shows
signing the optimal business tax structure.
We begin by providing a framework under
revenues for fiscal year 1992 by category of
tax and in total for the U.S. Business taxes
which businesses might be taxed to optimal
accounted for 28.9 percent of all state-local tax
effect. Following definition and measurement
revenue, amounting to approximately $160
of current state-local business taxation, we
billion. Among the categories, property taxes
discuss alternative business tax structures.
were the most significant single item, account
Among these alternatives, the benefits princi
ing for 42.8 percent of business taxes. Corpo
ple is identified as the best by far. Turning to
rate income taxes, general sales taxes, and
the specifics of how to implement the benefits
payroll taxes (that is, unemployment insur
principle, today’s practices are held up against
ance) each accounted for a sizable share.
the theoretical standard that business tax reve
nues should roughly cover direct
public service costs. In the final
T A B LE 1
section, we suggest how stateState & local business taxes in the United States, 1992
local government might lower
taxation of business by levying
Percent of
Percent of to ta l
uniform tax rates on a broad-based
Total
business
state-local taxes
measure of business activity—
$68,644
12.4
Property
42.8
value added.
Sales
$23,151
14.4
4.2
A fram ew ork fo r
business taxation
Unem ploym ent
insurance
$15,489
9.6
2.8
Definitions
Corporate
income
$21,937
13.7
3.9
Insurance
$4,043
2.5
0.7
Utility
$7,397
4.6
1.3
M otor fuel
$9,165
5.7
1.6
$10,687
6.7
1.9
Total business
taxes
$160,514
100.0
28.9
Total taxes
$555,479
—
Business taxes are not easy to
define. Many business taxes are
shifted from the legal or statutory
taxpayer to other entities. Taxshifting mechanisms are frequent
ly subtle and indirect; as a result,
theories of tax incidence are some
times controversial. Furthermore,
because only individuals, in their
capacities as consumers, workers,
entrepreneurs, or suppliers of land
and capital, can bear the burden of
FEDERAL RESERVE
BANK OF CHICAGO
Other3
-
aO ther taxes include occupational and business license taxes
and selective sales taxes.
Source: S taff calcula tions based on data reported by the U.S.
D epartm ent o f C om m erce, Bureau o f the Census, G overm ents
D ivision and in d iv id u a l state fiscal agencies.
3
Together, these four categories accounted for
more than 79 percent of all business taxes.
Excluded from our definition, for the most
part, are general and selective sales taxes on
items purchased by consumers; it is expected
that such taxes are shifted to the purchaser.1
However, if the buyer is a business enterprise,
the tax payment will have been captured by our
definition above.
We also exclude personal income tax lia
bilities upon the profits of unincorporated
enterprises. While one might expect that prof
its taxes would be treated independently of the
legal form of organization, that is not the case.
Corporate income tax is an added layer of
business tax; dividends and capital gains of
firms that pay corporate income tax are also
subject to personal income tax. Personal in
come tax applies to the returns of all capital
investments made by an individual, including
those arising from business ownership. Thus,
if the individual proprietor failed to engage in
business within the state, the assets would have
been invested in other pursuits and subject to
personal income tax. The only persuasive case
for including such taxes as business taxes re
lates to those proprietors with out-of-state
residences. For such individuals, personal
income taxes paid to the host state are costs of
doing business, which must be compared with
costs existing elsewhere. Fortunately, howev
er, the vast majority of unincorporated enter
prises are owned by residents.2
Rationale fo r general business taxes
The widespread use of business taxes
today does not in itself imply that their level
and structure are in accord with the principles
of good taxation.3 In this section, we discuss
the rationale for business taxation. Our discus
sion will be confined to those taxes which are
imposed upon business enterprises in general,
or on a large subset of business firms, such as
corporations. Taxes upon specific activities,
such as mineral extraction or chemical produc
tion, are not considered. Presumably, the ob
jective of such taxes is to correct for externali
ties, such as environmental damage, or to cap
ture benefits of natural resources for the citi
zenry as a whole. The rationale for such taxes
does not apply to the argument for general
business taxation. There may be a good case
for specific business taxes to control for envi
ronmental damage or to capture some of the
4
rents associated with a state’s unique resourc
es, such as mineral wealth or favorable loca
tion. Such taxes should be considered as sup
plements to the general business taxes that we
treat below.4
A number of possible motives for statelocal taxation have been suggested or can be
inferred from current practice. These include
ability to pay, tax exporting, political expedi
ency, and the benefits principle. Each was
analyzed by Oakland (1992). Only the bene
fits principle was shown to survive scrutiny.
Most other motives were seen to be unattain
able or based upon flawed economic reason
ing. Only the three most compelling types of
rationale will be treated here. The first two
may account for the widespread use of busi
ness taxation. The third is prescriptive—how
business should be taxed.
Ease o f raising revenue
Business taxation offers governments the
opportunity to collect large sums of revenue
from relatively few taxpayers. In addition,
because the incidence of business taxes is often
uncertain, it may encounter relatively little
political opposition. Many taxpayers may
perceive that such taxes are paid out of the
“deep pockets” of rich corporations and/or
absentee rich shareholders. Others may not
hold that opinion, but would vigorously oppose
attempts to raise their personal taxes; in effect,
business taxation may appear to public offi
cials to be the only course available.
While ease of collection is a valid criterion
for tax policy, particularly in less-developed
economies, advances in tax administration
have enabled governments in advanced econo
mies to collect personal taxes at acceptable
compliance costs.5 Hence, collection costs
cannot serve as a principal criterion for the
choice of tax structure. As far as reducing
citizen opposition to higher personal taxes is
concerned, this is more properly viewed as a
serious disadvantage of business taxes. Good
tax policy should confront citizen-taxpayers
with the true costs of providing public services.
If citizens consistently underestimate these
costs, they will support too large a range and
level of public services.6 Viewed in this light,
general business taxation has the potential to
do serious economic damage and should, there
fore, be discouraged.
ECONOMIC PERSPECTIVES
To export the tax burden
A common rationale for business taxation
is that it extends the reach of the taxing juris
diction to residents of other jurisdictions. We
offer as evidence the increasingly dispropor
tionate weighting of sales in allocation formu
las to determine the state share of the profits of
multistate or multinational corporations when
levying corporate income tax.7 We find further
evidence in the rapid spread of legalized gam
bling activity, apparently prompted by the
desire to attract out-of-state gamblers.8
Whether it be through taxing the profits of
out-of-state shareholders, taxing out-of-state
consumers of goods produced locally, or taxing
the income of out-of-state landholders, busi
ness taxation may be viewed as a means of
transferring some of the costs of local govern
ment to residents of other jurisdictions. While
this may be legitimate if the activity is limited
to recovering costs of government services
extended to such “foreigners,” there is no rea
son to suppose that the practice would be so
limited.9 The prospect of a “free lunch" has
irresistible political appeal.
However, like most free lunches, the bene
fit is more illusion than reality. The opportuni
ties for successful tax exporting are quite limit
ed, and those that exist can be more successfully
exploited by finer instruments than general
business taxes. For example, consider the dis
proportionate use of sales factor by consuming
states. The resultant higher taxes increase the
cost of selling in the taxing state; this prompts a
price increase so that the firm can receive the
same net revenue as from selling the item in
some other market. In general, the ability to
export taxes is restricted to situations where the
state has some competitive advantage, owing to
superior or unique natural resources. Here the
state can successfully capture the “rent” of these
resources through taxation. However, the ap
propriate tax is not one on all businesses but a
selective tax on the resource itself (for example,
a severance tax) or on a product that uses the
resource (for example, a tax on hotels). Hence,
the case for general business taxation cannot be
based upon tax exportation.10
To recoup the costs o f public services
Government provides the business com
munity with a legal framework for conducting
its affairs, through its civil court system. It
also offers direct services to businesses and
FEDERAL RESERVE
BANK OF CHICAGO
their employees, such as transportation and
public safety. These services make it possible
for the firm to produce more efficiently, allow
ing for lower prices and/or higher wages and
profits. Business taxation allows those who
benefit from these services, whether within or
outside the jurisdiction, to contribute to their
costs. It also has the salutary effect of lower
ing the taxes to citizen-taxpayers, enabling
them to make a more accurate assessment of
the true costs of public services rendered di
rectly to them and to the business community.11
In such circumstances, business taxation
promotes the benefits approach to taxation.
Without business taxation, this approach would
be difficult, if not impossible, to adopt. For
example, if the beneficiaries of business servic
es are out-of-state individuals or business enti
ties, the home state simply has no means of
taxing them directly. On the other hand, if the
beneficiaries are home-state residents, the state
would have to know how the services translat
ed into lower goods prices or higher wages and
profits—an insurmountable task. By taxing
business directly for services received, such
computations are unnecessary, and ultimate
beneficiaries would be taxed in proportion to
the costs incurred by the government sector.
The benefits principle has particular rele
vance for state and local tax structures. Its
rival criterion, the ability-to-pay principle, is
difficult to implement at these levels of gov
ernment because of mobility limitations. For
household service provision and taxation, the
well-to-do tend to flee from jurisdictions with
punitive tax burdens. Mobility becomes a
more compelling issue for businesses and may
play an important role in economic develop
ment. In contrast, business taxes which con
form to the benefits principle will be neutral
with respect to economic development. They
place the jurisdiction at neither a competitive
advantage nor disadvantage per se.12
Can the benefits principle be implemented?
The merits of the benefits approach to
business taxation have been noted in the tax
literature. However, many analysts have ques
tioned whether it can be implemented (ACIR
1978). These analysts argue that because most
government services are provided to businesses
free of charge, there is no objective measure of
use by different business entities; ergo, the
benefits principle cannot be implemented.
5
The major premise that business utilization
rates of government services cannot be finely
measured must go unchallenged. However, it
does not follow that relative business utilization
rates cannot be approximated. It surely is the
case that within a broad industry grouping, for
example, the finance, insurance, and real estate
industry or manufacturing, larger firms utilize
more services than smaller firms. Even among
disparate industry groups, it is also likely that
government services arising from employment
are more heavily used by large employers than
small ones. So business size is a likely impor
tant correlate of business service costs.
Using size as the sole measure of relative
service benefits would undoubtedly be subject
to error. However, the degree of error in rela
tive treatment would be far less than that of a
policy which charged business nothing for
government services. A tax based upon size
would eliminate the relative subsidy to large
firms. Moreover, the failure to charge business
taxes would distort the price facing citizens for
their public consumption goods. To get this
price right, business taxes in the aggregate
should equal the cost of providing business
services. Therefore, we believe there is merit
in business benefits taxation on the average.
While there will remain errors and distortions
in the resulting pattern of business taxation,
these errors will be smaller than if no tax at all
were imposed. In the absence of any other
sound basis for business taxation, it follows
that the imposition of size-related business
taxes is the appropriate policy prescription.
The case fo r business taxation
On the plus side, business taxes can be
used to promote the principle of benefits taxa
tion, which places the burden of taxation on
those who enjoy the ultimate benefits of certain
public services, and at the same time neither
penalizes nor subsidizes economic develop
ment. On the negative side, because it may not
be perceived as a cost to the citizen-taxpayer,
business taxation may be pushed to excessive
levels, encouraging wasteful expansion of
publicly provided consumption services and
leading to a diminution of job opportunities
within a jurisdiction. Given that political expe
diency may prevail over economic efficiency,
one might expect general business taxation to
be carried to levels beyond that suggested by
the benefits approach. In the empirical work to
6
follow, this hypothesis will be examined in the
Seventh District and in other regions. In addi
tion, we measure how state-local governments
might maintain the current level of business tax
collections by levying taxes as a uniform per
centage of value added.
Busine ss taxes and business
expenditures
Taxes
Businesses are taxed by both local and
state governments. While authority for partic
ular tax bases varies from state to state, gener
ally speaking local governments rely primarily
on the property tax for funding, while state
governments generally collect sales taxes and
corporate income taxes, as well as the bulk of
tax revenues on insurance premiums, motor
fuel sales, and the gross receipts of public
utilities. In the Seventh District states, corpo
rate income taxes, unemployment compensa
tion, and insurance premiums are major busi
ness taxes which are exclusively collected for
state government operations; taxes on general
sales, public utility gross receipts, and motor
fuel are levied at the state level and, to a lesser
degree, at the local level. The property tax has
been, in recent decades, almost exclusively a
local tax source.
Drawing from data collected by the Bu
reau of the Census and from state fiscal author
ities, business tax revenues at both the state
and local levels can be distinguished from tax
revenues from the household sector. Corporate
income tax revenues and business license taxes
can be wholly allocated to the business sector.
In all other instances, the business and house
hold sectors are taxed under the same statutes.
For example, state sales taxes are imposed on
the final retail purchases of households and on
certain intermediate purchases made by busi
nesses. Accordingly, revenues must be par
celed between the household sector and the
business sector for major revenue sources,
which include the general sales tax, public
utility gross receipts, insurance premiums,
motor fuel, and property tax.
According to studies of business taxes for
states and regions of the United States, busi
ness taxes declined from 42 percent of total
state-local tax collection in 1957 to 29 percent
in 1992 (ACIR 1967, 1981; Tannenwald 1993)
(figure 1). The declining share of taxes attrib
uted to business largely reflects the rising
ECONOMIC PERSPECTIVES
FIGURE 1
Business’ share of taxes in the U.S.
percent
Source: ACIR (1981), appendix.
dominance of personal income taxation by
states over the past 25 years, rather than any
marked slowing in the pace of business tax
collections. The rise in personal income taxa
tion corresponds to the growing share of public
services provided to households by state-local
government—especially health and education.
Variation in the dependence on business
taxes (as most commonly defined) in 1992
among regions, as defined by the U.S. Bureau
of Economic Analysis, lies within a fairly
narrow band. When we update this methodolo
gy, originally developed by the U.S. Advisory
Commission on Intergovernmental
Relations (ACIR), for the 1992
fiscal year, we find that in the
Great Lakes region (that is, Illinois,
Indiana, Michigan, Ohio, and Wis
consin), business taxes comprise
29.0 percent of state-local taxes,
compared with 30.7 percent in the
U.S. The Southwest leads with
41.3 percent, because of its heavy
use of state severance taxes on
energy minerals. All other regions
lie within 3 percentage points of
the national average (figure 2).13
In measuring business taxes for
the states of the Seventh District, we
differ from much of the literature in
both definition and methodology.
We exclude from our business tax
definition selective excise taxes,
such as severance or lodging taxes,
FEDERAL RESERVE
BANK OF CHICAGO
because they are often targeted to a specific
industry, indicating to us that the intent of the
tax is other than to cover the government ex
pense of providing business services. Perhaps
these selective taxes are intended to compensate
for environmental damage or to expropriate the
income on assets of out-of-state owners.
Some taxes that we do include may appear
to be selective, such as insurance premiums,
public utility gross receipts, and motor fuel tax.
We include these because they are applied to a
wide spectrum of each state’s business sector
and can, therefore, be considered a tax on in
termediate inputs to business production. For
these revenue sources, some care must be taken
to apportion tax revenues accurately to the
business sector rather than to the government
and household sectors. So too, following De
Boer (1992) and Oakland (1992), data provid
ed by state fiscal agencies can often be grouped
more finely than nationally reported data for
important hybrid taxes such as the property
tax. Data collected nationally by federal agen
cies must understandably compromise some
detail in exchange for a broad reporting of
data.14 (See appendix for methodology.)
In reviewing our business tax measure
ments, property tax collections dominate
business tax collections in states of the Dis
trict (figure 3).15 An estimated 47 percent of
1992 business tax collections were derived
from this revenue source. Corporate income
(17.2 percent), unemployment compensation
7
FIGURE 3
Distribution of business taxes, 1992
u.s.
Seventh District
Motor
fuel
(5.7%)
Other
(6.7%)
Public utilities"
(4.6%)
|
Insurance
(2.5%)
Source: Staff calculations based on data provided by state fiscal agencies and
U.S. Department of Commerce, Bureau of the Census, Governments Division.
(11.4 percent), and the state sales tax portion
collected on intermediate purchases by the
business sector (11.6 percent) also represent
major business taxes.
While we have chosen to define business
taxes by their broad-based application to the
business sector, there is at least one noteworthy
imbalance in the business tax structure which
suggests a lack of evenness and neutrality
across types of businesses. Specifically, a
heavy share of state-local business taxes in the
Seventh District and in the nation is initially
imposed on business capital by way of proper
ty tax and state corporate income tax. Such a
system may skew any burden of taxation to
ward goods-producing industries and away
from the service-producing industries which
tend to employ more labor than capital. Heavy
state taxation of public utility inputs and sales
taxation of tangible inputs to production would
only tend to aggravate such an imbalance.
We and others have long noted other im
balances in the structure of state-local business
tax systems (ACIR 1978; Stocker 1972). The
taxation of profits (within corporate net income
tax) would seem to penalize exactly those
(profitable) firms that may have desirable pros
pects for rapid growth and development.16
Another imbalance may involve the unemploy
ment insurance system, which frequently taxes
new firms (having no employment history) at a
8
very high rate. Many such firms tend to be
labor intensive, small, and innovative.
Expenditures
Expenditures by function for state-local
governments are reported annually by the Gov
ernments Division of the Bureau of the Census,
U.S. Department of Commerce. Total direct
expenditures by function include all payments
to employees, suppliers, contractors, beneficia
ries, and all other final recipients of govern
ment payments. Intergovernmental expendi
tures—payments and grants between state and
local governments—are excluded. Such ex
penditures become expenditures of those gov
ernments where the funds come to rest. Since
we are interested only in those expenditures
made by state-local government, federal grant
monies by function are netted out of these
same functional expenditures. Similarly, reve
nues derived from user charges and fees (such
as college tuition and roadway tolls) are netted
out of appropriate expenditures made by statelocal government. The remainder represents
those direct expenditures by function that are
funded by state-local own-source tax revenues.
In allocating state-local spending to the
Seventh District’s business sector, we classify
expenditure programs into business, household,
prorated, and joint (shared). “Business” pro
grams are identified as dedicated solely to
ECONOMIC PERSPECTIVES
FIGURE 4
Distribution of state and local expenditures, 1992
U.S.
Seventh District
Source: Staff calculations based on data provided by state fiscal agencies and
U.S. Department of Commerce, Bureau of the Census, Governments Division.
business, for example, agricultural programs
and water transportation terminals. These are
estimated at less than 1 percent of total statelocal direct expenditures in 1992 for the Seventh
District states as a whole (see figure 4). In
contrast, “household” expenditures comprise
62.5 percent overall, and are assumed to benefit
households only, for example, education, wel
fare, health, parks and recreation, and housing.
“Prorated” programs include “overhead”
functions, such as general public buildings,
legislative and financial administration. These
expenditures are allocated to the business sec
tor proportionately, based on the share of busi
ness expenditures to the total of business plus
household expenditures. For the Seventh Dis
trict, we find that prorated business expendi
tures account for 2.0 percent, in comparison to
the 12.8 percent share commanded by the
household sector.
Finally, “joint” or shared expenditures are
perhaps the most difficult to allocate between
the business and the household sectors, because
of the broad categories into which state-local
expenditure data are classified. We choose to
liberally allocate shared expenditures to the
business sector. Accordingly, these programs,
which include police and fire, corrections, and
transportation, are assumed to be shared equal
ly between the business and household sectors,
FEDERAL RESERVE
BANK OF CHICAGO
so that each sector commands 10.9 percent of
state-local direct expenditure. All told, public
spending that can be classified as an intermedi
ate input to business production amounts to
13.8 percent of the total.
The large remaining share of state-local
spending attributable to the household sector
may seem disproportionate to some observers.
While state-local government does provide
essential business services, such as transporta
tion infrastructure and protection of business
property, its role has increasingly come to
focus on welfare and education. From 1950 to
1992, the share of state-local government’s
direct general expenditure on education and
social welfare (including health and hospitals)
climbed from 44.4 percent to 58.9 percent.
(Other services such as police, fire, transporta
tion, and general administration are shared by
the household sector.) While the business
sector arguably benefits indirectly from such
services, the direct benefits mainly accrue to
households. To the extent that these services
raise labor productivity, businesses will pay for
higher productivity through wages paid to the
household sector. More to the point, our inten
tion here is to measure those expenditures and
taxes directly accruing to business and directly
paid by business. To the extent that general
business expenditures are in alignment with
9
Rather, the finding that general
business tax collections tend to
exceed expenditures suggests the
need for further study, using
individual state and local fiscal
reporting systems that more
finely distinguish business from
household service expenditures.
Based on the 1992 data,
states in every Census region
appear to have taxed business in
excess of direct business service
expenditures (table 2). For
fiscal 1992, state-local general
business taxes in the U.S. ex
ceeded expenditures by 70 per
cent, on average. Nonetheless,
across the nine Census regions,
the aggregate ratio of taxes to
expenditures lies with a fairly
tight band, ranging from 1.45 in
the South Atlantic region to a
high of 2.08 for the West South Central states.
The Seventh District average of 1.87 is close
to the national average.
general taxes paid by business, it can be argued
that the price signals between the voting public
and its government sector are not distorted, so
that the correct degree of both business servic
Tax stru c tu re : Which business taxes
es and household services will be chosen by
to employ?
public decisionmakers.
It is important to think about the combined
Even with somewhat generous assump
effects
of all general business taxes employed.
tions about the direct benefits of shared expen
It
may
well
be that any particular tax is too
diture programs, figure 5 suggests that in the
narrow
in
application
but that, in combination
Seventh District states overall and in each state
with
some
other
tax,
it
provides a suitably
individually business taxes exceed business
expenditures by healthy propor
tions. In fiscal year 1992, business
TABLE 2
taxes in the District states overall
State
and
local
business
taxes and expenditures, 1992
exceeded expenditures almost two
fold. This indicates that, taking the
Business
Ratio of taxes
Region
expenditures
Taxes
to expenditures
benefits principle approach, discus
sions of tax reform should be di
(- -millions of dollars— )
rected toward bringing business
U.S.
$160,514
$94,136
1.71
taxation and business expenditures
New England
$9,022
5,076
1.78
into closer alignment.
M id-Atlantic
16,762
29,899
1.78
Given the approximate nature
East North Central
15,077
1.84
27,781
West North Central
6,228
$9,843
1.58
of our calculations, especially in
South Atlantic
15,735
22,837
1.45
classifying expenditures on public
East South Central
4,290
6,768
1.58
services to businesses versus
West South Central
8,589
17,909
2.08
households, individual states have
Mountain
5,471
8,169
1.49
no reason to be alarmed about
Pacific
16,906
28,285
1.67
competitive harm vis a vis neigh
Seventh District
12,760
23,816
1.87
boring district states due to excess
taxation. Expenditure classifica
Source: Staff calculations based on data reported by the
U.S. Department of Commerce, Bureau of the Census,
tions as reported by the Census
Governments Division and individual state fiscal agencies.
Bureau are necessarily broad.
10
ECONOMIC PERSPECTIVES
broad basis of business taxation. It is also
clear from the above discussion, that any ac
ceptable system must meet the test of compre
hensiveness. The business tax system should
reach all segments of the business community.
This would rule out taxes such as the state
corporation income tax, because there is no
countervailing tax that would apply exclusively
or mainly to unincorporated private sector
enterprises or to nonprofit business enterprises,
which do not earn taxable income.
Given that business benefits taxes should be
size-related, what measures of size can be used?
Here are two possibilities: (1) amounts of spe
cific inputs; (2) amounts of output. It is possible
to assess tax liabilities in accordance with labor
inputs, capital inputs, or material inputs. The
latter is unacceptable, given the widespread use
of materials produced outside the jurisdiction.
While labor or capital taxes would apply to all
business entities, to focus on one or the other
would induce the firm to move away from the
taxed input to the non-taxed. It also would tend
to favor or punish firms with differing degrees
of capital intensity. In general, there is no rea
son to believe that capital-intensive firms con
sume more public services than labor-intensive
firms. For some services, say fire protection,
capital may be a preferred indicator. While for
others, such as police protection, employment
measures may be preferable.
Since neither measure is a superior benefit
indicator, avoidance of substitution distortions
and inequities is enhanced by a system which
utilizes both measures. This raises the question
of weights. One attractive weighting scheme
would utilize input earnings; this is tantamount
to an origin-based value-added tax. The out
come could be approximated by a combination
of property taxes and payroll taxes. The quali
ty of the approximation would, of course, de
pend upon the relative use of the two taxes.
The use of outputs as measures of business
services leads to similar conclusions. Basical
ly, there are two possible measures: gross re
ceipts and value added. Gross receipts are an
unacceptable measure for the same reason that
materials are an unacceptable indicator of
input—they include a major component of
materials produced outside the district. Gross
receipts taxation would also tend to be pyra
mided to the extent that materials flow from
one producer to another within a jurisdiction.
Hence, we are left with value added as our
FEDERAL RESERVE
BANK OF CHICAGO
output indicator of firm size. Since value add
ed also serves as an adequate measure of input
use, it would seem to be the best candidate for
allocating the cost of business services.
The administrative costs of levying busi
ness taxes according to value added by origin
are not formidable for most industries. Michi
gan has been imposing a form of value-added
tax since 1975.17 Value added can be derived
for each firm by summing its payments for
factors of production, including payroll, inter
est paid, capital consumption, rents, and prof
its. Alternatively, value added can be derived
by subtracting firm purchases of intermediate
components and services from gross receipts.
Either way, the tax base would reflect the de
gree of productive activities within the state, it
would be largely neutral with respect to capital/labor proportions, and it would be neutral
with respect to industry and legal form of busi
ness organization.
The viability of subnational value-added
taxation is best illustrated by the relative ease
with which a rough approximation of the state
tax rates needed to raise revenue can be pre
sented.18 The Bureau of Economic Analysis
(BEA) publishes annual estimates (by industry)
of value added.19 Taking our estimates of
FY1992 business tax collections as a numera
tor, and BEA value added for the nongovern
ment sector as a denominator, we produce the
uniform ad valorem tax rates necessary to raise
equivalent business tax revenues in District
states (table 3). These figures show that a
business tax rate running between 1.5 percent
and 2.5 percent of value added would generate
the revenue equivalent of all state-local busi
ness taxes, based on data for 1992.
These rates are low compared with the
statutory rates now on the books for taxing
corporate income, gross receipts, sales on inter
mediate inputs, and the like. These low rates
reflect the much broader basis of taxation im
plied by using value added as a tax base. Us
ing value added would go a long away toward
avoiding the skewness of the present system of
state-local business taxation which tends to
assess many service firms lightly (even though
the service sector has become a much larger
share of nominal output).
We would expect these low rates to miti
gate state-local concerns over competitive
fiscal disadvantages arising for certain capitalintensive industrial sectors. Remaining rate
11
Also, they focus almost exclu
sively on taxes on business capital
Taxes as a percentage of nongovernment
and
profits taxes, overlooking
gross state product
important differentials in taxes
Hypothetical
Current
paid by business firms on their
Region
business taxes
business taxes
intermediate purchases and on
their
payroll.
3.1%
1.8%
U.S.
By
incorporating all taxes
New England
2.9
1.6
3.4
1.9
M id-Atlantic
directly affecting business and
3.2
1.7
East North Central
taking into account the costs of
West North Central
2.8
1.8
government services offered to
2.7
1.9
South Atlantic
the business community, our
2.5
1.6
East South Central
approach offers a more compre
1.6
West South Central
3.3
hensive measure of the business
M ountain
3.1
2.1
tax climate. It also enables us to
1.9
Pacific
3.1
detect important disparities in the
3.4
business tax base. While it is true
Seventh District
1.8
Illinois
3.6
1.8
that other properties of a state’s
2.9
Indiana
1.3
fiscal system, such as personal
3.5
2.2
Iowa
taxes and expenditure on educa
Michigan
3.3
1.8
tion, may influence business
W isconsin
3.2
2.3
profitability, without a complex
general
equilibrium model, such
Note: Gross state product (GSP) is net of government GSP.
Source: Staff calculations based on data provided by the
effects are difficult to quantify.
U.S. Department of Commerce, Bureau of the Census,
The absence of such a complete
Governments Division and state fiscal agencies.
model also rules out the accurate
assessment of the marginal fiscal
climate. Given these limitations, the best we
differences would become smaller as the tax
can do is compare the average fiscal climate of
burden is spread over more industries. The tax
competing states.
rates would need to be cut in half if the stateBecause of their relative simplicity and
local sector were to bring business expendi
transparency, our measures offer a useful alter
tures into line with public expenditures directly
native to complex cost-of-capital models for
benefiting the business sector. More impor
tax analysts in state capitols, whose job it is to
tantly, remaining tax rate differences would
enlighten legislators on the possible conse
come to reflect differing public service needs
quences of alternative business tax policies.
among states as reflected by industry mix.
With regard to competitive tax climates in
Remaining tax rate differences might also
particular, firms may prefer regions that offer a
reflect different regional approaches to devel
level and mix of business services for which
opment policy as some states and local com
the business community pays a proportionate
munities, perhaps acting in partnership with
price and where household expenditures are
their business communities, choose to offer
not subsidized by general business taxes. Tax
differing levels, mix, and delivery of public
ing business in line with business services can
inputs to private production.
also help the voting public choose the best
Conclusion
levels and mix of publicly provided goods and
It should be acknowledged that our ap
services. Voters and their elected representa
proach to business location neutrality departs
tives will be able to perceive the accurate price
sharply from the rate-of-return approach in
signals for these goods. A dynamic dialogue
recent studies of state business tax climates.20
between the business community and govern
These studies examine how the financial re
ment services providers can develop which
turns on investment are influenced by state and
can, in turn, stimulate income creation or quali
local tax structures. As such, they inherently
ty of life improvements in those regions that
deny the value of government services that
choose to follow the benefits principle.
may accrue to businesses at different sites.
12
TABLE 3
ECONOMIC PERSPECTIVES
APPENDIX
Methodology fo r business taxes
and expenditures
Taxes
Unemployment insurance tax—Taxes are im
posed by both the federal and state governments
on the basis of payroll of those workers covered
by unemployment insurance. We report state
collections only, as reported by the Governments
Division, Bureau of the Census, U.S Department
of Commerce.
General sales tax collected from business—
The hybrid nature of the sales tax as consumerbusiness tax presents formidable obstacles in distin
guishing the business sector’s share of revenues
from that of consumers. State revenue departments
typically report data by type of store or vendor
from which the sale takes place, with no informa
tion about the buyer. The existence and variety of
exemptions and partial exemptions for business
purchases further complicates the matter, as does
the varying exemption and coverage of certain
consumer items, such as food, clothing, and pre
scription drugs.1
One estimation method has been to survey
vendors within a state as to their thoughts on who
purchases their taxable sales (Fryman 1969; ACIR
1981). Another method applies sales tax rates to
government-reported data of consumer expendi
tures; the residual represents an estimate of busi
ness and tourist payments of the sales tax (Ring
1989; Blume 1983). Other studies use interindustry
relationships, perhaps as reported in input-output
models, to estimate the volume of business pur
chases subject to states sales taxation (DeBoer
1992; KPMG Policy Economics Group 1993),
while other estimates are derived from reported
collections by type of vendor (DeBoer 1992; Oak
land 1992).
Our estimates take a decidedly conservative
approach, based on the Fryman and ACIR esti
mates. We adjust and update those earlier esti
mates by examining changes in tax-base coverage
that have occurred over time. For these changes,
the business share of the sales tax intake is adjusted
by regression elasticities, which capture the sensi
tivity of sales tax revenues to specific tax exemp
tions, such as that on industrial machinery and
equipment in Illinois during the 1980s.
Estimates of the business sector’s share of state
sales tax revenue collections are applied to Census
Bureau figures of general sales tax collections at the
state-local level for fiscal 1991-92 to arrive at esti
mates of sales tax paid by businesses. By our esti
mates, the sales tax comprised 14.4 percent of statelocal business taxes in the U.S. in fiscal year 1992.
The corresponding share in the Seventh District lies
close to this estimate at 11.6 percent, with Indiana’s
20.2 percent share being the highest among District
FEDERAL RESERVE
BANK OF CHICAGO
states. Michigan’s relatively low 7.8 percent share for
1992 has increased since that year; Michigan raised its
state sales tax from 4 percent to 6 percent in 1994.
Corporate income tax—These collection figures
are reported by the Census Bureau for fiscal 199192 and, within the Seventh District, all collections
derive from state taxes. Michigan imposes its single
business tax on the business activity or value added
of businesses operating within the state, rather than
on corporate net income. Indiana is one of only
three states in the nation that taxes gross receipts of
corporations rather than net income. The Indiana tax
is levied on the greater of tax due from gross receipts
or an alternative tax on corporate net income. In
some 22 states, taxes are also levied on capital stock
or net worth, and then sometimes under a corporate
franchise tax. Illinois imposes corporate levies on
capital stock or net worth, which may be termed
corporate franchise taxes.
Property tax—Beginning with a 1963 study, the
U.S. Advisory Commission on Intergovernmental
Relations began estimating property taxes paid by
commercial, industrial, and agricultural enterprises.
These estimates are based on tables of assessment
and collection values reported at five-year intervals
by the Census o f Governments. We depart from that
practice and instead use property tax collections as
reported by individual state fiscal agencies for
business classes of property in the Seventh District.
For Michigan only, such collections by class must
be estimated.
Taxation of real property is predominantly im
posed by local governments rather than by state
governments. Because tax rates are usually applied
in an even fashion to classes of property, and be
cause business property comprises a substantial
portion of real estate, a sizable share of the local
property tax falls on business property.2 The gross
assessed value of commercial, industrial, and acre
age combine to account for one-third of all value
(commercial and industrial combined account for
one-fourth).3
The practice of taxing personal property (non
realty tangible property) of business firms can also
be a great concern for those firms making heavy use
of industrial machinery and equipment, and firms
that own significant stocks of tangible inventory.
Over time, most states have moved toward exempt
ing tangible personal property of both firms and
households, as Illinois did across the board in 1979.4
Most district states liberally exempt business person
al property or are moving in that direction.
Business licenses and fees—We follow the ACIR
practice of including fees and taxes imposed on the
right to do business, at the state or local level.
These data are collected and grouped by the Gov
ernments Division of the Bureau of the Census.
13
Taxes on broad-based inputs to production—We
exclude selective taxes such as those levied on
tobacco, alcohol, and amusement. Presumably,
these are intended to be shifted forward to consum
ers, or their taxation is intended to discourage the
activity rather than to act as a broad-based payment
for government services rendered. Likewise, taxes
on specific industries, such as motel/hotel or sever
ance taxes, are not broad-based business taxes but
are intended to discourage or compensate for dam
ages imposed on the state or local community. In
contrast, we do include the following selective sales
taxation of items which are broadly purchased as
intermediate inputs by the business community:
Insurance—Most states tax the premiums on
insurance sold in the state. Since businesses
broadly purchase insurance, we estimate the
business sector’s share of such purchases in
allocating total insurance premium tax collec
tions. The sector’s share is calculated for re
ported premiums sold by in-state companies to
other businesses in each of the respective states.
Such estimates are provided courtesy of the
Regional Economics Applications Laboratory,
which is a joint venture between the Federal
Reserve Bank of Chicago and the University of
Illinois at Urbana-Champaign. We average the
latter estimates with groupings of insurance
premiums sold by type for each state, making
reasonable assumptions concerning likely types
of insurance purchased by the business sector
versus the household sector. In contrast, ACIR
estimates typically include total insurance pre
miums, including those sold to households.
Motor fuels taxes—Following DeBoer (1992),
we estimate motor fuel purchases by the business
sector as opposed to households in allocating
revenues collected. These data are collected and
grouped by the Governments Division of the
Bureau of the Census.
Public utility gross receipts taxes—The busi
ness portion of revenues is allocated using data
on investor-owned public utilities. The Statistical
Yearbook o f the Electric Utility Industry reports
gross receipts derived by sector, household ver
sus commercial and industrial sector. These data
are collected and grouped by the Governments
Division of the Bureau of the Census.
state and local—are excluded. Such expenditures
become expenditures of those governments where
the funds come to rest. Since we are interested
only in those expenditures made by state-local
government, federal grant monies by function are
netted out of these same functional expenditures.
Similarly, revenues derived from user charges and
fees (such as college tuition and roadway tolls) are
netted out of appropriate expenditures made by
state-local government. The remainder represents
those direct expenditures by function that are fund
ed by state-local own-source tax revenues.
Two categories of expenditures must be allocat
ed. “Shared” expenditures are those for which little
information on benefits to business versus house
holds are available, for example, police, fire, tran
sit, sewerage, sanitation, and parking. For these, a
liberal 50 percent is allocated to the business sector.
Those expenditures representing general gov
ernment overhead, such as all financial administra
tion services, all general public buildings, all other
miscellaneous government, interest on general debt,
all legislative, and other-unallocable, are assigned
to the business sector on a prorated basis. The
proration reflects the share of business expendi
tures, plus shared business expenditures to total
direct expenditures (net of prorated expenditures).
Other categories of spending are allocated di
rectly to the business or to the household sector.*234
'For state-by-state coverage of consumer items in the sales
tax base, see ACIR (1994).
2The practices under which tax rates and/or property
assessment ratios vary by type of property is called classi
fication. Only a handful of states authorize classification.
Among the five district states, classification is authorized
only for Cook County, Illinois. There, commercial and
industrial property is assessed at a rate more than double
that for single-family residential properties.
Of course, there are many selective tax abatements that
can be applied (usually on commercial properties) at the
discretion of local governments (which may be acting on
economic development concerns). So too, state property
tax systems often contain “circuit breakers” and “exemp
tions,” which exclude assessed value or offer tax reduc
tions to classes of residential taxpayers, such as the elder
ly, the poor, or veterans. See ACIR, ibid.
Expenditures
3See table 4, U.S. Department of Commerce, Bureau of
the Census (1987).
Expenditures by function are reported annually
by the Governments Division of the Bureau of the
Census, U.S. Department of Commerce. Total
direct expenditures by function include all pay
ments to employees, suppliers, contractors, benefi
ciaries, and all other final recipients of government
payments. Intergovernmental expenditures—
payments and grants to other governments between
4U.S. Department of Commerce, Bureau of the Census
(1988) reports in table 2 (p. 4) that personal property
comprises 10.3 percent of locally assessed property (not
all of which is business property). State-assessed property
also includes personal property in some states, especially
that belonging to public utilities. However, in total, stateassessed property (real and personal) comprised only 5
percent of overall state-local gross assessed value in 1987.
14
ECONOMIC PERSPECTIVES
APPENDIX TABLE A
Seventh District share of state-local expenditures allocated
to businesses and households, FY1992
( m i l l i o n s o f dollars)
Spending
category
Households
Prorated
household
Shared
household
Business
Prorated
business
Shared
business
$35,968
753
8,706
4,011
803
17
$35,968
Education
753
Libraries
W e lfa re
8,706
H ealth
4,011
803
H ospital
V e te ra n services
N a tu ral resources
(fish + fo restry )
Total
17
Parks and recreation
1,729
155
1,729
H ousing and
c o m m u n ity
d e v e lo p m e n t
1,120
1,120
U n e m p lo y m e n t
insurance
4,467
155
7
4,467
7
N a tu ral resources ag ricu ltu re
341
341
N a tu ral resou rces n.e.c.
434
434
W a te r tra n s p o rt
Financial
a d m in is tra tio n
G eneral public
building s
1,775
285
2,060
645
103
749
G eneral in terest
on deb t
4,988
799
5,787
O th e r g o v e rn m e n t
a d m in is tra tio n (L+CS)
1,313
210
1,523
All o th e r and
un a llo cab le
3,072
3,564
52
492
26
A ir tra n s p o rta tio n
T ran s p o rta tio n
sub sidies
H ig h w ays
26
9
9
3,619
3,619
56
56
Parking
891
891
Police
2,185
2,185
C orrections
Fire p rotectio n
19
7,238
113
1,782
4,370
3,106
1,717
1,553
1,553
Ju d icial
859
859
P rotective inspection
and reg u latio n
276
276
Sew age
626
626
553
1,252
Solid w aste
m anagem ent
542
542
1,084
M isc e lla n e o u s
fed eral grants
(555)
(1,111)
Total
57,729
11,794
10,087
(555)
782
1,890
10,088
92,370
Share of total
62.5%
12.8%
10.9%
0.8%
2.0%
10.9%
100.0%
Total household share
86.2%
Total business share 13.8%
Note: Columns may not add up due to rounding.
Source: Staff calculations based on data from U.S. Department of Commerce, Bureau of the Census, Governm ents Division.
FEDERAL RESERVE
BANK OF CHICAGO
15
APPENDIX TABLE B
Business taxes: A comparison of measurements, F Y 1 9 9 2
ACIR
method
Total
Property
Sales
Corporate
income
Insurance
U tility
Unemploym ent
—............ millions o f dollars —
<-------
Motor
fuel
■...........)
Illinois
7,945
3,285
1,135
970
198
1,171
922
0
Indiana
3,200
1,461
642
755
123
0
180
0
Iowa
1,382
6374
204
193
97
6
150
0
Michigan
6,934
3,111
550
1,730
178
44
1,113
0
Wisconsin
2,478
939
241
438
69
254
359
0
Seventh
District
21,939
9,433
2,772
4,086
665
1,475
2,724
0
Oakland/
Testa
Total
Property
Sales
Corporate
income
Insurance
Utility
Unemploym ent
--------- )
------------- millions o f dollars—-
(-------
Motor
fuel
Illinois
9,670
5,284
1,135
970
83
649
922
480
Indiana
3,191
1,305
642
755
64
0
180
217
Iowa
1,819
1,003
204
193
50
3
150
133
Michigan
5,994
2,063
550
1,730
92
23
1,113
298
Wisconsin
3,142
1,532
241
438
36
131
359
228
23,816
11,187
2,772
4,086
324
806
2,724
1,355
Seventh
District
Note: Figures may not add up due to tax categories omitted from this table.
Source: Staff calculations based on data from U.S. Department of Commerce, Bureau of the Census, Governm ents Division.
NOTES
'If the tax cannot be shifted forward, then this procedure
is flawed. For example, if a state levies a sales tax on
petroleum products refined in a particular state, and the
price of refined products are determined in world markets,
the tax would have to be added to the firm’s cost of doing
business within that state. Fortunately, such situations are
not commonly the case.
2For small states, however, this point is more telling.
Business owners in the New York metropolitan statistical
area may have the option of relocating their businesses in
several states, making the issue of personal income taxes a
relevant factor in the location decision. However, this is
mitigated by the common practice of crediting taxes paid
by host states.
3These issues are dealt with at greater length in Oakland
(1992).
4Indeed, the motor vehicle fuels tax could be treated under
either rubric. It could be viewed as a user charge for the
wear and tear and highway congestion associated with
business transportation. However, fuel consumed is not a
good measure of general environmental costs, such as
congestion and other nonpriced costs. Accordingly, we
choose to treat motor fuels tax revenues as part of general
business taxation.
16
5In many instances the administrative cost advantages are
exaggerated because they include costs shifted from
government to the taxpayer.
6A substantial body of empirical studies provide evidence
that voters respond to the perceived cost (that is, “tax
price”) in making public expenditure decisions (see
Rubinfeld 1985).
7Typically a three-factor formula is employed for such
purposes: payroll, capital investment, and sales. States
with few production facilities often put heavy, sometimes
exclusive, weight on the sales factor to capture a larger
share of the profits of multistate corporations. Multistate
corporations in Iowa can use sales by destination as the
sole factor in apportioning taxable income.
8Now, the main objective may be to stem the outflow of
gambling money to other jurisdictions or, in effect, to
reduce tax importing.
9One might think that if all states adopt the practice, there
will be no such “other” market; hence the firm will have
to absorb the tax. However, from the taxing state’s
vantage point, the policies of other states are irrelevant.
In the case under discussion, local residents would enjoy
lower prices than consumers elsewhere if the tax were not
imposed.
ECONOMIC PERSPECTIVES
"'If the superior resource provided competitive advantages
to all production activities within the jurisdiction, a
general tax might be in order. This might be true for
certain local governments— for example, cities with
outstanding harbors. However, even here the ubiquitous
ness of the advantage is questionable.
"While the business community can exert political influ
ence, only individuals can vote. Therefore, support for
desirable business services requires that voters not per
ceive a fiscal loss.
l2Of course, if other jurisdictions do not implement the
benefit principle, this neutrality would be vitiated.
uFor details see Greco, Oakland, and Testa (forthcoming).
l4Our finer measurements are carried out, not for each
region, but only for the states in the Seventh District.
l5The state of Michigan has since reduced its reliance on
property taxes and hiked its reliance on general sales taxes
for funding elementary and secondary education in the
state. However, we do not believe that overall reliance on
taxes imposed on the business sector has changed; proper
ty tax reductions, if any, have probably been offset by
increased business tax payments made under the state’s
now-higher sales tax rate. See Courant, Gramlich, and
Loeb (1995). A reduction in property taxes in Wisconsin
is also imminent, but the sources of revenue compensation
have not yet been decided.
l6States may be implicitly changing the nature of their
corporate taxes away from “profits or capital” taxes and
toward a type of sales or import tax. Specifically, states
have been changing the formulas by which they allocate
the tax base of multistate companies. By “double-weight
ing” the allocation factor which counts the proportion of
the firm’s sales that are in-state, the corporate income tax
implicitly taxes the sales of out-of-state firms that are
being sold in the home state. That is, the tax liability
correlates, not with firm profits, but with sales of imports
into the home state. To the extent that the firm sells to a
national market, such a tax would tend to raise the price
of the goods sold in the home state.
l7The single business tax (SBT) is levied on a tax base of
value added for firms in the state, calculated by adding
factor payments including interest paid, business income,
depreciation, and labor compensation. The tax base
deviates from value added by origin in that multistate
firms are allowed to apportion business activity according
to a formula that gives 50 percent weight of the taxable
base to the firm’s Michigan share of sales to total sales
nationwide, and 25 percent weight each to the Michigan
location of firm property and payroll. Other reductions or
credits involve small firms, low-profit small firms, and all
firms characterized by labor compensation bills which
exceed 63 percent of the tax base. See Citizen’s Research
Council of Michigan ( 1995). The state previously im
posed another form of the tax, the business activities tax,
from 1953 to 1967.
'"Value-added taxes are used by many countries, and a
lively debate is now under way in the U.S. over whether
to impose the tax at the national level. Such a tax would
likely differ in intent and structure from that envisioned
herein for state governments. A national tax in the U.S. is
often envisioned as a “consumption-type” value-added
tax, a national sales tax which would be imposed on
consumption and might be designed to replace some
existing revenue sources to encourage national savings
behavior. In contrast, the tax base for state value-added
taxation could include capital consumption, thereby
relating more closely to business benefits received as
reflected in total business activity in a state.
In many other countries, value-added taxes were enacted
to eliminate significant imbalances in “turnover” type
taxes, which tended to tax the gross receipts of firms at
each stage of production.
'These value-added data by industry sector are derived by
both the addition method and the substraction method.
See U.S. Department of Commerce, Bureau of Economic
Analysis (1985). Gross state product is equivalent in
concept to national gross domestic product (which includ
ed capital consumption and indirect taxes in its defini
tion).
20Such studies often follow the “rate-of-return” approach
developed by James Papke. For example, see Tannenwald (1993).
REFERENCES
Aaron, Henry, “Differential price effects of a
value-added tax,” N a tio n a l Tax Journal, Vol. 21,
No. 2, June 1968, pp. 162-78.
_______________ , “State-local taxes with an initial
impact on business,” R eg io n a l G row th: In tersta te Tax
C om petition, Washington, DC: ACIR, March 1981,
pp. 61-77.
Advisory Commission on Intergovernmental
Relations (ACIR), “State-local taxation and in
dustrial location,” Washington, DC: ACIR, 1967.
_____ ,
_______________, “The Michigan single business
tax: A different approach to state business taxation,”
Washington, DC: ACIR, 1978.
_____ ,
FEDERAL RESERVE
BANK OF CHICAGO
S ig n ifica n t F ea tu res o f F iscal
Washington, DC: U.S. Government
Printing Office, 1988.
F ederalism ,
S ig n ifica n t F ea tu res o f F iscal
Washington, DC: U.S. Government
Printing Office, 1993.
F ederalism ,
17
_____ ,
S ig n ifica n t F eatures o f F iscal
Washington, DC: U.S. Government
Printing Office, 1994.
F ederalism ,
Bartik, T., "The effects of property taxes and other
local public policies on the intrametropolitan pat
tern of business location,” in In d u stry L ocation and
P ublic P olicy, Henry Herzog and Alan Schlottman
(eds.), Knoxville, TN: Univ. of Tennessee Press,
1991, pp. 57-80.
Fryman, R., “Sales taxation of producer’s goods in
Illinois,” N a tio n a l Tax J o u rn a l, Vol. 12, No. 2,
June 1969, pp. 273-281.
Greco, J., W. Oakland, and W. Testa, “Statelocal business taxation in the Seventh District,”
Federal Reserve Bank of Chicago, regional working
paper, forthcoming.
Insurance Information Institute. 1992 Property
1993, pp. 34-40.
/
C asualty Insurance Facts,
Blume, L., “The sales and use taxes,” in M ich ig a n 's
Harvey E. Brazer
and Deborah S. Laren (eds.), Ann Arbor. MI: Uni
versity of Michigan Press, 1983, pp. 595-619.
F iscal a n d E conom ic Structure,
CCH, Incorporated, Sta te Tax H andbook as o f
Chicago: CCH, Incorporated,
December 1994.
D ece m b e r 31, 1994,
Citizens Research Council of Michigan, O utline
18th ed., report. No.
315, July 1995.
KPMG Policy Economics Group, A Study o f the
Iow a S tate a n d L o a d Tax S tru ctu re, Report submit
ted to the Tax Equity and Fairness Study Commit
tee—General Assembly of Iowa, January 1993.
Oakland, W. H„ “How should business be taxed?”
in S tate Taxation o f B usiness: Issu es a n d P olicy
O ptions, Thomas Pogue (ed.). National Tax Associ
ation, 1992.
o f the M ichigan Tax System ,
Congressional Budget Office, F ederal Taxation o f
Tobacco, A lc o h o lic B evera g es a n d M o to r F uels,
Papke, James A., and Leslie E. Papke, “The
competitiveness of Indiana’s business tax struc
ture,” in In d ia n a 's R even u e S tru ctu re, James Papke
(ed.), Lafayette, IN: Purdue University, 1983.
August 1990.
Courant, Paul N., Edward Gramlich, and Sussana Loeb, “A report on school finance and educa
tional reform in Michigan in 1995,” in M idw est
A p p ro a c h es to S ch o o l R eform , T. Downes and W.
Testa (eds.), Chicago: Federal Reserve Bank of
Chicago, 1995, pp. 5-33.
DeBoer, L., “Shares of major Indiana taxes paid by
businesses and individuals, 1991,” Report prepared
for the Commission on State Tax and Financing
Policy, 1992.
Due, John, and J. Mikesell, S a les Taxation: S ta te
a n d L o c a l S tru c tu re a n d A d m in istra tio n , 2nd ed.,
Washington, DC: Urban Institute Press, 1995,
pp. 1-106.
Ebel, Robert D., The M ich ig a n B u sin ess A ctivities
Tax, V a lu e-A d d ed in a S u b n a tio n a l E conom y, East
Lansing, MI: Michigan State University Business
Studies, 1972.
Ebel, Robert D., and Janies A. Papke, “A closer
look at the value-added tax,” P roceedings o f the
Sixtieth A n n u a l C onference o f the N a tio n a l Tax
A sso c ia tio n -T a x In stitu te o f A m erica , Columbus,
OH, 1967, pp. 155-170.
Edison Electric Institute, S ta tistic a l Y earbook o f
the E le c tric U tility In d u stry 1992, Washington,
Papke, L., “Interstate business tax differentials
and new firm location: Evidence from panel data,”
J o u rn a l o f P u b lic E co n o m ic s, Vol. 45, 1991,
pp. 47-68.
Parker, Robert P., “Gross state product by indus
try, 1977-90,” S u rvey o f C urrent B usiness, Vol. 73,
No. 5. May 1993, pp. 33-54.
Pogue, T., S ta te T axa tio n o f B u sin ess: Issu e s a n d
P o lic y O ptions, National Tax Association, 1992.
Ring, R., “The proportion of consumers’ and pro
ducers’ goods in the general sales tax,” N atio n a l
Tax J ournal, Vol. 42, No. 2, 1989, pp. 167-179.
______________ , “Consumers’ share and produc
ers’ share of the general sales tax,” Presented to the
National Tax Association Annual Conference on
Taxation, St. Paul, MN, mimeo, 1993. (Do not cite
without permission.)
Rubinfeld, D.L., “The economics of the local
public sector,” in H an d b o o k o f P u b lic E conom ics,
J. Auerbock and M. Feldstein (eds.), Vol. 2, New
York: North-Holland, 1985.
Stocker, Frederick D., “State and local taxation of
business: An economist’s viewpoint,” B usiness
Taxes in S ta te a n d L o c a l G o vern m en ts, Lexington,
MA: Lexington Books, 1972, pp. 37-46.
DC, 1992.
18
ECONOMIC PERSPECTIVES
Studenski, Paul, “Toward a Theory of Business
Taxation,” J o u rn a l o f P o litic a l E co n o m y , Vol. 68,
October 1940, pp. 621-654.
_____ ,
C om pendium o f G overn m en t
F in a n c es : 1977, Vol. 4,
m ent, Washington, DC:
No. 5 of C ensus o f G o v ern
U.S. Government Printing
Office, 1978.
Tannenwald, R., “Massachusetts tax competitive
ness: Working paper prepared for the Massachu
setts Special Commission on Business Tax Policy,”
Massachusetts Special Commission, April 1993.
Tax Foundation, F acts & F igures in G overnm ent
F inance, 1992 E d itio n , Washington, DC, 1992.
_____ ,
G o vern m en t F in a n c es: 1986-
Washington. DC: U.S. Government Printing
Office, No. GF/92-5P, 1988.
87,
_____ ,
G o vern m en t F in a n c es: 1991-92
(P relim in a ry R eport), Washington, DC: U.S. Gov
ernment Printing Office, No. GF/92-5P, 1994.
Tax Institute, Inc., H ow Should C orporations be
Taxed? Proceedings from a symposium conducted by
the Tax Institute, New York, NY, 1946.
_____ ,
A R eappraisal o f B usiness Taxa
Proceedings from a symposium conducted by
the Tax Institute, Princeton, NJ, 1961.
tion,
Tax Policy League, Inc., H o w S h a ll B usiness Be
Taxed? Proceedings from a symposium conducted
by the Tax Policy League, 1936.
U.S. Department of Commerce, Bureau of the
Census, A sse sse d V aluations f o r L o ca l G eneral
P roperty T axation, Vol. 2, No. 1 of 1987 C ensus o f
G overnm ents, Washington, DC: U.S. Government
Printing Office, 1988.
_____ ,
S tate G o v ern m e n t F in a n c es
:
Washington, DC: U.S. Government Printing
Office, No. GF/89-3, 1988.
1987,
_____ ,
S ta te G o v ern m e n t F in a n c e s
:
Washington, DC: U.S. Government Printing
Office, No. GF/92-3, 1993.
1992,
U.S. Department of Commerce, Bureau of Eco
nomic Analysis, “Experimental estimates of gross
state product by industry,” staff report. No. SP85042, May 1985.
Wheaton, W., “Interstate differences in the level of
business taxation,” N a tio n a l Tax Jo u rn a l, Vol. 36,
No. 1, March 1983, pp. 83-94.
_____ ,
A sse sse d V aluations f o r L ocal
G eneral P roperty Taxation, Vol. 2, No. 1 of 1992
C ensus o f G overnm ents, Washington, DC: U.S.
Government Printing Office, 1994.
FEDERAL RESERVE
BANK OF CHICAGO
19
Rethinking Banl
The 32nd annual Conference on
Bank Structure and Competition
Federal Reserve Bank of Chicago
M a y 1-3, 1996
On May 1-3, 1996, the Federal
Reserve Bank of Chicago will hold
its 32nd annual Conference on Bank
Structure and Competition at the
Westin Hotel in Chicago.
The major theme of this year’s
conference will be an in-depth
evaluation of bank regulation. The
conference will address some of
the most fundamental public policy
issues facing the financial services
industry today, including systemic
risk, optimal merger activity, bank
product powers, and regulatory
reform.
Historically, the American pub
lic has been concerned about banks
power, asymmetric information, or
market externalities—which may
make the economy more vulnerable
to systemic crises. The question
then is whether the financial services
sector requires regulation to sup
press market forces. Are potential
market failures so pronounced that,
left to their own devices, the finan
cial markets would generate highly
inefficient and inequitable distribu
tions of resources?
If the answer is yes, then what is
the optimal regulatory design? How
can regulation address these failures,
complementing or limiting market
forces as necessary? Can the goals
Can regulators use market informa
tion to regulate banks more effec
tively? Is regulator information
superior to that of the marketplace?
The 1996 conference will fea
ture discussions of these policy is
sues by some of the industry’s most
prominent participants. Featured
speakers include Alan Greenspan,
Chairman of the Board of Governors
of the Federal Reserve System, and
James Leach, Chairman of the U.S.
House of Representatives Banking
Committee. Theme and special
session participants include Thomas
Brown, Donaldson, Lufkin, and
Jenrette; John Hawke, U.S. Treasury
Regulation: What Should Regulators Do?
becoming excessively large and
wielding significant market power.
In response to this concern and oc
casional turbulence in financial mar
kets, banks have been regulated in
nearly all aspects of their operations.
However, in the last two decades
bank regulation has been deemed
excessive, and a number of laws
have been implemented to deregu
late the industry. Still, many argue
that the term “deregulation” is a mis
nomer and that, as one of the more
extensively regulated industries in
the U.S., banking continues to be
excessively constrained.
The conference will evaluate the
rationale, intent, and consequences
of bank regulation. For example,
economists typically argue that regu
lation can be beneficial when market
failure causes inefficient resource
allocation. This may happen be
cause of concentration of market
of regulation be identified and can
regulations be tied to specific market
failures? How effective are regula
tions in achieving their objectives?
Are there unintended consequences?
Do existing regulations decrease or
exacerbate market concentration
and externalities?
If specific regulations are appro
priate, what then is the optimal regu
latory structure to achieve the stated
goals? Should regulation be institu
tion-, industry-, or function-based?
Should a single regulator supervise
the financial services industry? If
not, how much cooperation should
there be among domestic regulators
and among international regula
tors? Should supervisory powers
be used to direct industry behavior
or should market information be
used to discipline bank behavior?
How can regulators be held account
able for their supervisory decisions?
Department; and Edward Kelley,
Board of Governors of the Federal
Reserve System.
The first day of the conference,
intended primarily for an academic
audience, will focus on technical
research papers. The Thursday and
Friday sessions will appeal to a more
general audience.
Invitations to the conference
will be mailed in March 1996. If you
are not currently on the conference
mailing list or have changed address
and would like to receive an invita
tion, please contact the Meeting and
Travel Services Department of the
Federal Reserve Bank of Chicago at
312-322-5186, or mail your request
to Public Affairs Department,
3rd Floor, Federal Reserve Bank
of Chicago, P.O. Box 834, Chicago,
Illinois, 60690-0834.
Some comments on the
role of econometrics in
economic theory
M a rtin E ich en baum
In this article, I offer some
comments on the role of
econometrics in macroeco
nomics.1 These reflect a spe
cific perspective: The role of
econometrics ought to be the advancement of
empirically plausible economic theory. This is
a natural perspective for any economist to take,
but it is one that is particularly compelling for
a macroeconomist. Lucas’ (1976) critique of
econometric policy evaluation aside, it seems
obvious that most policy questions cannot be
fruitfully addressed using traditional quasireduced form econometric models. In the end,
there are no alternatives to the use of fully
specified general equilibrium models for ad
dressing many of the problems that interest
macroeconomists.
The real issue is: Different fully specified
general equilibrium models can generate very
different answers to the same question. Indeed
it is possible to work backwards from any
answer to some model. So given a particular
question, which model should a macroecono
mist use? Developing the tools to answer this
question is the key challenge facing econome
tricians. Because all models are wrong along
some dimension, the classic Haavelmo (1944)
program of testing whether models are “true”
will not be useful in meeting this challenge.2
We do not need high-powered econometrics to
tell us that models are false. We know that.
What we need to know are the dimensions
along which a given model does well and the
dimensions along which it does poorly. In
Learner’s (1978) terminology, we need a
2 2
workable version of “specimetrics” that is
applicable to dynamic general equilibrium
models.3 Developing the diagnostic tools for
this specimetrics program ought to be the pri
mary occupation of econometricians, not de
veloping ever-increasingly sophisticated tools
for implementing the Haavelmo program.
The need for progress on this front is
pressing. General equilibrium business cycle
analysts have begun to move beyond their
initial practice of assessing models on a small
set of moments without a formal statistical
methodology.4 Real business cycle (RBC)
theory is evolving to accommodate a wide
variety of impulses to the business cycle, in
cluding shocks to fiscal and monetary policy.
But the process is in its infancy. The ultimate
success of the enterprise will depend on the
willingness of econometricians to devote more
energy to the development of diagnostic tools
for structural models and less to the develop
ment of estimators for the parameters of re
duced form systems and increasingly powerful
tests of null hypotheses, such as The model is
a literal description of the data-generating
mechanism’.
What is at stake for econometricians in all
this? Why should they care about the needs of
macroeconomists? Because, as social scientists,
Martin Eichenbaum is a professor of economics
at Northwestern University and a senior consult
ant to the Federal Reserve Bank of Chicago. The
author is grateful to Craig Burnside, Larry Christiano, John Cochrane, Ian Domowitz, Jonas Fish
er, Lars Hansen, Joel Mokyr, and Tom Sargent for
their comments.
ECONOMIC PERSPECTIVES
their product has to meet a market test. There
is no point in producing elegant merchandise
that is buried in the inventory of advanced
econometrics textbooks. Unfortunately, this
happens all too often. To many young macro
economists, econometrics seems irrelevant.5
To remedy the situation, econometricians need
to write instruction manuals for their products
in a language that their customers understand.
The language of economists centers on objects
like agents’ criterion functions, information
sets, and constraints.6 Consequently, econome
tricians need to focus their efforts on develop
ing tools to obtain information about those
objects. To the extent that they concentrate on
analyzing the parameters of reduced form
representations of the data or devising tests of
whether specific structural models are false,
their output is likely to be ignored by most of
their (macro) colleagues.
This is not to suggest that there is no room
for specialization in research or that econome
tricians should not engage in basic research
and development. No one knows in advance
which tools will be valuable in applied re
search. Still, the paradigm within which
econometricians operate affects the types of
tools they are likely to develop. The fact is
that economists need to work with false struc
tural models. It follows that econometricians
need to abandon the Haavelmo paradigm and
adopt one that more closely captures the ongo
ing dialogue between theory and data.7
B uilding c o n fid en c e in m odels
Focusing on the task of evaluating the
effects of alternative policy rules is one way to
make concrete the ongoing interaction between
theory and data that marks actual practice in
macroeconomics. With data drawn from other
wise identical economies operating under dif
ferent policy rules, we could easily dispense
with economic theory. Such data are not avail
able. And real world experimentation is not an
option. We can perform experiments only in
structural models. Indeed, Lucas (1980) argues
that one of the critical functions of theoretical
economics is to provide fully articulated eco
nomic systems. These systems can serve as
laboratories in which policies that would be
prohibitively expensive to experiment with in
actual economies can be tested.
This sounds fine in principle. But which
fully articulated economic system should we use?
FEDERAL RESERVE
BANK OF CHICAGO
Lucas suggests that we
test models as useful imitations of
reality by subjecting them to shocks
for which we are fairly certain how
actual economies, or parts of econo
mies, would react. The more dimen
sions on which the model mimics the
answers actual economies give to
simple questions, the more we trust
its answers to harder questions.
(“Methods and problems in business
cycle theory,"Journal o f Money,
Credit and Banking.)
The problem with this advice is that Lucas
doesn’t specify what “more” and “mimics”
mean or how we are supposed to figure out the
way an actual economy responds to an actual
shock. But absent specificity, we are left won
dering just how to build trust in the answers
that particular models give us. In the remain
der of this article, I discuss two strategies. One
strategy uses exactly identified vector autore
gressions (VARs) to derive the answers that
actual economies give to a simple question and
then to see if structural models reproduce that
answer.8 The specific simple question that
VARs can sometimes answer is: How does the
economy respond to an exogenous shock in
agents’ environments? A different strategy,
the one most RBC analysts have pursued, is to
focus on a model’s ability to account for se
lected moments of the data, like variances and
covariances, that they believe are useful for
diagnostic purposes.
Id e n tify in g th e e ffe c ts o f a c tu a l shocks
to a ctu al econom ies
Without observable exogenous variables,
it is not easy to determine the answers that
real economies give to even simple questions.
Limited progress can be made by combining
historical and institutional knowledge with
exactly identified VARs to isolate empirical
measures of shocks to the economy. Re
duced-form VAR-based exercises cannot
provide answers to hard questions like ‘How
would the economy react to a systematic
change in the Federal Reserve’s monetary
policy rule?’ That’s because they are not well
suited to investigating the effects of systemat
ic changes in agents’ constraint sets. But they
can, in principle, answer simpler questions
like ‘What is the effect of an exogenous shock
to the money supply?’
23
To the extent that complete behavioral
models can reproduce answers that exactly
identified VARs provide, we can have greater
confidence in the behavioral models’ answers
to harder policy questions. Suppose, for exam
ple, that we want to use a particular structural
model to assess the impact of a systematic
change in the monetary authority’s policy rule.
A minimal condition we might impose is that
the model be consistent, qualitatively and
quantitatively, with the way short-term interest
rates respond to shocks in the money supply.
To the extent that the answers from VARbased exercises are robust to different identify
ing assumptions, they are useful as diagnostic
devices. For example, different economic
models make sharply different predictions
about the impact of a shock to monetary poli
cy. Both simple monetized RBC models and
simple Keynesian models imply that interest
rates ought to rise after an expansionary shock
to the money supply. Limited participation
models embodying strong liquidity effects
imply that interest rates ought to fall.9 Bernanke and Mihov (1995) and Pagan and Roberston (1995) review recent VAR-based research
on what actually happens to interest rates after
a shock to monetary policy. The striking as
pect of these papers is how robust inference is
across a broad array of restrictions: expansion
ary shocks to monetary policy drive short-term
interest rates down, not up. This finding casts
strong doubt on the usefulness of simple mone
tized RBC and Keynesian models for address
ing a host of monetary policy issues.
Often, historical and institutional informa
tion can be very useful in sorting out the plau
sibility of different identifying schemes. Just
because this information is not easily summa
rized in standard macro time series does not
mean it should be ignored. Consider the task
of obtaining a ‘reasonable’ measure of shocks
to monetary policy. We know that broad mon
etary aggregates like M 1 or M2 are not con
trolled by the Federal Reserve on a quarterly
basis. So it makes no sense to identify unantic
ipated movements in Ml or M2 with shocks to
monetary policy. Similarly, based on our
knowledge of U.S. institutions, we may have
very definite views about the effects of mone
tary policy on certain variables. For example,
a contractionary monetary policy shock is
clearly associated with a decrease in total gov
ernment securities held by the Federal Reserve.
24
A measure of monetary policy shocks that did
not have this property would (and should) be
dismissed as having incredible implications.
Does this mean that we should only use
VARs to generate results that are consistent
with what we already think we know? Of
course not. In practice we build confidence in
candidate shock measures by examining their
effect on the variables that we have the stron
gest views about. In effect we ‘test’ the re
strictions underlying our shock measures via
sign and shape restrictions on the dynamic
response functions of different variables to the
shocks. When enough of these ‘tests’ have
been passed, we have enough confidence to use
the shock measure to obtain answers to ques
tions we don’t already know the answers to.10
To my knowledge, econometricians have not
yet provided a formal Bayesian interpretation
for this procedure. Such a framework would
be extremely valuable to practitioners.
H o w w e ll does a m o d el m im ic
a d ata m om ent?
Another strategy for building confidence
in models is to see whether they account for
prespecified moments of the data that are of
particular interest to economic model builders.
This strategy is the one pursued by most RBC
analysts. In so doing, they have made little use
of formal econometric methods, either when
model parameters are selected, or when the
model is compared to the data. Instead a vari
ety of informal techniques, often referred to as
calibration, are used.
A key defect of calibration techniques is
that they do not quantify the sampling uncer
tainty inherent in comparisons of models and
data. Calibration rhetoric aside, model param
eter values are not known. They have to be
estimated. As a result, a model’s predictions
are random variables. Moreover, the data
moments that we are trying to account for are
not known. They too have to be estimated.
Without some way of quantifying sampling
uncertainty in these objects, it is simply impos
sible to say whether the moments of a fully
calibrated model are “close” to the analog
moments of the data-generating process. In the
end, there is no way to escape the need for
formal econometric methodology.
Do the shortcomings of calibration tech
niques affect inferences about substantive
claims being made in the literature? Absolutely.
ECONOMIC PERSPECTIVES
The claim that technology shocks account for a
given percent, say X, of the variance of output
amounts to the claim that a calibrated model
generates a value of X equal to
('*',)/<%•
Here the numerator denotes the variance of
model output, calculated under the assumption
that the vector of model structural parameters,
4*, equals 4^ while the denominator denotes
an estimate of the variance of actual output.
The claim that technology shocks account for
most of the fluctuations in postwar U.S. output
corresponds to the claim that X is close to one."
In reality, 4/ | and the actual variance of
output, o~d, have to be estimated. Consequent
ly, A, is a random variable. Eichenbaum (1991)
investigated the extent of the sampling uncer
tainty associated with estimates of X. My
conclusion was that the extent of this uncer
tainty is enormous.12 The percentage of aggre
gate fluctuations that technology shocks actual
ly account for could be 70 percent as Kydland
and Prescott (1989) claim but it could also be 5
percent or 200 percent. Under these circum
stances, it is very hard to attach any importance
to the point estimates of X pervading the litera
ture.
There are a variety of ways to allow for
sampling uncertainty in analyses of general
equilibrium business cycle models. The most
obvious is to use maximum likelihood meth
ods.13 A shortcoming of these methods is that
the estimation criterion weights different mo
ments of the data, exclusively according to
how much information the data contain about
those moments. At a purely statistical level,
this is very sensible. But as decisionmakers we
may disagree with that ranking. We may insist
on allocating more weight to some moments
than others, either at the estimation or at the
diagnostic stage. Different approaches for
doing this have been pursued in the literature.
Christiano and Eichenbaum (1992) use a
variant of Hansen’s (1982) generalized method
of moments (GMM) approach to estimate and
assess business cycle models using prespeci
fied first and second moments of the data.
Ingram and Lee (1991) discuss an approach
for estimating parameter values that minimiz
es the second-moment differential of the actu
al data and the artificial data generated by the
model. Diebold, Ohanian, and Berkowitz
FEDERAL RESERVE
BANK OF CHICAGO
(1994) propose frequency domain analogs, in
which the analyst specifies the frequencies of
the data to be used at the estimation and diag
nostic stages of the analysis. King and Wat
son (1995) pursue an approach similar in
spirit to those mentioned above but geared
more toward assessing the relative adequacy
of competing models with respect to prespeci
fied features of the data.
These approaches share two key features.
First, the analyst has the option of using differ
ent features of the data for estimation and diag
nostic purposes. Second, standard econometric
methodology is used to provide information
about the extent of uncertainty regarding dif
ferences between the model and the data, at
least as these reflect sampling error. In princi
ple, the first key feature differentiates these
approaches from maximum likelihood ap
proaches. In practice, it is easy to overstate the
importance of this difference. In actual appli
cations, we have to specify which variables’
likelihood surface we are trying to match. So
there is nothing particularly general or compre
hensive about maximum likelihood methods in
particular applications, relative to the ap
proaches discussed above.
Still, the more moments an approach uses
to diagnose the empirical performance of a
model, the more general that approach is. An
important shortcoming of many RBC studies
(including some that I have conducted) is that
they focus on a very small subset of moments.
Some of the most interesting diagnostic work
being done on general equilibrium business
cycle models involves confronting them with
carefully chosen but ever-expanding lists of
moments. The evolution of RBC models be
yond their humble beginnings parallels the
wider range of phenomena that they are now
being confronted with.
To illustrate this point, I now consider
some of the strengths and weaknesses of a
simple, prototypical RBC model. Using the
approach discussed in Christiano and Eichen
baum (1992), I show that the model does very
well with respect to the standard small list of
moments initially used to judge RBC models.
I then use this approach to display a point made
by Watson (1993): Standard RBC models badly
miss capturing the basic spectral shape of
real macroeconomic variables, particularly
real output. This reflects the virtual absence
of any propagation mechanisms in these
25
models. Model diagnostic approaches that
focus on a small set of moments like the
variance of output and employment mask
this first-order failure.
7) g ^ g o + g j + p g ^ + e,,
where the parameter a is between 0 and 1, K
denotes the beginning of time t capital stock,
and X represents the time t level of technology.
The stock of capital evolves according to
where g(| and g t are constants, t denotes time,
Ipl < 1, and £f is a mean zero shock to g: that
is serially uncorrelated and has standard
deviation <7 . The variable p controls the
persistence of gr The larger p is, the longer
lasting is the effect of a shock to e on gr
In the presence of complete markets, the
competitive equilibrium of this economy corre
sponds to the solution of the social planning
problem: Maximize equation 1 subject to equa
tions 2 to 7 by choice of contingency plans for
time t consumption, hours of work, and the
time t+ 1 stock of capital as a function of the
planner’s time t information set. This informa
tion set is assumed to include all model vari
ables dated time t and earlier.
Burnside and Eichenbaum (1994) estimate
the parameters of this model using the GMM
procedure described in Christiano and Eichen
baum (1992). To describe this procedure, let
VF| denote the vector of model structural pa
rameters. The unconditional moment restric
tions underlying Burnside and Eichenbaum’s
estimator of 4^ can be summarized as:
3)
8) E [«„(¥?)] =0,
A sim p le RBC m odel
Consider the following simple RBC mod
el. The model economy is populated by an
infinitely lived representative consumer who
maximizes the criterion function
1) £■„ £ P'[ln(C,)-6/V,].
;=0
Here 0 < (3 < 1, 0 > 0, C denotes time t con
sumption, Nt denotes time t hours of work, and
E{) denotes expectations conditioned on the
time 0 information set.
Time t output, T, is produced via the
Cobb-Douglas production function
2)
T = K''-a(N X')a,
KM = ( l- 6 ) K , + I,.
Here / denotes time t gross investment and
0 < 8 < 1. The level of technology, X , evolves
according to
4) X, = X_, exp (y+ v ),
where y > 0, vi is a serially uncorrelated pro
cess with mean 0 and standard deviation <7V .
Notice that unlike the class of models exam
ined in Eichenbaum (1991), the level of tech
nology is modeled here as a difference station
ary stochastic process. The aggregate resource
constraint is given by
5)
c + / + G<y,
Here Gt denotes the time t level of government
consumption which evolves according to
6)
G = x , g;.
The variable g*is the stationary component of
government consumption and gt = ln(g*)
evolves according to
26
where H/(|) is the true value of 4* and uu(») is a
vector-valued function that depends on the data
as well as 4/(). In Burnside and Eichenbaum’s
(1994) analysis, the dimension of uu(») is the
same as that of 4/t). Because of this, the mo
ment restrictions in equation 8 fall into two
categories. The first category consists of con
ditions that require the model to match the
sample analogs of various moments of the data,
like the capital to output ratio, and average
hours worked. The second category consists of
conditions that lead to estimating parameters
like those governing the behavior of govern
ment purchases, p, g(), and g , via least squares,
and parameters like the standard deviations of
the shock to technology and government pur
chases, as the sample averages of the sums of
squared fitted residuals.
Two features of equation 8 are worth noting.
First, there is no reason to view this equation as
holding only under the hypothesis that the model
is “true”. Instead equation 8 can be viewed as
summarizing the rule by which Burnside and I
chose model parameter values as functions of
unknown moments of the data-generating
ECONOMIC PERSPECTIVES
process. Second, our model is one of balanced
growth. This, in conjunction with our specifica
tion of the technology process, X, as a differ
ence stationary process, implies a variety of
cointegrating relationships among the variables
in the model.14 We exploit these relationships to
ensure that the moments entering equation 8
pertain to stationary stochastic processes.
The salient features of the parameter esti
mates reported in Burnside and Eichenbaum
(1994) is their similarity to the values em
ployed in existing RBC studies. So what dif
ferentiates the estimation methodology is not
the resulting point estimates, but that the ap
proach allows one to translate sampling uncer
tainty about the functions of the data that de
fine the parameter estimator into sampling
uncertainty regarding point estimates.
The procedure used to assess the empirical
plausibility of the model can be described as
follows. Let 4 \ denote a vector of diagnostic
moments that are to be estimated in ways not
involving the model. The elements of 4*, typi
cally include objects like the standard devia
tions of different variables, as well as various
autocorrelation and cross-correlation coeffi
cients. The unconditional moment restrictions
used to define the GMM estimator of 4/, can
be summarized as:
9)
restrictions from the model by r(4 /). Then
hypotheses of the form
11)
H0 : FC¥°) = O ^ 0) - r(y °) = 0
can be tested using a simple Wald test.
Early RBC studies often stressed the abili
ty of the standard model to account for the
volatility of output and the relative volatility of
various economy-wide aggregates. To exam
ine this claim, it is useful to focus for now on
the standard deviation of output, the standard
deviation of consumption, investment, and
hours worked relative to output, and the stan
dard deviation of hours worked relative to
average productivity.15 Column 1 of table 1
lists different moments of the data. Column 2
reports nonmodel-based point estimates of
these moments, obtained using aggregate timeseries data covering the period 1955:Q3-84:Q4.
Column 3 contains the values of these mo
ments implied by the model, evaluated at 4/ .
TABLE 1
Data and model moments
(Relative volatility testsa)
Moment
E [u2iC¥°2)\ = 0.
Here 4*° denotes the true value of 4/r The
vector m2/(*) has the same dimension as 4/°.
It is useful to summarize equations 8 and 9 as
10) E [ u m ] = 0
t= 1 ,. . . , T.
Here 4*° is the true value of (4i '4/2)/ and ut is a
vector valued function of dimension equal to
the dimension of 4/0. As long as the dimension
of ut(») is greater tljan or equal to the dimen
sion of 4'°, equation 10 can be exploited to
consistently estimate 4/0 via Hansen’s (1982)
GMM procedure.
Suppose we wish to assess the empirical
plausibility of the model’s implications for a
q x 1 subset of 41,. We denote this subset by co.
Let 0(4/) denote the value of co implied by the
model, given the structural parameters 4/). Here
denotes the (nonlinear) mapping between the
model’s structural parameters and the relevant
population moments. Denote the nonparametric estimate of co obtained without imposing
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RANK OF CHICAGO
C i/°y
/<*„
a*/<LP,
U.S. data
Model
0.0192
(0.0021)
0.0183
(0.0019)
[0.712]
0.437
(0.034)
0.453
(0.005)
[0.633]
2.224
(0.079)
2.224
(0.069)
[0.999]
0.859
(0.080)
0.757
(0.050)
[0.999]
1.221
(0.132)
1.171
(0.032)
[0.729]
aThe sta tistic o ; is the standard de via tio n o f the
H odrick-P rescott filte re d va ria ble /, / = /(o u tp u t),
c (co nsum p tion), / (inve stm en t), h (hours
w orked), and ap l (average p ro d u c tiv ity o f labor).
Notes: N um bers in parentheses denote the
standard e rro r o f the co rre sp o n d in g p o in t esti
mate. N um bers in brackets denote the p ro b a b ili
ty values o f the W ald statistics fo r te stin g the
hyp othe sis th a t the m odel and nonm odel-based
num bers are the sam e in po p u la tio n .
Source: This tab le is taken fro m B urnside and
E ichenbaum (1994).
27
Numbers in parentheses are the standard errors
of the corresponding point estimates. Numbers
in brackets are the probability values of Wald
statistics for testing whether the model and
data moments are the same in population. The
key thing to notice is how well the model per
forms on these dimensions of the data. In no
case can we reject the individual hypotheses
that were investigated, at a conventional signif
icance level.
Once we move beyond the small list of
moments stressed in early RBC studies, the
model does not perform nearly as well. As I
mentioned above, Watson (1993) shows that
the model fails to capture the typical spectral
shape of growth rates for various macro vari
ables. For example, the model predicts that the
spectrum of output growth is flat, with relative
ly little power at cyclical frequencies. This
prediction is inconsistent with the facts. A
slightly different way to see this empirical
shortcoming is to proceed as in Cogley and
Nason (1993) and focus on the autocorrelation
function of output growth. Panel A of figure 1
28
reports nonmodel-based estimates of the auto
correlation function of Ain ( Y ), as well as
those implied by the model. These are depict
ed by the solid and dotted lines, respectively.
The actual growth rate of U.S. output is posi
tively autocorrelated: specifically the first two
autocorrelation coefficients are positive and
significant.16 The model implies that all the
autocorrelations are negative, but small. In
fact they are so close to zero that the solid line
depicting them is visually indistinguishable
from the horizontal axis of the figure. Panel B
displays the difference between the model and
nonmodel-based estimates of the autocorrela
tion coefficients, as well as a two-standard
error band around the differences. We can
easily reject the hypothesis that these differ
ences reflect sampling error.
Various authors have interpreted this em
pirical shortcoming as reflecting the weakness
of the propagation mechanisms embedded
within standard RBC models. Basically what
you put in (in the form of exogenous shocks) is
what you get out. Because of this, simple RBC
models cannot simultaneously
account for the time-series prop
erties of the growth rate of out
put and the growth rate of the
Solow residual, the empirical
measure of technology shocks
used in first generation RBC
models.
How have macroeconomists
responded to this failing? They
have not responded as Haavelmo (1944) anticipated. Instead
they have tried to learn from the
data and modify the models.
The modifications include al
lowing for imperfect competi
tion and internal increasing
returns to scale, external in
creasing returns to scale, factor
hoarding, multiple sectors with
nontrivial input-output linkages,
and monetary frictions.17 Evi
dently when econometricians
convey their results in language
that is interpretable to theorists,
theorists do respond. Progress
is being made. Granted, the
econometric tools described
here fall far short of even ap
proximating the dynamic version
ECONOMIC PERSPECTIVES
of Leamer-style specimetrics discussed in the
introduction. Still, they have proved to be
useful in practice.
Conclusion
I would like to conclude with some com
ments about the classic Haavelmo program for
testing economic models. I did not discuss this
program at length for a simple reason: It is
irrelevant to the inductive process by which
theory actually evolves. In his seminal 1944
monograph, Haavelmo conceded that his pro
gram contributes nothing to the construction of
economic models. The key issue he chose to
emphasize was
the problem of splitting on the basis
of data, all a priori theories about
certain variables into two groups, one
containing the admissible theories, the
other containing those that must be
rejected. (“The probability approach
in econometrics,” Econometrica)
In reality, economic hypotheses and mod
els are generated by the ongoing interaction of
researchers with nonexperimental data. The
Haavelmo program conceives of economic
theorists, unsullied by data, working in splen
did isolation, and “somehow” generating hy
potheses. Only when these hypotheses appear,
does the econometrician enter. Armed with an
array of tools he goes about his grim task:
testing and rejecting models. This task com
plete, the econometrician returns to the labora
tory to generate ever-increasingly powerful
tools for rejecting models. The theorist, no
doubt stunned and disappointed to find that his
model is false, returns to his office and contin
ues his search for the “true” model.
I cannot imagine a paradigm more at vari
ance with the way actual empirical research
occurs. Theories don’t come from a dark clos
et inhabited by theorists. They emerge from an
ongoing dialogue with nonexperimental data
or, in Learner’s (1978) terminology, from on
going specification searches. To the extent
that the Haavelmo program is taken seriously
by anyone, it halts the inductive process by
which actual progress in economics occurs.
The fact is that when Haavelmo attacked a
real empirical problem, the determinants of
investment, he quickly jettisoned his method
ological program. Lacking the tools to create a
stochastic model of investment, Haavelmo
(1960) still found it useful to interact with the
data using a “false” deterministic model. For
tunately, economic theory has progressed to
the point where we do not need to confine
ourselves to deterministic models. Still we
will always have to make simplifying assump
tions. In his empirical work, Haavelmo (1960)
tried to help us decide which simplifying as
sumptions lead us astray. That is the program
econometricians need to follow, not the utopi
an program that was designed in isolation from
actual empirical practice. That road, with its
focus on testing whether models are true,
means abandoning econometrics’ role in the
inductive process. The results would be tragic,
for both theory and econometrics.
NOTES
'This article is based on a paper that appeared in the
November 1995 issue of Economic Journal.
2See Conclusion for further discussion of the Haavelmo
program.
3By specimetrics, Learner (1978, p. v) means: “. . . the
process by which a researcher is led to choose one specifi
cation of the model rather than another; furthermore, it
attempts to identify the inferences that may be properly
drawn from a data set when the data-generating mecha
nism is ambiguous.”
4Moments refer to certain characteristics of the datagenerating process, such as a mean or variance. Moments
are classified according to their order. An example of a
first-order moment would be the expected value of output.
An example of a second-order moment would be the
variance of output.
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5Some of the rhetoric in the early RBC literature almost
suggests that econometricians and quantitative business
cycle theorists are natural enemies. This view is by no
means unique to RBC analysts. See for example Keynes’
(1939) review of Tinbergen’s (1939) report to the League
of Nations and Summers’ (1991) critique of econometrics.
5Econometricians have many customers, such as govern
ment officials and private businesses, for whom the
language of economic theory may not be very useful.
7If these comments sound critical of econometricians
who ignore economic theory, I have been as critical, if
not more so, of business cycle theorists who ignore
econometrics. See Eichenbaum (1991) for a discussion
of the sensitivity of inference in the RBC literature to
accounting for sampling uncertainty in the parameter
estimates of structural models.
29
8A finite-ordered vector autoregressive representation for
a set of variables Z expresses the time t value of each
variable in Z as a function of a finite number of lags of all
the variables in Z plus a white noise error term. The error
term is often interpreted as a linear combination of the
basic shocks affecting the economy. These shocks include
unanticipated changes in monetary and fiscal policy.
Exactly identified VARs make just enough assumptions to
allow the analyst to measure the shocks from the error
terms in the VAR. These assumptions are referred to as
identifying assumptions.
T he key feature of limited participation models is the
assumption that households do not immediately adjust
their portfolios after an open market operation. Conse
quently, open market operations affect the bank-reserves
portion of the monetary base. It is this effect that gener
ates declines in interest rates following contractionary
open market operations in the model. See King and
Watson (1995) and Christiano and Eichenbaum (1995), as
well as the references therein.
l0See for example Christiano, Eichenbaum, and Evans
(1996), who use this strategy to study the response of the
borrowing and lending activities of different sectors of the
economy to a shock in monetary policy.
"See for example Kydland and Prescott (1989).
"This conclusion depends on the nature of the estimators
of 'P| and o f implicit in early RBC studies and the
hypothesis that the level of technology is a trend-stationary
process. The latter is an important maintained assumption
of early RBC studies.
"See for example Leeper and Sims (1994) and the refer
ences therein.
"With the exception of hours worked, all model variables
inherit a stochastic trend from the technology process, Xr
"Here all moments refer to moments of time series that
have been processed using the stationary inducing filter
discussed in Hodrick and Prescott (1980).
l6See Burnside and Eichenbaum (1994).
"This is a good example of Learner’s (1978) observation
that a critical feature of many real learning exercises is the
search for new hypotheses that explain the given data.
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Christiano, L. J., and M. Eichenbaum, “Cur
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Diebold, F. X., L. Ohanian, and J. Berkowitz, “Dynamic equilibrium economies: A
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ECONOMIC PERSPECTIVES
Ingram, B., and B. S. Lee, “Simulation esti
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and employment variation in business cycle
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Leeper, E., and C. Sims, “Toward a modern
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Pagan, A., and John Robertson, “Resolving
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Summers, L. H., “The scientific illusion in
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Watson, M., “Measures of fit for calibrated
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