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SEPTEMBER/OCTOBER 1991

ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago

Energy dependence
and e fficie n cy
B alan cin g a ct: Tax structure
in the Seven th D istrict




FEDERAL RESERVE BANK
OF CHICAGO

Contents
Energy dependence
and e ffic ie n c y ........................................................................................................2
Ja ck L. Hervey

What ever happened to solar power and yurts?
The author discusses developments in energy
since the oil crisis of the early 1970s.

B alan cin g a ct: Tax structure
in the Seventh D istric t...................................................................................... 22
Richard H. M atto o n

Should states tax snacks or cap taxes? As
discussed in this article, raising revenues in a
recession can be tricky business.

ECONOMIC PERSPECTIVES
Karl A. Scheld, Senior Vice President and
Director of Research
Editorial direction

Carolyn McMullen, editor, David R. Allardice, regional
studies, Herbert Baer, financial structure and regulation,
Steven Strongin, monetary policy,
Anne Weaver, administration
Production

Nancy Ahlstrom, typesetting coordinator,
Rita Molloy, Yvonne Peeples, typesetters,
Kathleen Solotroff, graphics coordinator
Roger Thryselius, Thomas O’Connell,
Lynn Busby-Ward, John Dixon, graphics
Kathryn Moran, assistant editor




SEPTEMBER/OCTOBER 1991 Volume XV, Issue 5

ECONOMIC PERSPECTIVES is published by
the Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and do not necessarily reflect the views
of the management of the Federal Reserve Bank.
Single-copy subscriptions are available free of
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Articles may be reprinted provided source is
credited and The Public Information Center is
provided with a copy of the published material.
ISSN 0164-0682

Energy dependence
and efficien cy

Jack L. Hervey

World oil market fragility was
demonstrated again last year
following the August 2 inva­
sion of Kuwait by Iraq and the
subsequent United Nations
imposed embargo on oil shipments from Iraq
and Kuwait. Concern about the potential cut­
off of Middle East oil brought back memories
of long lines at gas stations, dim lighting in
offices, lower thermostats on furnaces and
reduced use of air conditioners. In public de­
bate, issues of energy dependence, efficiency,
and conservation were again in vogue. Devel­
opments in the Middle East from August 1990
through February 1991 serve as an effective
reminder of the importance of energy in general
and petroleum in particular to the industrial
economies.
The intent of this article is two fold. In
order to set the stage, it first reviews recent
developments in the oil markets. Next, it sur­
veys concepts of energy and oil-use dependence
as well as energy and oil-use efficiency. It
proposes measures of dependence and efficien­
cy and uses these measures to compare devel­
opments in the world’s six heaviest consumers
of energy—Canada, France, West Germany,
Japan, the United Kingdom, and the United
States—during the period 1970 to 1988.
R ecent d ev elo p m en ts

Following the U.N. embargo on oil ship­
ments from Iraq and Kuwait, world crude oil
production declined 6 percent in August, a
reduction of 3.5 million barrels per day. How­
ever, initial fears of an oil shortage proved

2



unfounded. Within days, other major oil ex­
porters pledged to increase production to offset
the 4.5 million barrels per day of lost Iraq and
Kuwait oil. World crude oil production and
prices are shown in Figure 1.
Nevertheless, oil prices soared, bringing on
the fourth major price shock to world oil mar­
kets in less than two decades (counting the
rapid decline in oil prices in 1986). Uncertain­
ty in the markets intensified as multinational
forces opposing the Iraqi move began to deploy
in Saudi Arabia and the threat of military con­
frontation grew. Spot prices for crude oil
peaked at over $40 per barrel in early October,
up from $19 per barrel prior to the invasion of
Kuwait.
By late November, oil production by the 11
remaining OPEC members, in particular Saudi
Arabia, exceeded that of all 13 members of
OPEC prior to the invasion, thus wiping out the
Iraqi-Kuwaiti export deficit. World production
returned to pre-August levels of 60-61 million
barrels per day. In addition, world oil demand
was slipping because of weakening economic
conditions in oil importing countries and oil
consumers’ response to higher oil prices.
The author is a senior econom ist at the Federal
Reserve Bank of Chicago. The author w ould like to
express his appreciation to Kenneth Kuttner,
Prakash Loungani, James Moser, and Steve
Strongin for their helpful com m ents during the
project and on earlier drafts of the paper. The
views expressed herein, however, remain those of
the author and do not necessarily reflect the views
of the com m entators or the Federal Reserve Bank
of Chicago.

ECONOMIC PERSPECTIVES

By mid-December, spot prices for crude
had declined to well below $30 per barrel.
Analysts were beginning to suggest that crude
oil prices would once again drop to levels well
below $20 per barrel during 1991, assuming a
favorable resolution of the Persian Gulf situa­
tion.
With the initiation of the allied air offen­
sive against Iraq on January 16, 1991, oil prices
surged again, to more than $30 per barrel.
However, it soon became apparent that oil
production in the Gulf states would not be ap­
preciably affected by the war, nor would ship­
ping lanes in the area be disrupted. Oil prices
promptly declined to the $20-$25 per barrel
range.
The initiation of the land war by Coalition
Forces on February 24 and its rapid conclusion
contributed to a further easing of market ten­
sions. Real economic factors once again domi­
nated the market. Oil prices dropped into the
$ 18-$20 per barrel range and day-to-day price
variation decreased markedly.
The lesson learned from Kuwait

Soaring oil prices once again raised the
issue of the economic dependance of the
world’s economies on energy, in general, and
on petroleum in particular. This issue has been
ignored, if not forgotten, by all but a few ana­
lysts and policy makers during the last half of
the 1980s, a period during which nominal crude
oil prices declined from around $30 per barrel
to $10 per barrel before increasing again to
settle in the mid-to-high teens.

FEDERAL RESERVE



BANK OF CHICAGO

Not surprisingly, public
interest in energy conservation
and a national energy policy
subsided as soon as oil prices
declined into the low twenties
and high teens. Indeed, the oil
price most often faced by the
consumers, motor gasoline, was
lower, when adjusted for infla­
tion, at mid-year 1991 than prior
to the 1973-1974 price shock.
Public officials’ disinclina­
tion towards serious energy con­
servation measures is illustrated
by Congressional response to an
Administration proposal of a 12
cent per gallon gas tax as part of
the 1990 tax bill. The Congress
enacted a 5 cent per gallon in­
crease in the gasoline tax, an increase motivat­
ed more by the desire to increase revenue than
to promote conservation.1The Iraq and Kuwait
episode illustrates the fact that the stability of
the world oil market is fragile. That fragility
grows out of at least two factors: 1) the depen­
dence of the world’s economies on petroleum
as an energy source and 2) the mismatch be­
tween petroleum producers and consumers.2
In the United States, in particular, discus­
sion about energy and oil usage focused on how
dependent the economy is on oil and how inef­
ficient the U.S. economy is in its use of energy
and oil.
This raises the issue of what it means to
say that a country is dependent on oil, or on
energy in general. In fact, there are a number of
different ways to measure how dependent a
country is on energy in general, or on a particu­
lar energy source such as oil. In this article I
discuss two measures of energy dependence—
total requirements and per capita require­
ments—and compare the dependence of the six
heaviest users of energy (Canada, France, West
Germany, Japan, the United Kingdom, and the
United States) according to these measures.
Investigation into the sources of dependence
requires a discussion of energy efficiency.
Again, there are different ways to measure a
country’s energy efficiency. Four measures of
efficiency are presented and compared for the
six countries according to each measure of
efficiency. Finally, in order to explain some of
the differences in efficiency across countries,
efficiency by economic sector is examined.

3

The next section deals with a discussion of
dependence on energy in general, and on the
major energy sources in particular.
An o v e rv ie w o f en e rg y d ep en den ce

The primary energy sources available to an
economy are: 1) coal, 2) petroleum and petro­
leum products, 3) natural gas, 4) nuclear ener­
gy, 5) hydro-electric, geothermal, and solar
energy (H-G-S), 6) solid fuels other than coal
(for example, wood, peat, and incinerated gar­
bage), 7) electricity (normally electricity is a
derived or secondary energy form, however,
some countries import electricity, in which case
it then becomes a primary energy source to
those countries), and 8) heat derived from pub­
lic combined heat and power plants.3 In the
aggregate the last three categories are of minor
importance, or, as in the case for the other solid
fuels category, the data are inadequate, there­
fore these categories are not considered in the
analysis.
An economy’s overall dependence on
energy or on a particular energy source, for
example, petroleum, can be measured in sever­
al ways. This article specifically examines
total energy utilized from all sources by the
economy; energy requirements relative to popu­
lation (for example, per capita energy require­
ments from all sources or per capita energy
requirements derived from oil); and energy use
by source (for example, oil) as a proportion of
an economy’s total energy requirements.
Energy consumption varies widely across
economies. Table 1 presents total primary
energy requirements (TPER) for the years 1970
TABLE 1

Total primary energy requirements
(Millions of tons of oil equivalent)
Year

U.S.

Japan

Germany

U.K.

1970

1,579

268

237

208

155

1972

1,695

299

249

213

170

1974

1,721

335

258

212

179

1976

1,778

328

262

205

180

1978

1,900

347

272

209

191

1980

1,826

355

274

201

198

France

1982

1,707

337

252

193

187

1984

1,782

364

262

192

195

1986

1,793

369

270

205

204

1988

1,928

399

274

209

209

4



through 1988 for the world’s six heaviest ener­
gy users: Canada, France, West Germany, Ja­
pan, the United Kingdom, and the United States
(see note 3 for an explanation of the source and
makeup of these data, and a definition of total
primary energy requirements). According to
Table 1, as of 1988, the U.S. was by far the
largest user of energy. With total energy re­
quirements of 1,928 million tons of oil equiva­
lent (Mtoe—see note 3 for a definition of Mtoe)
U.S. requirements were nearly five times that
utilized by the next largest user (Japan) and
nine times that of the smallest users, France and
the U.K. At the same time, the rate of increase
for the U.S. compared favorably with that of
the other 5 countries. Indeed, in 1988, U.S.
TPER were only 1.5 percent above 1978 lev­
els.4 Only in the U.K. and Germany was the
growth in TPER lower.
TPER falls short as a measure for compar­
ing the relative energy dependence of different
countries because it does not take into account
factors which determine energy dependence,
such as population, the size of the economy, the
geographical size of the country, the type of
goods produced, and the preferences and con­
sumption habits of the population. For exam­
ple, a country with a large population may have
greater total energy requirements than a country
with a small population without necessarily
being more energy dependent, if per capita
energy requirements are the same in both coun­
tries. A geographically large country that relies
heavily on automotive transportation may be
more energy dependent than a small country
where the automobile is a lesser
factor. Issues of economic size,
population, geographic size,
industrial composition and con­
sumptions habits are addressed in
more detail in the balance of the
Canada
article. Here I turn to a consider­
ation of per capita energy re­
154
quirements for the six countries.
171
Per capita measures of total
184
primary energy requirements are
199
presented in Table 2 and Figure
211
2. They contrast sharply with the
223
total requirements data in Table
213
1. U.S. per capita requirements
224
for all energy remain high in
233
comparison with those of Japan
250
and the European countries but
are substantially lower than for

ECONOMIC PERSPECTIVES

TABLE 2

Total primary energy requirements per capita
(Millions of tons of oil equivalent/million population)
Year

U.S.

Japan

Germany

U.K.

France

1970

7.7

2.6

3.9

3.7

3.1

1972

8.1

2.8

4.0

3.8

3.3

1974

8.1

3.0

4.2

3.8

3.4

1976

8.2

2.9

4.3

3.7

3.4

1978

8.5

3.0

4.4

3.7

3.6

1980

8.0

3.0

4.5

3.6

3.7

1982

7.3

2.8

4.1

3.4

3.4

1984

7.5

3.0

4.3

3.4

3.6

1986

7.4

3.0

4.4

3.6

3.7

1988

7.8

3.3

4.5

3.7

3.7

Canada. Most telling, changes over time as
derived from the data in Table 2 indicate that the
increase in per capita energy dependence in the
U.S. during the 1970-1988 period compared
favorably with the other countries. In 1988, U.S.
per capita dependence for all energy increased
less than 2 percent as compared with 29 percent
for Canada, 23 percent for Japan, 20 percent for
France, and 14 percent for Germany. Per capita
requirements declined 2 percent in the U.K.
Even more favorable is the per capita energy
requirement performance of the U.S. during the
last ten years of the period. By this measure the
U.S. joined the U.K. in reducing its per capita
overall energy dependence while energy depen­
dence elsewhere continued to rise.

FEDERAL RESERVE



BANK OF CHICAGO

Canada

I now turn to a discussion of
energy dependence by energy
source.
Petroleum

Before discussing the specif­
ic measures of oil dependence it
is important to distinguish be­
7.9
tween an economy’s overall
8.2
dependence on petroleum and an
8.6
economy’s import dependence on
9.0
petroleum. For example, a coun­
9.3
try may use little oil and produce
8.6
none domestically, consequently
9.0
importing all oil used. Such a
9.2
country would have a low total
9.6
dependence on petroleum but a
high import dependence. Alterna­
tively, an oil-rich country that has a high level
of oil utilization may be a net exporter of petro­
leum. This country would have a high total
dependence but no dependence on imports.
The press and policy makers are often interest­
ed in import dependence because it has impor­
tant implications for a country’s national secu­
rity and its international balance of payments.5
However, for the reasons just given, import
dependence should not be confused with overall
dependence. In this article I restrict attention to
overall dependence and do not address the issue
of import dependence.
As a group, the six countries increased
their TPER supplied by oil from 1,270 Mtoe in
1970 to 1,377 Mtoe in 1988, an increase of 8
percent (refer to note 3 for definitions of TPER
and Mtoe). The totals are de­
rived from Table 3. Significant­
ly, however, the absolute level of
oil requirements in 1988 was
down 11 percent from the aver­
age 1,540 Mtoe requirement
during the peak period of 19781980. Further evidence indicat­
ing that dependence on oil de­
clined is found in data presented
in Tables 4 and 5. Here we see
that in 1988 two measures of oil
dependence, proportion of TPER
supplied by oil and per capita oil
requirements, respectively, were
well below levels recorded during
the high consumption period of
the late 1970s.
7.2

5

throughout most of the 19 year
period, oil accounted for a sub­
Primary energy requirements supplied by petroleum
stantially smaller proportion of
(Millions of tons of oil equivalent)
TPER in the United States than
Year
U.S.
Japan
Germany
U.K.
France
Canada
elsewhere—except Canada and to
a lesser extent the U.K. At the
184
1970
691
128
94
101
72
same time, however, the decline
1972
771
219
140
111
114
78
in oil’s proportional contribution
1974
244
774
134
105
118
83
to total energy requirements was
1976
824
232
139
92
116
89
markedly smaller in the United
904
1978
255
142
117
95
89
States than elsewhere.
1980
792
235
131
82
111
89
As shown in Table 4, in 1970
1982
708
208
111
77
93
77
the proportion of total energy
requirements supplied by petro­
1984
724
214
111
88
86
72
leum ranged from a low of 44
207
1986
751
118
78
86
73
percent in the United States to a
791
1988
226
116
79
86
79
high of 69 percent in Japan.
Eighteen years later the propor­
The reduction in dependence on oil by the
tion of total energy requirements provided by
oil was substantially reduced, ranging from a
six countries combined, as compared with the
late 1970s, is all the more interesting in the face
low of 32 percent in Canada to a high of 57
of the increase in total primary energy require­
percent in Japan.
ments by these economies over the same period
Indeed, the absolute dependence on petro­
(see Table 1). Total energy requirements in the
leum, that is, the total amount of oil utilized by
six countries combined increased 23 percent
the economy, declined for three of the countries
between 1970 and 1988 but only 4 percent
between 1970 and 1988: France, Germany, and
during the latter half of the period—between
the U.K. (see Table 3). In all six countries the
1978-1980 and 1988.
TPERs supplied by oil were lower in 1988 than
In an examination of the individual country
during the peak oil-use years of the late 1970s;
data presented in Table 4, two patterns stand
ranging from down 13 percent for the U.S. to
out. First, in each of the six countries, petro­
down 37 percent for France.
leum accounts for a major but declining propor­
This reduction in the proportion of TPER
tion of total energy requirements. Second,
supplied by oil and/or the reduction in the abso­
lute contribution of oil to TPER
occurred in the face of a contin­
TABLE 4
ued expansion in overall energy
Proportion of total energy met by petroleum
requirements in these econo­
(Percent)
mies—with the exception of the
Year
U.S.
Japan
Germany
U.K.
France
Canada
United Kingdom, where TPER
from all sources remained stable
1970
43.8
68.8
54.1
48.8
60.5
46.9
(see Table 1).
1972
73.2
45.5
56.2
52.1
66.7
45.7
During the 1970-1988 peri­
1974
45.0
72.7
51.8
49.6
65.6
45.0
od, less than half of U.S. energy
1976
46.3
70.6
53.0
45.0
64.4
44.6
requirements (ranging from 48
1978
47.6
73.4
52.4
45.5
61.1
42.3
percent in 1978 down to 41 per­
1980
43.4
66.1
47.9
40.9
56.0
39.9
cent in 1988) were derived from
1982
61.7
41.5
44.3
39.9
49.6
36.1
oil, while in Japan well over half
1984
(ranging from 73 percent in 1972
40.6
58.9
42.5
45.9'
44.3
32.3
to 57 percent in 1988) of energy
1986
41.9
56.2
43.8
37.7
42.1
31.4
requirements were supplied by oil
1988
41.0
56.6
42.5
38.1
41.2
31.5
(see Table 4).6
*The downward trend was interrupted by increased oil use during a
During much of the 1970s,
prolonged coal miners' strike in 1984.
the proportion of total energy
requirements supplied by oil in

6



TABLE 3

ECONOMIC PERSPECTIVES

In sum, the per capita mea­
sure of oil dependence gives a
Primary energy requirements supplied by
somewhat different picture than
petroleum per capita
does the measure of oil require­
(Million of tons of oil equivalent/million population)
ments as a proportion of total
Canada
Year
Japan
Germany
U.K.
France
U.S.
energy requirements. The pro­
portional measure suggests that
3.4
1.8
1.9
3.4
1.8
2.1
1970
the dependence on oil relative to
2.0
2.2
3.6
1972
3.7
2.0
2.3
all energy sources is compara­
2.2
3.7
2.2
2.2
1.9
1974
3.6
tively low for Canada, France,
2.2
3.9
2.1
2.3
1.6
1976
3.8
and the U.K. The relative oil
1.7
2.2
3.8
4.1
2.2
2.3
1978
dependence of the U.S., accord­
3.7
2.1
2.1
1.5
1980
3.5
2.0
ing to this measure, is in the
middle of the six countries, and is
1.4
1.7
3.1
1982
3.1
1.8
1.8
especially high for Japan. How­
1.6
1.6
2.9
1984
1.8
1.8
3.1
ever, the per capita measure
1.4
1.6
2.9
1986
1.7
1.9
3.1
indicates that the U.S. and Cana­
1.4
1.9
1.5
3.0
1988
3.2
1.8
da experience a comparatively
high level of dependence on
petroleum; substantially lower dependence
Canada, France, Germany, and the U.K. gener­
levels are recorded in the other four countries.
ally fell within the range circumscribed by the
As discussed in more detail later, these high
U.S. and Japan. During the late 1980s, howev­
dependence levels for the U.S. and Canada are
er, the relative degree of reliance on oil as an
in part linked to their dependence on transporta­
energy source by these countries declined so
tion and the related large geographical size of
that their use of oil as a proportion of total
the countries. There is a common thread
energy requirements became nearly equal to or,
through both measures across countries, howev­
in some cases, less than that of the United
er. Dependence on oil, especially since the late
States.
1970s, has declined.
Thus, while the United States compared
The above discussion implies several con­
favorably in oil usage as a proportion of total
clusions for the issue of petroleum dependence.
energy requirements at the outset of the period,
First, the response of the U.S. economy to the
its economy did not progress as rapidly toward
oil price shocks in the post 1973 period appears
the replacement of oil with other sources of
weaker than elsewhere. During the 1970-1973
energy within the overall energy requirements
period the U.S. economy relied proportionately
composite as did the others.
The per capita measure of oil
dependence presents a rather
different perspective. Per capita
oil requirements, as shown in
Table 5 and Figure 3, split the six
countries into two packs. Ac­
cording to this measure, Canada
and the United States appear as
high oil dependent economies, as
they did for total per capita ener­
gy requirements. Per capita oil
requirements in the U.S. and
Canada in 1988 (3.2 Mtoe/million population and 3.0 Mtoe/
MP) were double that of France
and the U.K. and were more than
50 percent larger than the per
capita measures of 1.8 and 1.9
Mtoe/MP in Japan and Germany.
TABLE 5

FEDERAL RESERVE BANK OF CHICAGO




7

less on petroleum to meet its total energy needs
than did any of the other five countries. In the
aggregate, U.S. oil use accounted for 44 percent
of U.S. energy requirements, well below an
average (weighted by TPER by country) of 52
percent for the other five. By 1988, oil’s share
of total U.S. energy requirements had declined,
but by only 3 percentage points, to 41 percent.
The weighted average oil share of total energy
requirements for the other five countries de­
clined 8 percentage points, but at 44 percent
remained above the U.S. figure, primarily as a
result of the influence of Japan’s continued
heavy relative dependence on oil. However, in
an absolute sense, that is, in terms of quantity
of energy consumed, the U.S. and Canadian
economies are heavily dependent on energy in
total and on petroleum in particular. Per capita
requirements for these two countries are consis­
tently well above those for the other countries.
The reduction in their dependence levels has
been substantial, but they have a long way to go
to attain levels comparable with the other coun­
tries. Indeed, the geographical size and the
related dependence on transportation of the
U.S. and Canada could effectively set lower
limits on their dependence levels that are well
above those of the other four countries.
O th e r energ y sources

movement away from oil utilization toward the
alternatives. However, within this general
pattern, there were substantial differences be­
tween countries and between energy forms.
Coal

During much of the 1970-1988 period, coal
ranked second to oil as an energy source in the
three European countries and Japan. Coal
utilization for the six countries in total, like that
for oil, increased during 1970-1988 while at the
same time coal’s relative importance as an
energy source declined. However, the aggre­
gated figures mask important individual coun­
try diversions from the overall trend.
Total energy requirements derived from
coal declined in France, Germany, and the U.K.
during the 1970-1988 period. As coal is prima­
rily a power source for the generation of elec­
tricity, it is not surprising that the decline in
coal energy requirements appears to parallel the
increased use in these economies of natural gas
and nuclear power. Coal remained an impor­
tant energy source in Germany and the U.K.,
accounting for around 30 percent of their total
energy requirements in 1988. Along with the
absolute decline in coal use in France, Germa­
ny, and the U.K., the relative importance of
coal as an energy source also declined (see
Table 6).
In the U.S., Japan, and Canada, coal use
increased progressively during the 1970-1988
period. In Canada, coal was relatively less

Apart from petroleum there are two other
major hydro-carbon energy categories (coal and
natural gas) and two nonhydro­
carbon energy categories (nuclear
and an agglomeration of hydroTABLE 6
electric-geothermal-solar) that
Proportion of total energy met by coal
constitute the remainder of pri­
(Percent)
mary energy sources for these
Year
Japan
U.S.
Germany
U.K.
France
Canada
economies. Given some reason­
able adjustment period and favor­
1970
18.5
37.9
23.0
42.7
23.9
11.1
able relative prices, these energy
1972
17.1
18.3
32.7
33.3
17.3
9.6
sources are potential substitutes
1974
18.1
18.4
32.8
32.1
16.5
8.1
for petroleum products in numer­
1976
19.2
17.2
29.7
34.2
16.7
8.4
ous industrial and power genera­
tion uses. The marginal cost of
1978
18.8
13.4
27.4
32.3
15.8
8.5
these other primary energy sourc­
1980
20.6
16.8
30.3
34.3
16.6
9.5
es rose less rapidly than for petro­
1982
21.7
19.1
33.2
32.5
16.0
10.8
leum during the decade following
1984
23.1
19.1
31.6
24.4*
13.2
11.9
the initial 1973-1974 OPEC oil
1986
23.2
18.7
28.7
31.9
10.1
10.3
price shock. (In the U.S. this was
1988
27.1
31.7
23.5
18.5
9.2
11.0
partially due to government regu­
*The sharp drop in share was due primarily to a prolonged coal miners'
lation.) Consequently, it is not
strike during 1984.
surprising that over the period
examined there was a relative

8



ECONOMIC PERSPECTIVES

important as an energy source
TABLE 7
than in the European or Japanese
Proportion of total energy met by natural gas
economies. During the 19 year
(Percent)
span, coal utilization increased
Year
Japan
Germany
UK.
France
Canada
U.S.
apace with the increase in the
economy’s total energy require­
4.9
1970
31.6
1.1
5.0
5.3
19.0
ments. Thus, in Canada, coal
1972
8.2
30.8
1.2
11.0
6.8
20.5
maintained a rather stable though
7.9
1974
12.2
14.2
20.1
29.0
2.0
comparatively low level share of
9.4
19.4
1976
25.8
3.0
13.5
16.3
total energy requirements—
24.2
15.2
17.7
9.9
19.3
1978
4.5
ranging between 9 percent and 11
1980
26.1
6.1
16.1
20.1
10.9
19.3
percent of the total.
6.7
14.9
1982
25.2
21.1
11.3
19.9
Coal’s role as an energy
source in the United States
1984
23.7
22.7
12.1
20.2
8.9
15.6
moved counter to the trend else­
11.9
1986
21.7
9.6
15.2
23.0
20.1
where. Indeed, coal was the only
11.4
22.2
9.4
16.2
22.2
20.8
1988
major hydrocarbon-based fuel to
record an increased proportional
made more plentiful in Europe by the opening of
contribution to U.S. energy requirements during
natural gas pipelines from the U.S.S.R. and the
the period—increasing from 19 percent to 24
development of economically viable ocean going
percent of total energy requirements.
natural gas tankers during the 1970s. During the
On a per capita basis, energy requirements
same period, natural gas use doubled in Canada,
supplied by coal increased during 1970-1988 in
approximately keeping pace with total energy
Canada and the United States, remained stable
requirements. As a result, only marginal gains in
in Japan, and declined elsewhere. As an abso­
the relative contribution of natural gas to total
lute measure, U.S. per capita dependence on
energy requirements occurred in Canada. In the
coal remains well above that of any of the other
U.S., natural gas use declined between 1970 and
countries— 1.8 Mtoe/MP as compared with 1.2
1988, with a consequent sharp drop in the rela­
Mtoe/MP in Germany, the second largest per
tive contribution of this energy form to total
capita dependent user of coal.
energy requirements.
In sum, by 1988, coal still retained its
Per capita dependence on natural gas in­
position as the second largest energy source in
creased in all countries but the U.S., where it
Germany, Japan, and the U.K., and became the
declined by 33 percent between 1970 and 1988.
second largest source of energy for the U.S.
Still, by comparison, the U.S. was highly depen­
Natural gas
dent on natural gas. Only in 1984 did Canada
With the exception of the United States
surpass the U.S. as a country more per capita
and Canada, natural gas was a distinctly minor
dependent on natural gas. In 1988, Canada’s
factor in the overall energy package during the
dependence level on natural gas stood at 2 Mtoe/
early 1970s. This probably was due, in large
MP. The United States followed with a depen­
part, to the lack of known indigenous supplies
dence level of 1.7 Mtoe/MP. Of the six coun­
and the lack of adequate transport facilities. As
tries, Japan recorded the lowest dependence level
shown in Table 7, prior to the oil crisis of 1973with per capita requirements of 0.3 Mtoe.
1974, natural gas accounted for 30 percent and
Nuclear power
20 percent of total energy requirements in the
Nuclear energy is the only primary energy
U.S. and Canada, respectively.
source to record a common pattern across coun­
Elsewhere, the natural gas contribution to
tries over the time frame examined. Table 8
total energy requirements of the respective
shows the proportion of total energy require­
economies ranged from 1 percent in Japan to 5
ments met by nuclear energy. In each country,
percent in France and Germany. Increases in
nuclear power recorded multiple gains during the
the importance of natural gas-derived energy
1970-1988 period, in terms of its total energy
from the mid-1970s to mid-1980s were substan­
equivalents as well as in its proportion of total
tial, in total volume as well as proportional
energy requirements.
terms. This was possible because supplies were

FEDERAL RESERVE BANK OF CHICAGO




9

other energy forms. Within this
category, hydroelectric energy
Proportion of total energy met by nuclear energy
was among the earliest energy
(Percent)
forms harnessed. Despite new
Japan
Germany
U.K.
France
Canada
Year
U.S.
technologies utilized to extract
geothermal and solar power,
0.4
0.8
0.1
0.6
2.8
1970
0.3
these energy sources have not yet
0.9
1972
0.8
0.8
3.1
1.9
0.8
made a widespread impact. For
1.4
1.1
3.5
1.8
1.8
1974
1.6
example, as of 1988, geothermal
2.1
3.9
2.0
2.0
2.5
2.5
1976
power is estimated to have ac­
3.3
3.4
4.2
3.0
4.0
3.6
1978
counted for less than 3 percent of
4.1
5.7
6.9
3.8
3.3
3.6
1980
U.S. total energy requirements.7
As shown in Table 9, of the
7.4
5.1
13.0
4.0
1982
5.6
3.9
six countries examined, only
5.2
4.4
7.9
21.9
1984
9.0
6.3
two—Canada and France—re­
6.4
27.8
6.8
10.2
9.9
1986
5.5
corded appreciable gains in the
7.4
29.5
10.0
11.8
6.8
1988
6.5
absolute level of energy derived
from H-G-S. Only Canada,
which in fact relies heavily on hydroelectric
The most dramatic of the increases was in
power, recorded an appreciable increase in the
France, where the nuclear power contribution to
share of its total primary energy supplied by
total energy requirements rose from less than 1
this source—from 23 percent of the total in
percent in 1970 to 30 percent in 1988. The gain
1970 to 27 percent in 1988.
in the nuclear share of total energy requirements
Canada’s per capita dependence on H-G-S
in the other countries was less dramatic but none­
totaled 2.6 Mtoe/MP in 1988, 27 percent of its
theless substantial. Except for the U.K., where
total energy requirements. Per capita depen­
nuclear power accounted for nearly 3 percent of
dence on H-G-S energy by the other countries
total energy requirements in 1970, nuclear power
was well below that of Canada. France ranked
generally accounted for less than 1 percent of
second with a dependence level of 0.3 Mtoe/
total energy requirements in 1970. Apart from
MP, about 9 percent of its total energy require­
France, by 1988 nuclear power’s contribution to
ments. Dependence levels for the remaining
total energy requirements ranged from less than
four countries were at 0.2 Mtoe/MP or lower.
7 percent in the U.S. to 12 percent in Germany.
However, in Japan H-G-S energy accounted for
On a per capita basis, France also appears to
about 6 percent of total energy.
be relatively dependent on nuclear energy. In
1988 it recorded the highest per
capita dependence on nuclear
TABLE 9
power, at 1.1 Mtoe/MP. Canada,
Proportion of total energy met by
at 0.7 Mtoe/MP, and Germany, at
hydroelectric-geothermal-solar energy
0.5 Mtoe/MP ranked well behind
(Percent)
France in both per capita and
U.K.
Canada
Year
Japan
Germany
France
U.S.
relative dependence. The U.S.,
the U.K., and Japan round out the
1.7
0.6
8.2
23.0
7.3
1970
3.6
list in terms of their dependence
23.7
3.7
7.2
1.2
0.5
6.5
1972
on nuclear power.
TABLE 8

1974

Hydroelectric-geothermal-solar
(H-G-S) power

The proportion of energy
requirements met by H-G-S pow­
er is shown for each country in
Table 9. A country’s utilization
of H-G-S energy is more heavily
dependent on the natural resource
base of the country than are the

10



4.0

6.2

1.5

0.5

7.1

25.6

1976

3.6

6.6

1.2

0.6

6.1

23.9

1978

3.4

5.3

1.5

0.6

8.1

25.0

1980

3.5

6.4

1.5

0.6

8.0

25.1

1982

4.2

6.2

1.7

0.7

8.6

27.1

1984

4.2

5.3

1.6

0.7

7.8

28.6
29.8
27.4

1986

3.8

5.3

1.5

0.8

7.2

1988

2.7

5.4

1.7

0.7

8.4

ECONOMIC PERSPECTIVES

In summary, energy consumption and
energy dependence vary widely across coun­
tries and by source of energy. Among the ma­
jor industrial countries, the U.S., along with
Canada, recorded levels of dependence on total
energy that are comparatively high, as mea­
sured by per capita requirements. U.S. per
capita requirements are on the order of twice
those in Western Europe and Japan. At the
same time, however, the rate of growth in U.S.
per capita energy requirements was generally
lower than elsewhere.
Dependence on oil in per capita terms for
the U.S. and Canada also stands out. In Mtoe
per million population, the U.S. and Canada’s
oil dependence are considerably higher than the
next most dependent country, Germany. To
some degree this is likely due to the large geo­
graphical area of these two countries and the
importance transportation plays in their respec­
tive economic activity (this issue is discussed in
more detail below). It is interesting to note that
Japan, an economy that recorded the lowest per
capita dependence on total energy of the six
countries, was the only economy of the six that
in 1988 recorded a per capita dependence on oil
equal to 1970 levels (still only 1.8 Mtoe/MP)
although by this measure its oil dependence had
declined from the higher levels in the late
1970s.
Only Canada and France moved signifi­
cantly away from hydrocarbon energy forms
during the period examined. Both developed a
strong reliance on nuclear and H-G-S energy
forms while the other four countries remained
heavily dependent on the various forms of
hydrocarbon energy.
Energy e ffic ie n c y

Energy is a ubiquitous factor-input in any
industrial/consumption oriented economy. An
understanding of how well or how efficiently
energy is utilized in the output of any economy
is a key variable in examining the energy envi­
ronment. Efficiency in the utilization of energy
inputs, and differentials in energy efficiency
across countries, may explain in part why one
economy is more dependent on energy, or on
certain forms of energy, than is another econo­
my. It should also be expected to be a signifi­
cant factor contributing to the overall and rela­
tive productivity of the economies.
The concept of efficiency is based on the
relationship between the physical inputs in

FEDERAL RESERVE



BANK OF CHICAGO

production and the resulting level of physical
product. Measures of energy-use efficiency are
easily enough derived where there are well
defined inputs and outputs. Unfortunately, the
physical product (output) of an economy is not
so neatly defined. The closest such output
measure is in the form of gross national product
(GNP) or gross domestic product (GDP) adjust­
ed for inflation to give real GNP:GDP.8 Thus,
given measures of aggregate energy inputs
(total primary energy requirements) and eco­
nomic output (real GDP) a technical efficiency
measure can be defined as:
(1) E = GDP / TPER ;
where E. t is the technical efficiency level for
country i, at time t\ GDP t is gross domestic
product valued in billions of home currency at
constant prices for country i, at time t; and
TPER is total primary energy requirements in
millions of ton oil equivalents (Mtoe) for coun­
try / at time t.
Technical efficiency is adequate for a
within-country measure of “home country”
efficiency, but is clearly meaningless for analy­
sis of relative changes in cross-country efficien­
cy or in an analysis of relative levels of effi­
ciency across countries. One problem is that
cross-country currency exchange value is not
taken into account in measures of technical
efficiency. For example, the $2.3 billion per
million tons oil equivalent (Mtoe) technical
energy efficiency for the U.S. in 1988 cannot
be meaningfully compared with the DM7.2
billion/Mtoe level for Germany. Energy effi­
ciency, in particular, output, must be measured
in common units in order to compare countries.
However, finding a common base to use in
computing energy efficiency measures raises a
new set of problems.
This article examines four efficiency mea­
sures, the results of which are described below.
Technical efficiency level (TEL), or home
country efficiency, as described above, is a
measure of the relationship between an econo­
my’s output (in price adjusted GDP, valued in
terms of the home country currency) relative to
the economy’s energy input (all energy forms
are converted to oil equivalents).
The technical efficiency ratio (TER) re­
moves the units of measure (that is, value of
home country GDP per quantity of oil equiva-

11

lents used) from the technical efficiency level
measure, and thus allows cross-country com­
parisons in terms of rates of change from some
common base period. This ratio is derived
from the index of a country’s GDP divided by
the index of its energy inputs. The base period
is defined in the home country GDP index and
the energy inputs index. Except where other­
wise noted these indexes are set equal to 100
for the period 1970-1972. This measure suffers
from the standard problems associated with
indexes. In particular it is devoid of informa­
tion about the level of efficiency (that is, the
value of GDP output relative to the quantity of
energy input) across countries. Further, it de­
pends critically upon the countries’ relative
energy efficiency positions in the base year.
The ratio reflects comparative developments in
energy efficiency across countries as compared
to their relative positions as of the base period.
However, despite its shortcomings, this mea­
sure arguably provides the most meaningful
basis for cross-country comparisons of energy
efficiency.
Observed energy efficiency is obtained by
converting TEL to a U.S. dollar base using
annual average market exchange rates. I refer
to this efficiency measure as “observed” be­
cause it is based on an observed exchange rate.
The observed rate is the market exchange rate
that is typically, though not necessarily appro­
priately, used to convert various countries’
outputs to a common currency base as a means
to facilitate cross-country comparisons.
Purchasing power parity (PPP) energy
efficiency is calculated by converting the TEL
to a U.S. dollar base using PPP exchange ratebased estimates of GDP. Because PPP rates are
based on the relative real purchasing power of
currency units, a relationship that changes
slowly, period-to-period movement in PPP
exchange rates is far more constrained than that
of market exchange rates. Consequently, PPP
energy efficiency should be less volatile than
that for observed energy efficiency.
The last two measures of energy efficiency
represent an attempt to express levels of energy
efficiency across countries. Such measures
would be useful, for example, in the analysis of
cross-country productivity. This article pre­
sents efficiency measures based on these for­
mulations but the severity of the limitations
inherent in such measures merits more than

12



cursory examination. To that issue I now turn.
One of the problems with the observed
efficiency measure is that the wide fluctuation
in exchange rates during the past 20 years has
exerted a profound influence on the measure of
efficiency, an influence that does not reflect
changes in the relative output or the relative
welfare across the economies. For example,
during the period examined, the annual average
for the German mark/U.S. dollar exchange rate
ranged from 3.65 DM/$ in 1970 to 1.76 DM/$
in 1988. During 1988, the DM/$ exchange rate
ranged from a low of 1.57 DM/$ to a high of
1.90 DM/$. If no change whatsoever had oc­
curred in relative technical efficiency between
the U.S. and Germany, the change in exchange
rates would have implied a reduction in the
level of U.S. observed energy efficiency by
more than 70 percent between 1970 and 1988.
Prima facie, this is not a plausible conclusion.
A decrease in the energy efficiency level of that
magnitude implies a concurrent deterioration in
U.S. welfare relative to Germany. There is no
evidence that such a shift in relative welfare
occurred.
Another possible approach is to use an
exchange rate that provides a ratio of exchange
between two currencies such that a specified
value of either currency would purchase the
same bundle of goods in either country. Econo­
mists refer to this construction as the purchas­
ing power parity (PPP) exchange rate.
The OECD estimates that in 1988 the GDP
purchasing power parity exchange rate between
the German mark and the U.S. dollar was
equivalent to 2.44 DM/$, as compared with the
annual average DM 1.76/$ market rate. From
an economic perspective, a PPP exchange rate
would appear to be the theoretically correct rate
to use when converting economic output mea­
sures of foreign countries to common dollar
base. Economists agree that market rate devia­
tions from PPP should be expected because PPP
is a long-run concept, while the market rate is
short-term. Still, the last time the DM/$ ex­
change rate approached 2.44 DM/$ was in
January 1986, when the rapidly depreciating
dollar “passed through” on its way down from
the exchange rate highs reached during the first
quarter of 1985.
While it may be argued that the PPP rate is
the theoretically correct rate over the long term,
the market rate has seldom been even remotely
in line with PPP rates. Market decisions are not

ECONOMIC PERSPECTIVES

based on PPP based exchange
rates. A firm’s management does
not look at the international com­
petitive ability of its firm in terms
of PPP exchange rates. It seems
a reasonable question then wheth­
er efficiency measures based on
PPP conversions are any more
economically meaningful than
observed efficiency.9
Clearly, if levels of energy
efficiency are a vital consider­
ation, the analyst is faced with an
unpleasant choice of tools. As
will be seen shortly, over the last
decade, market exchange rate
movements have overwhelmed
technical efficiency changes.
While some discussion of effi­
ciency levels follows it is emphasized that it is
not the intent of this paper to focus undue atten­
tion on such measures. Their inclusion is in­
tended primarily to be illustrative of the diffi­
culty in developing an economically meaning­
ful measure of petroleum efficiency levels.
Results

As shown in Table 10 and Figure 4, techni­
cal efficiency improved substantially in each of
the six countries during the 1970-1988 period.
Not surprisingly, most of the improvement
occurred during the 1980s as changes in eco­
nomic structures, prompted by the 1973-1974
and 1979-1980 oil price shocks, filtered through
the economies. By 1988, technical efficiency
gains in the six countries ranged from a low of

14 percent in Canada, relative to its 1970-1972
average, to a high of 39 percent in the U.K.
Performance of the U.S. economy compared
favorably with respect to the remaining coun­
tries; its technical efficiency ratio rose 31 per­
cent from its 1970-1972 average—a more rapid
gain than in France and Germany but slower
than in Japan.
Table 10 shows that observed efficiency
varied broadly across countries and illustrates
the dramatic influence of movements in ex­
change rates. As can be seen in Figure 5, the
impact of the dollar appreciation during the
1980-1985 period and the subsequent deprecia­
tion during 1985-1987 is clearly outlined in the
data. Canada is the exception, where exchange
rate movements were less pronounced.

TABLE 10

Change in energy efficiency
(Efficiency levels in billions of dollar/Mtoe)
U.S.

Japan

Germany

U.K.

France

Canada

Technical efficiency

Percent change
(1970 to 1988)

31

38

24

39

20

14

Observed efficiency

1970 (level)

1.70

1.73

1.54

3.10

3.61

1.71

1988 (level)

2.31

7.05

4.13

3.43

4.11

1.71

31

141

99

10

13

0

1970 (level)

1.70

2.42

1.71

4.53

4.21

1.67

1988 (level)

2.31

4.35

2.97

3.18

3.27

1.67

31

59

55

-35

-25

0

percent change
PPP efficiency

percent change

FEDERAL RESERVE BANK OF CHICAGO




13

Table 10).1 The level of energy
0
efficiency for the U.S. remained
well below that of the other coun­
tries (except Canada) during most
of the period. The rate of gain in
U.S. energy efficiency based on
PPP compares favorably with
Canada, France, and the U.K. and
lagged behind that of Germany
and Japan, though not so severely
as when the common valuation
measure of output was based on
the prevailing exchange rates.
Indeed, the most dramatic devel­
opment coming out of the PPP
based data is the deterioration in
energy efficiency levels in France
and the U.K.
Observed efficiency levels in four of the
countries (Canada, Germany, Japan, and the
U.S.) began the period in relatively close prox­
imity—$1.5 to $1.75 billion GDP/Mtoe. On
the other hand, the French and the U.K. econo­
mies recorded substantially higher observed
efficiency levels in 1970; $3-$3.5 billion
GDP/Mtoe. By 1988, observed efficiency
levels for the six countries diverged broadly,
ranging from $1.7 billion/Mtoe for Canada
and $2.3 billion/Mtoe for the U.S. to $7.1 bil­
lion/Mtoe for Japan.
As expected, PPP efficiency levels show
change over time that is considerably less dra­
matic than the fluctuations recorded in the
observed efficiency measure (see Figure 6 and

14



Energy e ffic ie n c y by eco n o m ic s ecto r

Here to fore the discussion has focused on
energy utilization by whole economies. Differ­
ent sectors of an economy might be expected to
be more or less dependent on energy and more
or less efficient in their use of energy. Large
efficiency gains in certain sectors might be
expected to positively influence the competi­
tiveness of those sectors relative to other sec­
tors, or relative to similar sectors in other coun­
tries. The limited data available suggest, not
surprisingly, that efficiency differentials exist
across sectors of an economy as well as across
countries.
This article focuses upon two different
types of comparison. First, it looks at two
broad economic sectors defined
as “industrial” and “nonindustri­
al.” The second comparison
examines a sector classification
defined by “all transportation”
and “nontransportation.”
The industrial/nonindustrial
sector analysis examines three
countries—Germany, Japan, and
the United States—for the period
1974-1988. The industrial sector
includes a broad aggregation of
manufacturing, construction, and
mining and quarrying. The non­
industrial sector includes all other
sectors of the economy. This
particular sector and country
breakdown is used to facilitate
the construction of efficiency

ECONOMIC PERSPECTIVES

measures, as GDP (output) and energy consump­
tion (input) data are available by these aggregate
economic sectors.
Efficiency measures are calculated as the
ratio of the dollar value of gross domestic prod­
uct generated by industrial and nonindustrial
sectors to total energy consumption by these
two sectors. As in the earlier discussion, com­
parisons are based on measures of technical
efficiency levels (TELs) and dollar output mea­
sures using prevailing exchange rates and PPP
exchange rates, which yield measures of ob­
served energy efficiency and PPP energy effi­
ciency, respectively.
Within countries, GDP output by sector,
valued in the home currency relative to units
of energy consumed by the sector, indicate an
interesting diversity in efficiency trends. It was
expected that TELs (the technical efficiency
level) would be higher in the industrial sector
than in the nonindustrial sector. This pattern did
indeed emerge, but did not hold universally.
In the United States the nonindustrial sector
recorded a TEL of $1.8 billion/Mtoe, slightly
higher but probably not significantly different
from the $1.7 billion/Mtoe recorded for the in­
dustrial sector. By 1987, the TELs for both sec­
tors were identical at $2.5 billion/Mtoe.
In Germany, the industrial sector began
the period with a TEL of DM6.0 billion/Mtoe,
well below the DM7.3 billion/Mtoe for the non­
industrial sector. However, rapid efficiency
gains in industry during the late 1970s and
early 1980s pushed Germany’s industrial TEL
to DM9.2 billion/Mtoe, substan­
tially higher than the DM7.8
billion/Mtoe TEL for the nonin­
dustrial sector.
Among the most interesting
developments were the relative
sector levels and changes in tech­
nical efficiency derived from
the Japanese data. In 1974, in­
dustry’s TEL stood at Y493
billion/Mtoe, far lower than the
nonindustrial Y 1,106 billion/
Mtoe. By 1987, nonindustrial
TEL still remained above that of
industry, but industry’s dramatic
increase in energy efficiency
brought its TEL to Y 1,092 bil­
lion/Mtoe compared with Y1,266
billion/Mtoe for the nonindustrial
sector.

FEDERAL RESERVE BANK OF CHICAGO




One result which met the expectation of
higher industrial TELs in each of the three
economies was the more rapid rates of gain in
energy efficiency in the industrial sector as
compared with the nonindustrial sector. The
most rapid TEL gains in industry occurred in
Japan, up 80 percent, and Germany, up 42
percent, as compared with a gain of 36 percent
for U.S. industry. Higher energy costs could be
expected to stimulate increased efficiency in
that sector, relative to the nonindustrial sector.
The industrial sectors in Japan and Germany
account for a somewhat larger proportion of
GDP, 42 and 36 percent respectively, in 1974
as well as in 1987, than in the United States
where industry’s proportion dropped from 33
percent in 1974 to 30 percent in 1987. It re­
mains puzzling, however, as to why the indus­
trial TELs in Germany and especially Japan
compared poorly with nonindustrial TELs in
the early 1970s.
Another interesting development is most
easily seen in a graph of the technical efficien­
cy ratio (TER). Recall that this ratio is the
index of the home country GDP divided by the
index of energy input. In this case the base
period is 1974, the first year of the data set.
TERs for the industrial and nonindustrial sec­
tors in the U.S., Japan, and Germany for the
period 1974-1988 are shown in Figures 7 and 8.
Figure 7 shows that in the nonindustrial sector
the U.S. performed relatively better than the
economies of either Japan or Germany. U.S.
technical efficiency in this sector rose 31 per-

15

cent between 1974 and 1987 while nonindustri­
al energy efficiency in Japan and Germany rose
13 percent and 7 percent, respectively.
As shown in Figure 8, the TERs for the
industrial sector indicates that in this case the
U.S. did not fair so well relative to gains in
Japan and Germany. The TER for U.S. indus­
try rose 35 percent compared with 31 percent
for the nonindustrial sector. The ratio’s gain in
Germany was somewhat greater (42 percent)
and in Japan substantially greater (80 percent).
The United States’ overall TER, buoyed up by
gains in the nonindustrial sector, showed a gain
(up 32 percent) about midway between Japan
(47 percent) and Germany (19 percent).
Measures of observed and PPP efficiency
levels for the industrial and nonindustrial sec­
tors were subject to the same dominating influ­
ences of exchange rate movements noted earli­
er. Throughout, the PPP based and observed

efficiency levels for industrial
and for nonindustrial sectors in
Japan and Germany were well
above efficiency levels in the
United States, indicating prima
facie that the U.S. lost ground in
energy efficiency in the industrial
sector as well as in the nonindus­
trial sector. However, two-thirds
of the gain in observed energy
efficiency in Japan’s industrial
category and nine-tenths of the
gain in its nonindustrial category,
for example, were due to changes
in market exchange rates. Ex­
change rate movements had a
similar effect on Germany’s
observed efficiency measures for
industrial and nonindustrial sec­
tors. Once again, exchange rate movements
dominate the data.
As noted earlier, a country’s physical size
and the dispersion of its population may affect
energy efficiency. In particular, one would
expect a country with a comparatively high
level of economic activity in a small geograph­
ic area to have a comparatively high level of
energy efficiency, due to lower energy expend­
ed on transportation. That is, countries with
greater population densities should be more
energy efficient, other things being equal. As
shown in Table 11, the U.S. and Canada have
substantially smaller population density per
square mile than the other countries in the sam­
ple. This may explain in part why the U.S. and
Canada fair relatively poorly on energy effi­
ciency measures compared to the other coun­
tries. In order to investigate this hypothesis, we
examine the development of energy efficiency

TABLE 11

Selected demographic characteristics
(1988)
U.S.

Japan

Germany

UK.

France

Canada

3,615.1

144.0

96.0

94.2

212.8

3,851.8

246.3

122.6

61.4

57.1

55.9

26.0

68.1

851.5

639.5

606.0

262.5

6.7

Geographic
area,

(000) sq. mi.
Population,

millions
Population
density

per sq. mi.

16



ECONOMIC PERSPECTIVES

in the transportation vs. nontrans­
portation sectors over the 19701988 period.
Two formulations of the data
are examined: Both are modifi­
cations of previously discussed
measures—technical efficiency
and the per capita utilization
measure used above in the energy
dependence section. This analy­
sis relies on OECD data that
facilitate a breakdown of energy
consumption by source of energy
into total transportation and nontransportation sectors." Because
transportation relies primarily on
oil, rather than all energy, oil is
used as the energy source mea­
sure. The reader should be aware
that the data limitations cited in
note 11 mean that the technical
efficiency measures constructed
here are not comparable with
those constructed in earlier sec­
tions of the paper.
The TERs for the transportation/nontransportation sectors
shown in Figures 9 and 10 and
Tables 12 and 13, respectively,
suggest some interesting relation­
ships. First, gains in oil efficien­
cy in the transportation sector
were well below those for nontransportation. This is not sur­
prising because the opportunity
for the substitution of alternative
energy sources is greater for
nontransportation than for trans­
portation. Figure 9 also indicates that these
ratios tended to remain closely bundled until
the 1979-1980 oil price shock, after which the
ratios for the U.S., Canada, and to a lesser
degree Japan, broke from the pack.
A somewhat surprising result was that
three of the six countries (France, Germany,
and the U.K.) recorded TERs for transportation
that declined and one country (Japan) recorded
a transportation efficiency ratio that increased
only modestly. During the 1970-1988 period,
percentage changes in the transportation TERs
ranged from a decline of 13 percent for Germa­
ny to an increase of 27 percent for Canada.
The gain in the U.S. TER was 20 percent.

FEDERAL RESERVE BANK OF CHICAGO




In those countries where gains were record­
ed the data suggest that it took the transporta­
tion sector some time to adjust to the initial
shock of higher oil prices in 1973-1974 and the
subsequent shock in 1979-1980. The major
gains occurred post-1980.
The pattern of change in the TERs for the
nontransportation sector was markedly different
from that of the transportation sector (see Fig­
ure 10). All six of the countries recorded sub­
stantial gains in oil efficiency in nontransportation—gains ranged from 64 percent in the U.S.
to 117 percent in the U.K. One might expect
that the heterogeneous nature of this sector,
with its greater diversity of potential energy

17

TABLE 12

Technical energy efficiency ratio for the
transportation sector
(1970-1972 average=l)
Year

U.S.

Japan

Germany

U.K.

France

Canada

1970

1.02

1.03

1.04

1.02

1.04

0.98

1972

0.99

1.00

0.98

0.98

0.97

1.00

1974

1.01

0.95

1.02

1.02

0.95

0.98

1976

0.97

0.92

0.99

1.03

0.88

0.99

1978

1.01

0.91

0.91

1.00

0.90

1.01

1980

1.12

0.94

0.92

0.97

0.91

0.98

1982

1.12

1.02

0.92

0.98

0.92

1.11

1984

1.18

1.04

0.92

0.96

0.91

1.22

1986

1.21

1.07

0.91

0.95

0.91

1.30

1988

1.22

1.06

0.88

0.93

0.89

1.30

TABLE 13

Technical energy efficiency ratio for the
nontransportation sector
(1970-1972 average=l)
Year

U.S.

Japan

Germany

U.K.

France

Canada

1970

0.98

1.04

1.01

1972

1.00

1.02

0.99

1.17

1.01

0.96

1.20

0.99

1974

1.11

1.00

1.08

1.37

1.11

1.02
1.06

1976

1.11

1.13

1.11

1.56

1.24

1.28

1978

1.12

1.24

1.16

1.68

1.29

1.32

1980

1.28

1.56

1.39

2.16

1.48

1.45

1982

1.49

1.92

1.70

2.42

1.92

1.77

1984

1.70

1.92

1.76

2.76

2.10

2.11

1986

1.81

2.07

1.70

2.94

2.27

2.28

1988

1.89

2.14

1.96

3.22

2.51

2.42

sources and substitutability, contributed to the
progressive improvement in the efficiency ratio
throughout the period.
The second approach to examining the
geographical size/transportation issue looks
directly at the geographical size component of
the economies. The per capita consumption
measures used in the energy dependence dis­
cussion earlier is modified to incorporate coun­
try size. The modification is accomplished by
constructing a standard population density
series for each country across the 1970-1988
period. This results in two series per country—
oil consumption relative to density for the
transportation sector and oil consumption rela­

18



tive to density for the nontranspor­
tation sector.
The data indicate that low
population density does appear to
go hand-in-hand with high oil
consumption. Both the U.S. and
Canada recorded much higher
consumption to density figures
than did the other countries (see
Tables 14 and 15) These data also
indicate that oil consumption in
transportation, relative to popula­
tion density, increased through out
the period in France, Germany,
Japan, and the U.K. On the other
hand, the U.S. and Canada record­
ed declines in consumption rela­
tive to density in transportation
from the late 1970s, although the
data showed an up-tick in 1988.
In the nontransportation sector
the geographical size of the U.S.
and Canada also appear to domi­
nate the data. The data for the
U.S. does indicate a decline in
oil consumption relative to popula­
tion density, albeit from compara­
tively high levels. The U.K. and
France also recorded reductions in
oil consumption relative to popula­
tion density.
In short, it would appear that
geographic size does influence
an economy’s level of oil use
efficiency in the transportation
sector, and also in the nontranspor­
tation sector.
C onclusion

Dependence on energy is a fact of life for
the world’s economies. How dependent and on
what energy forms that dependence relies is not
universally alike. On the contrary, there appear
to be substantial differences across countries in
their level of aggregate dependence, the form of
that dependence, and how they have responded
to changes in the energy environment following
the 1973-1974 oil shock.
While oil continues to dominate the energy
picture in each of the six countries, each of the
countries has reduced its relative dependence on
oil, at least from those periods of highest depen­
dence in the late 1970s. But it is also the case
that the alternative energy sources toward which

ECONOMIC PERSPECTIVES

example, nuclear and H-G-S ener­
gy provide 38 and 35 percent,
Oil consumption by transportation sector
respectively, of France’s and Cana­
relative to population density
da’s energy requirements. France
(Millions of tons of oil equivalent/population density)
in particular has moved well away
Year
Japan
Germany
U.K.
France
Canada
U.S.
from dependence on hydrocarbon
fuels toward nuclear power during
0.05
0.05
0.05
0.09
5.25
1970
6.11
the period examined. Not only did
1972
6.65
0.05
0.05
0.05
0.10
5.68
it maintain a comparatively low
1974
6.67
0.05
6.28
0.05
0.05
0.11
per capita total energy requirement
7.06
0.06
0.05
0.05
0.12
6.47
1976
but it also maintained a compara­
7.34
6.57
1978
0.06
0.06
0.06
0.13
tively low reliance on oil and hy­
drocarbon fuels in general. In
6.34
0.07
0.07
1980
0.06
0.13
6.90
relative terms, Canada moved well
6.44
1982
0.07
0.06
0.06
5.87
0.13
away from hydrocarbon fuels as a
1984
6.62
0.07
0.07
0.14
5.77
0.06
general category, but because of its
0.07
0.07
0.14
1986
6.73
0.07
5.77
high per capita total energy re­
7.07
0.07
1988
0.08
0.08
0.15
6.21
quirements, the highest of the six
countries, its dependence on oil
remained high.
TABLE 15
An economy’s reliance on
Oil consumption by nontransportation sector
energy depends on numerous fac­
relative to population density
tors. Central to how an economy
(Millions of tons of oil equivalent/population density)
responds to shocks in prices or the
Year
Japan
U.S.
Germany
U.K.
France
Canada
availability of its energy resources
is how efficient the economy is in
1970
15.25
0.23
0.23
0.20
0.43
14.54
energy utilization. Standard tech­
1972
15.54
0.24
0.25
15.54
0.20
0.45
nical efficiency measures indicate
1974
0.27
0.24
15.02
0.20
0.45
16.63
that each of the six economies
have recorded substantial overall
1976
14.79
0.26
0.25
0.19
0.42
16.96
gains in technical efficiency. In
1978
15.03
0.25
0.25
0.19
0.45
17.39
the U.K. the efficiency ratio for
0.24
1980
14.30
0.17
0.44
0.25
17.56
GDP-to-energy input stood 39
12.71
1982
0.22
0.22
0.17
0.39
16.18
percent higher in 1988 than in
1984
0.24
13.03
0.23
0.16
0.40
16.60
1970. In the U.S., which ranked
1986
12.40
0.23
0.24
0.17
0.39
16.69
third in overall efficiency gains
1988
13.18
0.25
0.17
0.23
0.38
17.42
behind Japan, technical efficiency
was up 31 percent.
As one would expect, these
these economies have shifted tend to be hydro­
gains are not uniform across sectors within an
carbon fuels, specifically coal and natural gas.
economy and the pattern of gains across sectors
The U.S. increased its relative dependence on
varies considerably between countries. Gains in
coal. Germany, Japan, the U.K., and to a lesser
technical energy efficiency in U.S. industry were
degree France, increased their relative depen­
only modestly greater (up 35 percent between
dence on natural gas. Indeed, as of 1988, hy­
1974 and 1987) than for the nonindustrial sector
drocarbon fuels continued to provide 85 percent
(up 31 percent). In Japan and Germany, techni­
to as much as 92 percent of total fuel require­
cal energy efficiency gains in industry were
ments in Japan, Germany, the U.S. and the
dramatically larger (up 80 percent and 42 per­
U.K. (in 1970, hydrocarbons provided well over
cent, respectively) than in the nonindustrial sec­
90 percent of fuel requirements in each of these
tor (up 13 percent and 7 percent, respectively).
countries).
This differential in technical efficiency gains
Only in France and Canada do nonhydro­
could be expected to be a factor in maintaining
carbon fuels constitute a conspicuous portion of
or enhancing international competitiveness by
their economies’ energy sources. In 1988, for
TABLE 14

FEDERAL RESERVE RANK OF CHICAGO




19

reducing energy input costs, thus possibly
helping to offset the adverse competitive impli­
cations, for Germany and Japan, of the dollar’s
depreciation in foreign exchange markets.
Several points stand out from this examina­
tion of energy dependence and efficiency: The
major industrial economies continue to be
heavily dependent on oil and other hydrocarbon
fuels. Among those countries, Canada and
France have made substantial strides in shifting
their dependence to nonhydrocarbon fuels. In
the aggregate, energy is more efficiently uti­
lized than it was prior to the 1973-1974 oil
shock. The gains in energy efficiency in the
U.S. have been spread rather evenly across the

industrial and nonindustrial sectors of the econo­
my. The efficiency gains in Japan and Germany
were primarily in the industrial sectors of the two
economies.
Much work remains to be done concerning
the issues of energy dependence and efficiency.
Because of the problems noted above concerning
the measurement of efficiency levels in cross­
country analysis, there is need for further work
concerning the measurement of efficiency, as
well as further study of the impact of geographi­
cal size on energy utilization and the impact of
prices, environmental concerns, and government
polices on energy use and efficiency.

FOOTNOTES
Currently, the Congress is considering an omnibus energy
production and conservation bill, the major focus of which
is to promote increased domestic oil production (and
reduced dependence on foreign oil) by relaxing drilling
restrictions in Alaska and in offshore areas. Also under
consideration are measures to decrease oil consumption
through administrative auto mileage requirements and
another token increase in the gasoline tax of 5 cents per
gallon.
2One might assert that this fragility is also due to an appar­
ent lack of appreciation by policy makers of their econo­
mies’ dependence on energy, especially petroleum, for
continued economic viability. This is exemplified by a lack
of will in some countries, especially the U.S., to apply
significant economic disincentives (e.g., gasoline taxes) to
the consumption of energy and oil. The preference instead
is for administrative distortions to the market place.
3Measures of energy utilization used in this study draw on
the Organization for Economic Cooperation and Develop­
ment (OECD) definition of domestic “Total Primary Ener­
gy Requirement” (TPER) and “Total Final Consumption”
(TFC). Where a common energy unit is required in the
analysis the OECD’s common energy unit, “tons of oil
equivalent,” usually measured in millions (Mtoe) is used.
During any given period, TPER is defined as the sum of a
country’s internal production of all energy resources, plus
imports, less exports, less international marine bunkers,
plus or minus inventory changes of these resources. This
measure differs from TFC primarily in that TPER includes
energy used in the transformation process, e.g., coal to
electricity, and distribution losses as in the transmission of
electricity. Energy forms also differ between TPER and
TFC. Nuclear or solar energy contribute toward fulfilling a
country’s energy requirements, TPER, but are not used
directly in consumption, TFC. Nuclear or solar energy is
consumed in the form of electrical energy, and thus does
not appear directly in energy consumption.

20



The OECD defines a “ton of oil equivalent,” where ton
refers to a metric ton (2,204.6 U.S. pounds), as equal to 107
kcal. of energy. All energy forms, be they petroleum,
nuclear power used to generate electricity, or electricity
consumption itself are converted to the common unit
“t.o.e.” In this article units will be reported in millions of
ton oil equivalent (Mtoe).
Percentage changes throughout the article are reported on
a logarithmic basis.
5Import dependence has implications for a country’s
international balance-of-payments. The larger the oil
import requirement needed to sustain the economy, the
greater the real resources required to finance the importa­
tion of oil. Other things remaining the same, a lower
standard of living results for the oil importing country than
if the oil could be sourced at equal cost domestically.
Import dependence is also a concern for national security.
The greater a country’s dependence on imported oil the less
independent it is from the political or economic whims of
its foreign oil suppliers. It is clear that in the current political/economic environment, energy and petroleum security
is vital. From a near-term perspective, it may be undesir­
able to be dependent on the political or economic whims of
foreign oil producers, however, one must also be aware of
longer-term security issues.
Arguably, a nation’s energy sources would be more secure
the less its dependence on foreign supplies. During 19891990, 40-45 percent of U.S. petroleum consumption was
derived from foreign sources. On the other hand, in an
environment of limited and relatively high cost domestic
supplies and relatively inexpensive foreign supplies the
utilization of imports serves to conserve and prolong those
limited domestic supplies, should a real emergency devel­
op. U.S. petroleum independence in the near-term—the
relatively more rapid depletion of domestic supplies—risks
the possibility of becoming more heavily dependent on

ECONOMIC PERSPECTIVES

foreign supplies in the future, barring major technological
innovation, such as, for example, economically viable solar
or fusion power. From an energy security perspective then,
it is not a clear cut decision that reduced import dependence
now is preferable to necessarily greater dependence later.
This is an argument that policy makers must not continue to
ignore.
6It is interesting to note how the region of source has
changed over time. From 1973 to 1988 the proportion of
total oil consumption by the six countries that was derived
from the Persian Gulf states generally declined: For Japan,
from 74 percent to 55 percent; for France, from 84 percent
to 28 percent; for the U.K. from 66 percent to 15 percent;
for Germany, from 49 percent to 9 percent; and for Canada,
from 19 percent to 4 percent. The U.S. share increased
from a comparatively low level of 6 percent to 9 percent.
’American Gas Association (1990), p. 124.
®Gross domestic product is used as the measure of a coun­
try’s output in order to obtain a more consistent data series.
GDP is the more commonly used output measure abroad.
GDP differs from GNP in that GDP excludes net factor

income from abroad. In U.S. national income statistics, for
example, most of the net factor income from abroad is in
the form of U.S. firms’ corporate profits from abroad—
profits earned abroad are not part of U.S. GDP, but are
included in GNP.
’Other economists, for example, Summers and Heston
(1984), have done extensive work that has focused on
developing meaningful measures of real national product
across countries.
^Organization for Economic Cooperation and Develop­
ment (1991).
n OECD data are available for energy and oil consumption
by transportation (air, road, and rail). An important restric­
tion in the transportation case is the lack of contribution to
GDP by sector data, as was the case for industrial/nonindustrial sectors—that is, contribution to GDP by the trans­
portation sector and contribution to GDP by the non­
transportation sector. The technical efficiency measures,
therefore, do not refer specifically to this sector. Rather,
they are a hybrid that relates total GDP output to energy
inputs for transportation/nontransportation.

REFERENCES
American Gas Association, 1990 Gas Facts,
1990
Central Intelligence Agency, International
Energy Statistical Review, Washington, select­
ed issues.
Energy Information Administration, Interna­
tional Petroleum Statistics Report, U.S. Depart­
ment of Energy, Washington, selected issues.
International Energy Agency, Oil and Gas
Information, Organization for Economic Coop­
eration and Development, Paris, selected issues.
Organization for Economic Cooperation and
Development, Energy Balances of OECD
Countries, Paris, selected issues.

Organization for Economic Cooperation and
Development, National Accounts 1960-1989,
Main Aggregates, Volume 1, Paris, 1991.
Organization for Economic Cooperation and
Development, OECD Economic Outlook, No.
48, Paris, December 1990, pp. 35-46.
Summers, Robert and Alan Heston, “Im­
proved international comparisons of real prod­
uct and its composition: 1950-1980,” Journal
of Income and Wealth, June 1984, pp. 207-262.
Worldmark Press, Worldmark Encyclopedia
of the Nations, John Wily & Sons, Seventh
Edition, Volumes 3, 4 and 5, New York, 1988.

Organization for Economic Cooperation and
Development, National Accounts, Detailed
Tables, Vol. 2, Paris, selected issues.

FEDERAL RESERVE BANK OF CHICAGO




21

Balancing act: Tax structure
in the Seventh D istrict

Richard H. M atto o n

£

gan and Wisconsin—focusing on their utiliza­
State and local governments
tion of the property, income and general sales
are facing their toughest fiscal
tax. Finally, it will review the tax options now
situation since the recession
under consideration to relieve state and local
years of the early 1980s. As
fiscal pressure.
tax revenues throughout the
country fall below projections, state and local
C rite ria fo r ju d g in g a good
governments are grappling to find the right s tru c tu re
ta x
course between spending cuts and tax increas­
Requirements for a good tax structure can
es. Owing to budget problems of its own, there
be distilled from a large body of analysis and
is little hope that the Federal government can
thought.1 Criteria often include the following:
help the states in these recessionary times.
• The distribution of the tax burden should be
As state and local governments begin to
equitable, with everyone paying a fair share.
examine their expenditure and revenue options,
it would be wise for policy makers to bear in
• Interference with the operation of efficient
mind what constitutes a good tax system, as
private markets by taxes should be minimized.
well as the major advantages and disadvantages
In particular, taxes should not distort econom­
of the tax sources available to state and local
ic choice by placing excess burdens on indi­
governments.
viduals.
Many analysts have described what they
• Taxes can, however, be used to correct ineffi­
believe the objectives of a good tax structure
ciencies in the private sector in situations
should be. While the criteria developed share
where markets do not behave efficiently.
many common concerns, no two lists are exact­
ly alike. Depending on which aspect of the tax
• The tax structure should help stabilize the
structure receives emphasis, goals can conflict
national economy while providing adequate
and blueprints for tax policy can become mud­
revenue growth.
dled. However, keeping well-defined criteria at
• The tax structure should permit efficient and
the forefront can help focus the tax policy de­
nonarbitrary administration and should be
bate and can force policy makers to be explicit
comprehensible to the taxpayer.
in recognizing the trade-offs that occur in se­
lecting one tax over another.
• Administration and compliance costs should
This article will begin by reviewing the
be reasonable.
criteria often cited for establishing a good
tax structure. Against these criteria, it will
The author is a regional econom ist at the Federal
Reserve Bank of Chicago. The author thanks
examine the tax structure of the five Seventh
W illiam Testa for guidance and com m ents on
District states—Illinois, Indiana, Iowa, Michi­
previous drafts.

22



ECONOMIC PERSPECTIVES

In order to design tax systems, state policy
makers often need more detailed guidelines
which incorporate strategies specific to state
and local government.2 In this regard, Robert
Kleine and John Shannon have developed the
following guidelines of taxation.
• Revenue sources for taxation should be diver­
sified. In particular, they should balance the
three principal tax bases available to state and
local government: income, property and sales
taxes.
• Revenue sources should be stable and taxes
should be moderate. This includes using
broad tax bases with minimum volatility and
insuring that expenditures and state revenues
grow at consistent and reasonably parallel
rates.
• Taxation should be fair and equitable. That
is, the tax structure should be progressive
enough to protect the lowest income members
of society from bearing a disproportionate
share of the tax burden.
• There should be state fiscal equalization pre­
venting property tax disparities from creating
local fiscal disparities in funding for education
and other programs. Specifically, this calls
for state government to take a “senior” role in
the state and local fiscal system and assume at
least 50 percent of the cost for education,
health and hospitals, and all of the cost of
nonfederal public welfare. In lieu of picking
up these costs directly, the state should offer
revenue sharing so that communities can fund
these programs without sole reliance on the
property tax.
• Changes to the tax structure should be politi­
cally accountable. Tax increases should be
the product of deliberate legislative action and
not inherent structural features of the tax
system which permit automatic tax hikes. To
cite two examples, “bracket creep” for income
taxes and changes in assessment practices for
property taxes often permit governments to
raise revenues without approval from either
taxpayers or their representatives. In contrast,
indexing income taxes and adopting truth in
property tax laws can help safeguard residents
from automatic tax increases.
• There should be property tax equity, defined
as uniform assessments both within and be­
tween towns.

FEDERAL RESERVE BANK OF CHICAGO




• State and local governments should strive for
tax competitiveness. Tax rates and policies
should avoid creating an image of a poor
business climate. Each state should be cau­
tious that its tax policies do not provide incen­
tives for desired companies to invest in lower
tax jurisdictions.
Neither of these lists exhaust the possible
criteria for designing a good tax system and it is
impossible to meet all of these criteria simulta­
neously. In trying to meet the goal of one as­
pect of the tax system, trade offs with other
goals are bound to occur; compromises must be
made. For example, offering tax incentives to
business may undermine revenue stability.
Many states have created special tax incentives
in order to attract and retain business and to
create a “competitive tax climate.” In doing so,
states narrow the base on their business taxes,
often making the revenue performance of the
tax more volatile and thereby undermining
revenue stability. Similarly, those sales tax
policies that exempt “necessities,” such as food
and clothing, are usually intended to promote
tax fairness. In doing so, the revenue stability
of the tax system may again be reduced by
narrowing the tax base. Furthermore, some of
the goals of a good tax system are ill-defined or
not universally accepted. Having everyone pay
their fair share is a goal of tax equity; however,
not everyone agrees on what constitutes a fair
share. Should a person’s fair share be based on
their ability to pay or on the benefit they re­
ceive from the public services provided by
taxation?
Given that it might not be possible to satis­
fy all of the objectives listed above simulta­
neously, the purpose of reviewing lists such as
these is to provide the framework for examin­
ing what specific needs and pitfalls should be
considered when trying to reform or modify a
state’s tax structure. Revenue systems are
reformed because one feature of the system has
fallen out of line. Too often, in the process of
re-alignment, other important features are ne­
glected.
Currently, revenue adequacy is the one
goal of taxation which is of most immediate
interest to policy makers. Many states are
finding that revenues are not adequate. None of
the three major state and local tax bases (prop­
erty, sales, income) appear to be easy targets
for revenue expansion to relieve the currently

23

strained state and local fiscal condition. Yet
states are largely limited to the property, sales
and income tax bases which have traditionally
been the focus of major tax changes.

FIGURE 1

Distribution of state/local tax
revenue by source
percent of total tax revenue

S even th D is tric t focu s

The District’s revenue structure

Seventh District states have established a
fairly conventional tax structure, raising the
bulk of their tax revenues from property, sales
and income taxes. District states differ some­
what from the rest of the nation in that they rely
on property taxes for a greater proportion of
revenue. Income and sales tax bases grew
faster during the 1980s than the property tax
base. As a result, District tax revenues grew
more slowly during the 1980s than the rest of
the nation.
The property tax

Table 1 compares the District with the U.S.
on property tax reliance. The Advisory Com­
mission on Intergovernmental Relations
(ACIR) tax effort index reported in the Table is
designed to measure a state’s tax effort relative
to the U.S. (see Box for details). Table 1 shows
that, as measured in terms of effective tax rate,
share of personal income and the ACIR tax
effort index, District states tend to utilize the
property tax more heavily than the national
average. It is therefore not surprising that in
terms of revenue raised, the property tax com­
prises the largest share of state and local tax
revenues in the District states, as shown in
Figure 1.

District
S O U RCE: Governm ent Finances: 1988-89, Bureau
of the Census.

Table 2 compares the growth of the proper­
ty, sales and income tax revenues for District
states and the U.S. during the 1980s. From
1981 to 1989, real property tax revenues in the
District grew by only 15 percent while sales
and personal income tax revenues were up
more than 25 percent, in spite of the fact that
the District attempts to tax property more vigor­
ously than the other tax bases. At the national
level, property tax revenues were the slowest
growing revenue source with receipts up 31
percent while sales and income were up 40 and
49 percent, respectively.
Before discussing the advan­
tages or disadvantages of the
TABLE 1
relative reliance on property
Property tax comparisons for the District and the U.S.
taxes for District states, it is nec­
essary to keep several caveats in
Effective
Share of
ACIR
tax rate*
personal income
index
mind. It is very difficult to make
1987
1988
1988
meaningful generalizations about
how the property tax burden
Illinois
1.59
3.8
129
uniformly affects any individual
Indiana
1.28
3.2
103
state due to the wide variation in
Iowa
1.96
4.5
152
local property tax administration.
Michigan
2.26
4.7
157
Given the local nature of the tax,
W isconsin
2.27
4.5
147
the property tax burden can be
U.S.
1.16
3.5
100
significantly different from town
^Effective tax rate reflects the estimated taxes on a FHA insured
to town and can reflect differenc­
single family home mortgage.
es in the level, quality and effi­
SOURCES:State Policy Data Book 89, Table D-40, Brizius & Foster.
States in Profile, 1990, Table D-9, Brizius & Foster.
ciency of town services, variation
1988 State Fiscal Effort, 1990, Advisory Commission on Intergovern­
in the local price of providing
mental Relations.
services, assessment practices,

24



ECONOMIC PERSPECTIVES

vestment is equal in both jurisdic­
tions. This will leave the high
Real tax growth by type of tax: 1981-1989
tax town with a diminished share
(Percent change)
of capital stock, which can be a
General
Personal
Total
major concern for a town’s eco­
Property
sales
income
tax
nomic growth and development.3
The District’s reliance on the
Illinois
15.6
19.5
19.1
13.2
property tax probably has little to
Indiana
9.7
31.1
109.1
34.9
do with the debate over who
Iowa
4.7
27.1
20.4
13.8
bears the burden of the tax. High
Michigan
12.8
20.6
29.2
19.5
property tax reliance is usually
W isconsin
30.2
46.2
7.6
25.6
related to a variety of other fac­
tors which relate taxes to the
U.S.
31.4
39.9
49.9
32.49
funding of public services ren­
District
15.0
25.5
27.6
19.58
dered rather than to who bears
SOURCE: Government Finances: 1980-81, 1988-89, Bureau
the tax burden.. If there is a
of the Census.
political preference for local
governments funding a large
share of public education expense or other local
and other factors. Simply noting that the aver­
programs, the property tax burden will be high­
age property tax burden for a given state is high
er. For example, in Illinois, the existence of
fails to recognize the extremely varied distribu­
thousands of special districts and other govern­
tion of this tax burden.
ments explains why the state’s reliance on the
Determining the ultimate burden of the
property tax is higher than the U.S. average.
property tax is also an issue of dispute. Origi­
Also, property tax reliance is often a product of
nally, tax theory held that property tax was
historical factors. Agricultural states tend to
passed on to tenants and consumers of property.
rely on property taxes because, historically, the
As such, the effect of the tax showed up in
property tax was a good way to relate the tax
either the tenants’ rent or in the price of a prop­
burden to the ability to pay. In an agrarian
erty. In practice, this made the property tax
economy the more farm land held, the greater
regressive with respect to income since lower
the ability to produce income.4
income households tend to devote a larger share
Critics often attack the property tax on
of their income to housing. For this reason,
several grounds. The first criticism is that it
many tax analysts held that reliance on the
serves as a poor proxy forjudging an individu­
property tax should be held in check due to its
al’s ability to pay the tax if the tax is viewed
regressive sting.
solely as a tax on the consumption of housing.
However, more recent theory has held that
The property tax is often claimed to be “hori­
the property tax is actually a tax on capital. As
zontally inequitable” in the sense that individu­
such, its incidence is reflected in a reduced
als with equal incomes or wealth rarely have an
return on capital investment which ultimately is
equal property tax burden due to variations in
also borne by labor. Labor is affected because
their housing consumption. For example, two
the reduction in capital stock caused by the
houses may be assessed and taxed at identical
property tax reduces labor output. The effect is
rates and yet disparities in the incomes of the
even more pronounced when there are differen­
owners can make the burden of the tax minimal
tials in property taxes between jurisdictions.
on one owner and heavy on the other. For
Here a distinction must be made between the
example, the tax burden is often heavy for
effect the tax has on land vs. its effect on capi­
senior citizens on fixed incomes who find that
tal. While land is immobile, capital is not.
property taxes consume a larger and larger
Consequently, differentials in property tax rates
fraction of income over time.
will induce capital to move to locations with
Another criticism is that the multiplicity of
lower tax rates, thereby increasing the return on
taxing districts and variations in tax structure
capital. This will cause investment funds to
often provides incentives for avoiding the tax.
flow out of high tax jurisdictions and into low
In states where mobile personal property such
tax jurisdictions until the return on capital in­
TABLE 2

FEDERAL RESERVE BANK OF CHICAGO




25

The Advisory Commission on Intergovernmental
Relations Representative Tax System
The Representative Tax System (RTS) was
created by the Advisory Commission on Intergov­
ernmental Relations (ACIR) in an effort to allow
comparisons of state and local tax capacity and
effort between states. RTS measures the amount
of revenue that would be raised if a state applied
national average tax rates to 27 different tax bases
within the state’s boundaries. The figure arrived
at through this process defines the hypothetical tax
capacity of a given state. It is important to note
that the RTS is a hypothetical measure that as­
sumes all states utilize all 27 tax bases and that all
states tax at the same rate.
Tax effort in the RTS attempts to determine a
state’s relative utilization of its tax base. Tax

effort is the ratio of actual state tax collections to
the state’s hypothetical tax capacity. A tax effort
above 100 indicates that the state’s utilization of
the tax is above the U.S. average. For example,
Wisconsin’s 1988 tax effort score for the personal
income tax was 157. This indicates that the state
imposes a tax burden which is 57 percent above
the national average. Conversely, a score below
100 indicates that the state’s utilization of the tax
is below the U.S. average. For example, Michi­
gan’s sales tax effort of 76 means that the state’s
sales tax effort was 24 percent below the U.S.
The RTS provides a basis for standard compari­
sons among states.

as automobiles is taxed, there is an incentive to
register cars in towns with low tax rates even if
the owner resides in a higher tax town. A fur­
ther criticism is that gaps in the property assess­
ment cycle can distort the relative value of both
personal property and new construction, forcing
both to bear an unfair share of the tax load.
This occurs when personal property and new
construction assessment reflect current value
while real property assessments are allowed to
lapse for several years in between revaluations.
In some states the gap between real property
revaluations can be as much as 10 years.
Evidence suggests that high property taxes
can also serve as an obstacle to business and
economic development, since the property tax
can often be the largest tax faced by a business.
A recent Wisconsin study found that the prop­
erty tax constituted 47 percent of the state and
local total tax liability for a group of six manu­
facturing industries.5 This out-distanced the
corporation business tax which comprised 35
percent of total state and local tax payments.
The view that high property taxes impede eco­
nomic development is supported by economic
theory, which holds that differentially high
property taxes will tend to increase the cost of
capital, thereby encouraging new investment to
seek lower tax jurisdictions.
Finally, high property tax reliance can
create fiscal disparities between communities.
Goals of equity and fairness can be undermined

when property poor towns are forced to provide
the bulk of their local services through the
property tax.
The primary defense of property taxation
tends to be founded more on political than
economic grounds. Because property tax
growth is relatively inelastic, or unresponsive to
swings in economic activity, it supplies a
steady but sluggish revenue source for local
governments. This steady growth can be a
stabilizing factor for local governments in bad
economic times.
The relative stability of the property tax
has proven to be an advantage during the recent
recession. National Income and Product Ac­
count data placed the property tax as the fastest
growing revenue source when measured from
the first quarter of 1990 to the first quarter of
1991. Specifically, property tax revenues have
grown by 6.5 percent while sales and income
tax revenues have increased by only 2.7 and 3.8
percent, respectively. Recessionary effects
which are impacting sales and income tax re­
turns are less likely to cut into property tax
gains. Since property tax assessments often lag
because of administrative features, this tax
source continues to grow as updated assess­
ments reflect past gains in property values even
though current values may have stabilized or
declined. This administrative lag can often
stabilize government spending in the early
periods of a recession and generally reduce

26



ECONOMIC PERSPECTIVES

reliance on faster growing but more volatile tax
bases such as income and sales.
In summary, the District’s reliance on
property tax suggests a choice of slower but
more stable revenue growth, more costly in­
vestment in property from a tax perspective and
an overall tax structure that is probably more
regressive with respect to income than is the
case for the U.S. as a whole. Further, while
the property tax may have the advantage of
increasing local government accountability by
requiring that more services be performed at the
local level, it reduces the redistributive role of
state government by reducing the potential
revenue raising capacity of state government.

FIGURE 2

Sales tax effort: 1988
U.S. average-100

The general sales tax

District wide reliance on the sales tax var­
ies significantly. While both Indiana and Illi­
nois draw 25 and 29 percent of total state and
local revenues from the sales tax, the remaining
three District states all draw less than 20 per­
cent. This variation is also evident in the rela­
tive burden of the tax as a percentage of person­
al income. In Indiana, the sales tax is 3.1 per­
cent of personal income, in Illinois it is 2.6
percent and in Wisconsin it is 2.5 percent. In
Iowa and Michigan the percentage falls to 2.1
percent. When viewed relative to the U.S.
average, only Indiana exceeds the national
figure of 2.8 percent. This variation occurs
despite the fact that state sales tax rates among
the five District states are quite similar, ranging
from 4 percent in Michigan to a high of 6.25
percent in Illinois.6
The significant difference in reliance has
come about because states differ in authorizing
localities to levy their own sales tax. Iowa,
Illinois and Wisconsin all permit other govern­
mental units to levy a sales tax in addition to
the basic state sales tax rate. In Chicago, for
example, the total sales tax rate levied by all
overlapping governments is 8 percent. Mean­
while, just over the state line in Indiana, the
rate is 5 percent. Such disparities can create an
incentive for people to avoid additional sales
taxes by crossing state borders to make pur­
chases.
Even in the ACIR tax effort figures, Dis­
trict states rank very low nationally on the sales
tax effort index (see Figure 2). Only Indiana
and Illinois at 105 and 104 respectively are
above the national average. When compared to
the very high property tax effort scores for

FEDERAL RESERVE BANK OF CHICAGO




August 1990, ACIR.

District states, it is clear that the District pro­
vides something of a break with respect to
consumption taxes. This reduced reliance does
not arise because of any smaller tax base in the
District. Rather, it most likely reflects differing
exemption policies for certain goods (all five
District states exempt manufacturing machinery
and materials as well as food and prescription
drugs from the sales tax) rather than lower
spending tendencies by District residents.
Low reliance on the sales tax is perhaps the
most unusual aspect of the District’s tax struc­
ture. Nationally, the sales tax is consistently
seen as the most popular tax in surveys of tax­
payers. Much of this popularity is due to ad­
ministrative features of the tax. The relatively
small amount of the tax attributable to the pur­
chase price of a good makes the tax less visible
on all but the largest purchases.
In addition to its relative popularity, the
sales tax is fairly easy to administer even
though sales tax audits are necessary and often
expose significant fraud. The sales tax also has
the added advantage of being an exportable tax
in that it is paid by those nonresidents such as
tourists and conventioners who make purchases
within the state.
One problem often noted with the sales tax
is that it is not progressive. That is, if a
wealthy person and a poor person buy the same
good, the tax bite as a share of income is much
greater for the poor person. Attempts to correct
this feature and reduce the regressivity of the

27

tax by exempting food and other necessities
often fail because the tax break tends to provide
relief to both income groups. As a further
drawback, exemptions of necessities, such as
food, increase the volatility of the tax base by
making the base more reliant on “big ticket”
consumer goods such as cars.
Further, the relative regressivity can be
capricious, because it is greatly influenced by
an individual’s particular consumption and
savings habits. This feature is moderated to
some extent because it is possible to escape
some of the sales tax burden by lowering the
level of consumption and increasing savings.
Indeed, some analysts favor this tax because it
encourages national savings. But low income
individuals have much less latitude in their
consumption vs. savings decisions. Much of
the decision to consume is based on the relative
need for a product. The more price inelastic
the demand for a product, the more regressive
the sales tax. For goods that are price elastic,
such as luxuries, the seller of the product may
have to absorb some of the tax burden.7 Neces­
sities are relatively price inelastic, consequently
the buyer must absorb all of the tax burden.
By underutilizing the sales tax, District
states generally forego revenues from the least
politically objectionable tax source. Their gain
may be greater revenue stability because they
are less reliant on this relatively more volatile
base. Furthermore, by permitting local sales
taxes, the states provide local governments with
an option for revenue diversification which can
lessen the dependence on the property tax.
However, taxpayers find it easy to avoid the
local sales tax by making purchases in lower
tax jurisdictions, thereby affecting shopping
location decisions.

nois at 1.7 percent is significantly below the
average.
With the exception of Illinois, with its low
reliance on the personal income tax (this will
change given the recent tax surcharge which
raised the income tax rate from 2.5 to 3 per­
cent), the District tends to conform fairly close­
ly to the ACIR criteria of raising a quarter of
revenues from this source. However, it does so
by imposing a slightly higher tax burden on
residents relative to the nation. Both the tax as
a share of personal income numbers and the
ACIR effort index reflect a relatively high
burden for this tax (see Figure 3).
Differences in reliance among District
states arise primarily from differences in the tax
structure. Three states—Illinois, Indiana and
Michigan—have flat rate income taxes which
range from 3 percent in Illinois to 3.4 percent in
Indiana and 4.6 percent in Michigan. Iowa and
Wisconsin have graduated rate income taxes,
with Iowa’s tax consisting of nine tax brackets
ranging from a tax rate of .4 percent to 9.98
percent, and Wisconsin’s consisting of three
brackets ranging from 4.9 percent to 6.93 per­
cent. All five states use some variant of federal
adjusted gross income as a starting point for the
tax base. As a group, none of the District states
can be characterized as having generous deduc­
tions or tax credits in arriving at state taxable
income. Both Illinois and Indiana permit only
a $ 1,000 standard deduction against individual
income before levying their flat rate tax. Iowa
and Wisconsin provide limited tax credits.
FIGURE 3

ACIR income tax effort: 1988
U.S. average-100

The personal income tax

The District tends to be slightly above the
national average in utilizing the personal in­
come tax. When measured as a share of state
and local revenues, the District tends to draw
on the personal income tax more heavily than
the U.S. as a whole. This is also reflected in
the burden of the personal income tax as a
percentage of income. The U.S. average for
state and local personal income taxes as a per­
centage of income is 2.1 percent. District states
above the average include Indiana at 2.3 per­
cent, Michigan at 2.5 percent, Iowa at 2.6 per­
cent and Wisconsin at 3.3 percent. Only Illi­

28



August 1990, ACIR.

ECONOMIC PERSPECTIVES

Iowa’s credit is $20 for the filer and $15 for
each dependent while Wisconsin limits its tax
credit to $50 per dependent. Michigan provides
the most generous standard deduction at
$2,000. The impact of these limited deductions
and credits is to make the income tax more
regressive in District states, particularly in
those with low standard exemptions and flat
rate tax structures, than in those states with
progressive rate tax structures or large personal
exemptions.8
There are several advantages to raising
revenues through income taxes. It is considered
the best tax in terms of progressively relating
the tax burden to one’s ability to pay. And
assuming that the tax uses a fairly broad mea­
sure of income, it is also horizontally equitable,
that is, it treats equally-situated individuals the
same. Tax compliance costs are also lessened
through conformance with the federal income
tax base guidelines. The tax is highly produc­
tive as a revenue source. As personal incomes
rise the tax base grows. As such it can provide
a substantial revenue source for the states.
Also, because most states choose not to index
the income tax base, state income tax revenues
can grow through bracket creep in which in­
creases in personal income push tax payers into
higher tax brackets even if their inflation-ad­
justed incomes have not increased significantly.
Since three of the District states utilize flat
income tax rate structures, bracket creep is less
of an issue within the District.
One disadvantage of the personal income
tax is that as it reduces disposable income, it
can serve as a drag on spending and investment.
A relatively higher income tax burden can
mean that people will adjust their spending and
savings habits in order to absorb the tax. This
behavior is likely because the income tax in
most cases cannot be transferred or shifted to
another party. As such, the District’s slightly
heavier burden on income taxes may tend to
reduce both consumption and savings. Further­
more, the preference toward flat tax rates with
limited deductions erodes much of the progres­
sive structure usually associated with income
taxes.
E x p o rta b ility

Tax exportability—the ability to levy taxes
in such a way that the burden is borne by outof-state residents—is quite understandably a
desirable goal from the point of view of the

FEDERAL RESERVE RANK OF CHICAGO




state levying taxes.9 The advantage for a state
in having a significant share of its tax base
exportable is that it lessens the tax burden on
state residents. Three states noted for having
highly exportable tax bases are Alaska, Nevada
and Hawaii. Alaska is able to export a great
deal of its tax burden through severance taxes
on the sale of oil. Because oil deposits are
mostly owned by large multi-national compa­
nies, which are in turn owned by non-Alaska
residents, severance tax incidence falls on outof-state residents. A 1980 study1 found that
0
Alaska was able to export 36 percent of its tax
burden largely because of the severance tax.
The same study found that Nevada was able to
export over 20 percent of its tax burden through
the sales taxes on gambling by out of state
residents. Hawaii exports taxes by taxing
spending by tourists.
By comparison, Seventh District states are
not so blessed. At present, there is no large
industry generating profits for out-of-state resi­
dents which can be tapped by the tax system.
Very little of existing revenue vehicles are able
to export the burden. This is due in part to the
District’s relatively heavy reliance on property
taxes, which are usually not exportable, and the
light reliance on sales taxes, which are the most
exportable. The 1980 study found that while
the average rate of tax exportation for the U.S.
was 9.6 percent, the range in the District states
was 7.7 percent in Illinois, 6.5 percent in Mich­
igan, 5.8 percent in Indiana, and 5.4 percent in
both Iowa and Wisconsin.
In a sense, taxes can also be exported to the
federal government when states take advantage
of the so-called federal offset permitting deduc­
tions from the federal income tax for selected
taxes paid to states and municipalities. In par­
ticular, income and property taxes are currently
eligible as a deduction for those who itemize
deductions on federal returns. District states
fare better with respect to federal tax exporta­
tion because they rely heavily on property and
income taxes. In 1980, the national average for
the federal offset of state taxes was an estimat­
ed 7.1 percent. Among District states, the
value of the offset was greater in all states ex­
cept Indiana; 7.5 percent in Illinois, 5.6 percent
in Indiana, 7.3 percent in Iowa, 9.2 percent in
Michigan and 10.2 in Wisconsin. Sales tax
deductions were phased out following the 1986
Tax Reform Act and are no longer a source of

29

federal tax exportability. With the elimination
of sales tax deductability, the size of the offset
has undoubtedly declined but, given the Dis­
trict’s lesser reliance on sales taxes, the decline
has probably been less precipitous than in high
sales tax states.
One final trend which also affects the rela­
tive value of the federal tax offset is the recent
popularity in state and local governments of
user fees and special charges. While these have
the advantage of diversifying revenue sources
and directly relating the cost of providing a
service to the beneficiary, they have the disad­
vantage of not being deductible from federal
taxes. User fees and charges often replace
revenues from deductible sources, such as prop­
erty and income, which in turn reduces the
value of the federal offset.
O p tio n s fo r raisin g ta x revenues

States are now facing the largest revenue
gap since the 1981-82 recession. Then, most
states initially tried to avoid major tax increas­
es. Nevertheless, states entered FY83 with
record tax increases. At the beginning of FY83,
16 states raised their income tax, 11 raised their
sales tax and 5 raised both. Furthermore, 10
states had a stated goal of trying to increase
revenues by 15 percent that year.1
1
While states are today looking at similar
options, fears of developing a less competitive
tax climate than neighbors have many states
attempting to raise revenues through means
other than raising major tax rates. Some states,
motivated by their current fiscal problems, are
reducing tax rates that are perceived as being
too burdensome, and replacing these taxes with
new ones. For example, Tennessee and Con­
necticut considered instituting state income
taxes and using the money raised to role back
the sales tax rate. In Tennessee’s case, the state
sales tax rate could be cut from 5.5 to 4 percent
and in Connecticut from 8 percent to 4.25 per­
cent. The belief is that a more balanced tax
system will ultimately be of greater benefit to
the states’ residents while also enhancing eco­
nomic development.1
2
In a turnaround of trends from the 1980s, a
number of states with progressive rate income
taxes are considering raising the top marginal
tax rate on individual income taxes. Proposals
to do so have been offered in California, Dela­
ware, Montana, Maine, and New York. For
example, a legislative package in California

30



proposed raising the top bracket marginal tax
rate from 9.3 to 11 percent. While these pro­
posals have received some popular support,
others have criticized them on the grounds that
higher income individuals tend to be more
mobile, so that high marginal rates may encour­
age the wealthy to leave, thereby diminishing
the tax base.1
3
The sales tax is the remedy most frequently
considered by states to relieve fiscal pressure.
Two kinds of changes are being considered.
Rather than increasing the tax rate, most states
are looking at ways to eliminate tax exemptions
for certain items such as snack food and maga­
zines, thereby broadening the tax base. Califor­
nia recently added a number of snack foods to
its sales tax base, although problems defining
what constitutes a snack food are being encoun­
tered. Alternatively, states are considering an
extension of the sales tax base to include ser­
vices. Service taxation is still an area where
states have been moving cautiously. A broadbased taxation of services has yet to emerge
although certain professional and personal
services are increasingly being taxed.
Service taxation has been defended on
several grounds. According to one argument,
the purchase of services is a form of consump­
tion just like the purchase of tangible property.
There is no reason to treat the choice of one
type of consumption differently from another.
Consequently, according to this argument,
service taxation is a matter of tax equity as well
as neutrality. It is unreasonable to penalize
those who consume tangible goods rather than
services, thus encouraging service purchases
rather than goods.
As a practical matter, services have not
been taxed because of difficulties in administer­
ing the tax. Because some services, such as
housekeeping and lawn cutting, are very infor­
mal, it is difficult to imagine that a tax on such
services could be easily imposed and easily
collected. However, other services, particularly
those involving the repair and maintenance of
tangible personal property, are particularly
vulnerable targets for sales taxes. Subscription
services such as cable television are also a
frequent target for the same reason. From a
practical point of view, service taxation is not
without advantages. The rapid growth in ser­
vice activities and in service consumption
makes this a particularly attractive potential tax
base. Increased service taxes can broaden and

ECONOMIC PERSPECTIVES

reduce the volatility of sales taxes which have
grown dependent on big ticket durable goods
purchases.
Objections to service taxation are based on
the fear that this is such a huge pool of revenue
that it will not only relieve current fiscal pres­
sures, but further encourage government spend­
ing. Another objection is that service taxation
should not apply to many of the services pur­
chased by business because this would be a
form of double taxation, i.e. the physical output
(which embodies the service) is ultimately
taxed once it is sold. According to this argu­
ment, just as most states try to limit taxes im­
posed on parts used in the manufacturing pro­
cess to avoid double taxation, services used by
businesses should receive similar treatment.
Finally, perhaps the strongest objection is based
on tax competitiveness. States are very sensi­
tive about taxing those services that are per­
ceived as footloose. Such taxation might also
put home state service companies at a competi­
tive disadvantage when competing against outof-state businesses.1
4
One final area that is receiving consider­
able attention (but limited action) is property
tax reform. Several states (for example, Illi­
nois, Michigan and Kansas) have proposed
reducing property tax burdens using either tax
caps or roll backs in property assessments.1
5
While these proposals are popular with vot­
ers—Michigan voters will again try to put an
initiative on the 1992 ballot to roll back assess­
ments by 20 percent—cash strapped state gov­
ernments have trouble identifying sources of
funds to replace these lost local revenues.
The consequences fo r ta x re fo rm
m easures

When examining the tax structure of a
given state or local government it is important
to realize that the effect of raising $100 million
in revenues through an increase in the sales tax
is not the same as raising 100 million through
the income tax. For District states, concern

about revenue sources is increased by the tight
fiscal situation facing its governments and the
resulting adjustments to state fiscal systems.
In recent tax developments, many of the
District states have attempted to reduce depen­
dence on property taxes. Wisconsin has passed
property tax relief measures and Illinois has
increased its personal income tax in order to
pay for a larger share of education spending,
thereby reducing the need for the local property
tax to fund these expenditures. Furthermore,
Illinois has considered capping property tax
assessment growth at 5 percent per year. Mich­
igan’s new governor proposed raising state
sales and/or income taxes in order to reduce
property tax dependence. If the trend to reduce
property taxes continues, the result will be a
larger role for state government in the District.
In the short run, if District policy makers
are forced to raise revenues, they need to con­
sider the tradeoffs suggested by the varying
theories of taxation presented here. If a state’s
interest lies in sparking capital investment, then
encouraging increases in local property taxes is
probably a bad idea as such a measure could, if
unaccompanied by services benefitting local
business, increase the cost of capital. If, on the
other hand, legislators want to increase tax
stability, then broadening the tax base of the
sales tax by reducing exemptions or taxing
services could provide a valid avenue. In any
case, the ability to export tax burden outside the
state’s boundaries is another consideration.
Given the tenuous position of state and local
economies, revenue raising decisions must be
made with care. Adjusting the tax rates of
major revenue sources in an ad hoc manner
fails to recognize the interaction between taxes
and economic activity. District policy makers
need to understand both how the current tax
structure effects the economy and how pro­
posed changes may improve or hinder future
economic activity.

FOOTNOTES
'See Musgrave and Musgrave (1976), pp. 210-211.

4See Fisher (1969), Chapter 4.

2See Kleine and Shannon (1986), pp. 33-36.

5Wisconsin Department of Revenue (1990).

T or more on the incidence and theory of the property tax
see Phares (1980), P. Mieszkowski (1972), and Musgrave
and Musgrave (1976), Chapter 19.

T he Council of State Governments (1991), Table 6.17.
Note also that the Illinois state government only collects
sales tax revenues based on a fixed tax rate. Revenues

FEDERAL RESERVE BANK OF CHICAGO




31

above this percentage are distributed to various other
governments in Illinois, such as special districts, municipal­
ities, etc. Also, Iowa’s tax rate is 4 percent; in Wisconsin
and Indiana the tax rate is 5 percent.

nSnell (1991).
1
2State Legislatures (1991).
l3State Budget and Tax News (1991).

7Musgrave and Musgrave (1976), chapter 20.
l4John Mikesell (1986).
8Council of State Governments (1991), Tables 6.19 & 6.20.
1
5State Budget and Tax News (1991).
9Phares (1986), chapter 5.
l(,Phares (1986), chapter 5.

R E F E R E N C E S

The Council of State Governments, The Book
of the States 1990-91, Lexington, Kentucky,
1990.
Fisher, Glenn. Taxes and politics, a study of
Illinois public finance, University of Illinois,
1969.
Kleine, Robert and John Shannon, “Character­
istics of a balanced and moderate state-local
revenue system,” Reforming State Tax Systems,
National Conference of State Legislatures, 1986.
Mieszkowski, P. “The property tax: An excise
tax or a property tax?” Journal of Public Eco­
nomics, 1972.
Mikesell, John, “General sales tax,” Reforming
State Tax Systems, National Conference of State
Legislatures, 1986.
Musgrave, Richard and Peggy, Public finance
in theory and practice, McGraw Hill, 1976.

Phares, Donald, Who pays state and local
taxes, Oelgescher, Gunn and Hain, 1980.
_________________________ , “The role of
tax burden studies in state tax policy,” Reform­
ing State Tax Systems, National Conference of
State Legislatures, 1986.
Snell, Ronald. “In the deep weeds” State
Legislatures, February, 1991.
State Budget and Tax News, Volume 10, Issue
10, May 6, 1991.
State Legislatures, “Tax reform gets sophisti­
cated,” May 1991.
State Policy Research, Inc., State Budget and
Tax News, Volume 10, Issue 9, April, 1991.
_________________________ , State Budget
and Tax News, Volume 10, Issue 10, May 1991.

National Conference of State Legislatures,
“Tax reform gets sophisticated,” State Legisla­
tures, May 1991.

32



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