Heterogeneous Responses to the U.S. Narrative Tax Changes: Evidence from the U.S. States

TL;DR

This study examines how U.S. states respond differently to federal tax changes, revealing that responses vary based on state-specific economic structures and policies, with heterogeneity evident in GDP and income growth but not employment or prices.

Contribution

It introduces a panel FAVAR approach to analyze state-level heterogeneity in response to federal tax shocks, highlighting the role of fiscal and structural factors.

Findings

States respond homogeneously in employment and prices.

Heterogeneous responses observed in GDP and income growth.

States with flexible markets and lower taxes are more responsive.

Abstract

This paper investigates the assumption of homogeneous effects of federal tax changes across the U.S. states and identifies where and why that assumption may not be valid. More specifically, what determines the transmission mechanism of tax shocks at the state level? How vital are states' fiscal structures, financial conditions, labor market rigidities, and industry mix? Do these economic and structural characteristics drive the transmission mechanism of the tax changes at the state level at different horizons? This study employs a panel factor-augmented vector autoregression (FAVAR) technique to answer these issues. The findings show that state economies respond homogeneously in terms of employment and price levels; however, they react heterogeneously in real GDP and personal income growth. In most states, these reactions are statistically significant, and the heterogeneity in the effects of tax cuts is significantly related to the state's fiscal structure, manufacturing and financial composition, and the labor market's rigidity. A cross-state regression analysis shows that states with higher tax elasticity, higher personal income tax, strict labor market regulation, and economic policy uncertainties are relatively less responsive to federal tax changes. In contrast, the magnitude of the response in real GDP, personal income, and employment to tax cuts is relatively higher in states with a larger share of finance, manufacturing, lower tax burdens, and flexible credit markets.