Sunday, July 27, 2008

Fiscal Transfers to the States and the U.S. OCA Status

In a previous post on the givers and takers among the states, I mentioned that it seemed odd that states in the Rustbelt--those states undergoing significant economic hardships--were on average paying more in federal taxes than they were receiving in federal expenditures over the period 1981-2005. I wanted to be more precise about my observations so I plotted the two figures below showing the relationship between federal dollar expenditures per dollar of federal taxes per state and the economic performance of each state. The first measure comes from The Tax Foundation while the second measure is the year-on-year growth rate of the Philadelphia Fed's coincident indicator series. My thinking--influenced by the optimum currency framework--was that federal fiscal transfers should on balance go more toward those states lagging economically. In short, I expected a negative relationship between the two plotted measures. Here is what I found for the period 1981-2005 (click on figures to enlarge):

The above graph does shows the negative relationship that I expected and it is significant at 6%. However, it has a R-squared of only 0.07--only 7% of variation in federal dollar expenditures per tax dollar can be explained by variation in the states economic performance! I redid the graph for years 2000-2005 and found the following:

Here there is no significant relationship and yet the Rustbelt states are really suffering. So at best, there is a significant relationship that explains next to nothing. My priors did not hold up.

These results were interesting to me because they are important in thinking about whether the United States is truly an optimum currency area (OCA). For the United States to be an OCA--and thus be best served by a single currency and monetary policy--states should either (1) share similar business cycles or (2) have the economic shock absorbers of wage and price flexibility, factor mobility, diversified economies, and federal fiscal transfers. In the former case, similar business cycles among the states mean that a national monetary policy, which targets the aggregate business cycle, will be stabilizing for all states. In the latter case, on the other hand, dissimilar business cycles among the states will result in a national monetary policy that is destabilizing—it will be either too simulative or too tight—for some of the states unless the economic shock absorbers listed above are in place. There is ample evidence that there is significant variation among the states' business cycles. So for the United States to be an OCA it is important for the economic shock absorbers to be in place. The evidence above suggest one of the shock absorbers is missing.

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