Israel Malkin and Daniel J. Wilson in the latest FRBSF Economic Letter:
Taxes, Transfers, and State Economic Differences, by Israel Malkin and Daniel J. Wilson, FRBSF Economic Letter: U.S. states collect their own taxes and determine their public spending. But they also pay taxes to and receive transfer payments and public services from the federal government. Many commentators have argued that this system of federal taxes and transfers provides not only considerable redistribution among regions, but also stabilization (see, for example, Krugman 2012). These commentators suggest that if the European Union (EU) had developed a similar system among member states, it might have avoided its recent fiscal and economic crises. In fact, as the EU was formed in the early 1990s, many economists doubted its viability because it lacked a stabilization system similar to that in the United States (see, for example, Sala-i-Martin and Sachs 1991).
Still, the size and mode of action of redistribution and stabilization in the U.S. system are not well understood. Stabilization implies that even a very high-income state whose economy temporarily worsens would receive some short-term relief through transfer payments or lower tax payments to the federal government, a kind of insurance offsetting temporary negative shocks. A system that provides redistribution from richer states to poorer states does not automatically provide stabilization. In other words, stabilization is separate from redistribution, in which over the long term the federal government collects more taxes from higher-income states and provides less support through transfers or public goods, regardless of temporary state-level economic problems. Thus, the extent of stabilization provided by a given tax-and-transfer system can’t be measured using simple cross-state correlations between average state income and taxes paid or transfers received by a state.
In looking at the U.S. system as a guide for how the EU or other cross-country economic unions might achieve stabilization, it is important to know how much stabilization in the United States results from taxation and how much from transfers, and what kinds of transfers best promote stabilization.
This Economic Letter looks at how much total redistribution and stabilization the U.S. system provides and how much is due to taxes and how much to transfers. We find substantial redistribution and stabilization, both driven entirely by the tax system. Surprisingly, federal government transfers to states—either to governments or to individuals or businesses—provide virtually no redistribution nor stabilization. This holds true whether we measure transfers broadly, including for example salaries of federal workers living in a given state and federal contracts with businesses in the state, or narrowly, including only grants to state and local governments and direct federal transfer payments to individuals, businesses, and nonprofits. One exception is federal emergency unemployment compensation, which rises when a state’s income falls and its unemployment rate increases. Rather, we find that the tax system has the most impact in stabilizing states in the short run, consistent with other research (see Asdrubali, Sorenson, and Yosha 1996, Sala-i-Martin and Sachs 1991, and Feyrer and Sacerdote 2013). ...
Implications for Europe
The key implication of our findings is that the U.S. tax-and-transfer system provides considerable interregional redistribution and economic stabilization. But what might these findings imply for the European Union? The EU lacks a comparable system of redistribution and stabilization among member countries, and that is often cited to explain why differences in economic performance among EU countries in the aftermath of the global recession have been so much greater than differences among U.S. states. A simple back-of-the-envelope calculation based on our results suggests that if the European Union had a system similar to that of the United States, Greek nominal disposable income per capita would have fallen 6.9% from 2008 to 2011 instead of the actual 11.2%. Income in Germany would have risen 3.7% instead of 5.9%.
This analysis is limited to quantifying the degree of stabilization that could be achieved in Europe if it had a U.S.-style tax-and-transfer system. How much stabilization among countries would be optimal is a separate and much more difficult question. Among other things, it depends on the costs and benefits of centralizing the allocation of resources and any moral hazard due to insuring countries against negative economic consequences resulting from poor policy decisions. Nonetheless, understanding the role of taxes and transfers in the United States could help guide European Union discussions about policy reforms.
[I omitted the sections with the supporting evidence, graphs, etc. showing the stabilization, tax, and transfer results for each state.]