Fiscal Centralization: Theory and Evidence from the Great Depression

Fiscal Centralization: Theory andEvidence from the Great Depression∗

Daniele Coen-Pirani† Michael Wooley‡

March 30, 2015

Abstract

The Great Depression produced a profound and lasting influence on thestructure of U.S. government. We study theoretically and empiricallythe increased centralization of revenue collection and expenditures in thehands of the states relative to local governments during the 1930s. In ourpolitical-economy model the income decline of the Depression causes arise in property tax delinquency, undermining the main source of revenuefor local governments and leading to increased political support for salestaxation and centralization by the states. Empirical evidence based oncross-state variation in the severity of the Depression is consistent withthe model’s key predictions.

Keywords : Centralization, Fiscal Federalism, Great Depression, PropertyTax, Sales Tax

JEL Classification: H77, H71, N42

∗We thank Robert Fleck for generously sharing his data with us. Thanks to Dennis Epple,Marty Gaynor, Bob Miller, Lowell Taylor, Marla Ripoll and seminar participants at theUniversity of Pittsburgh and Carnegie Mellon for useful comments. The usual disclaimerapplies.†Department of Economics, University of Pittsburgh. E-mail: [email protected]. Corre-

sponding author.‡Department of Economics, Northwestern University. E-mail: woo-

[email protected].

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1 Introduction

The Great Depression produced a profound and lasting influence on the sizeand structure of U.S. government. The size of the government grew as programsin areas like social insurance were expanded. Its structure also changed, as thefederal government grew in importance relative to state and local governments.For example, the federal government’s share of non-defense expenditures wentfrom about 27 percent on the eve of the Great Depression to almost 45 percenton the eve of World War II in 1940. The big losers in this period were localgovernments - cities, counties, school districts - whose share of expenditures felldramatically from about 54 percent in the late 1920s to 31 percent in 1940.1

While the New Deal and associated policies are usually credited with therise of the federal government in this period (Rockoff, 1998), a less well-knownbut important development of the 1930s was the rise of state governmentsrelative to local governments (see Wallis, 1984 for an early paper, discussedbelow, on this topic). Specifically, state governments’ share of combined stateand local expenditures and revenues on average increased by over 20 percentagepoints, the largest increase experienced in any decade of the 20th century.

The process of fiscal centralization by state governments is important beyondits historical interest because the new fiscal arrangements that emerged fromthe Great Depression were long-lasting and still exert a powerful influence intoday’s world. Two of these long-lasting developments are worth mentioningat the outset. First, general sales taxes, which now represent the single mostimportant source of revenues for state governments, were first introduced in theU.S. by 28 states during the Depression.2 Second, the current involvement ofstate governments in elementary and secondary education funding has its originsin the Great Depression. Prior to the Great Depression, local governments

1Here and in the rest of the paper we define expenditures to include both direct and indirectexpenditures of a given level of government. Indirect expenditures include intergovernmentalgrants to other levels of government. The numbers cited in the text are based on ourcomputations using data from the Historical Statistics of the U.S. The pre-Depression datarefers to the year 1927.

2On the importance of sales taxes in present times, see, for example, the summary reportof the 2012 Census of Finance, available at http://www.census.gov/govs/local/.

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accounted for over 80 percent of education revenue, with the states providingthe rest. By 1950, the share of local governments had declined to 60 percent;states provided most of the remaining 40 percent. The further expansionof states’ funding share after the mid-1970s is dwarfed by the increase thatoccurred during the 1930s.3

In this paper we seek to explain the rise of state governments during the1930s. In doing so, the paper makes two contributions to the topic of fiscalcentralization. First, it presents a novel theory of centralization, which isused to interpret the events of the Depression. We develop a positive theoryof centralization. As such, our paper complements the mostly normativeliterature on fiscal federalism. The latter discusses the trade-offs between thecosts of centralized public good provision - such as uniformity of provision asin Oates (1972) or conflict of interest between citizens in different jurisdictionsas in Besley and Coate (2003) - and the externalities across local jurisdictionsassociated with decentralized provision. The second contribution of our paperis to test empirically some of the key implications of this theory using data onU.S. states.

Our theory of fiscal centralization is based on the observation that localgovernments have historically relied on property taxation to fund their ex-penditures.4 By contrast, at the onset of the Depression the role of propertytaxation in states’ budgets was minimal and had been in decline for decades.5

3See, for example, National Center for Education Statistics (1993, Figure 12). TheFederal government did not play a significant role in K-12 education until the Elementaryand Secondary Education Act of 1965.

4The property tax has provided about two-thirds of own revenue for local governmentsboth before and during the Depression. Local sales and income taxes never accounted formore than one or two percent of all locally-collected revenues during the 1930s. Wallis (2001)provides a detailed explanation for local government’s reliance on the property tax. Teaford(2002, 122) remarks that many states barred local governments from collecting all but aselect set of levies.

5In the first three decades of the 20th century, the states reduced their dependence onthe property tax and adopted a number of new taxes such as excises on gasoline and motorvehicle registration fees. On the expenditure side, local governments’ main expenditurefunction was K-12 education which accounted for about one-third of their outlays, followedby highway expenditures, accounting for about one-sixth of total expenditures. States spentdirectly and through grants to local governments on highways and on education (includingtertiary education).

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Local governments’ heavy reliance on the property tax made them particularlysensitive to the sharp and sudden income decline at the onset of the GreatDepression that led to a large increase in property tax delinquency rates. Forexample, in 1933 more than a quarter of property taxes levied in cities witha population greater than 50,000 were delinquent (Bird, 1934 cited in Beito,1988). The rise in property tax delinquency rates early in the Depression playsa central role in our theory, as it made it difficult for local governments to fundordinary expenses such as education, let alone the rising demand for socialspending brought about by the Depression. This crisis in the ability of localgovernments to collect taxes provided the impetus towards states’ introductionof new taxes, such as sales taxes. Tax delinquency was much less of a problemwith sales taxes but it was only cost-effective for state or national governmentsto collect these levies (Wallis, 2001 and Nechyba, 1997). Though sales taxesaddressed the local revenue problem, they inevitably eroded local fiscal auton-omy. The widespread rise in property tax delinquency in the 1930s receivedmuch attention from contemporary economists and policymakers. For example,Fred Rogers Fairchild, an economist writing in the American Economic Reviewin 1934, described the connection between income decline and property taxdelinquency in the context of the Depression:

The property tax, though a direct tax levied upon capital value,is intended, not to deprive the taxpayer of a part of his capitalfunds, but to be paid out of income. But the tax is levied obviouslywithout reference to current income; though the capital value isthere, present income may be lacking. It may thus occur that aproperty tax, legally levied, finds the taxpayer without money topay or so short of cash that he feels forced to put other obligationsahead of taxes. So he postpones payment, and delinquency results,as does not ordinarily occur in connection with other forms oftaxation (1934, 143).

We embed these elements in a simple model of public good provision toillustrate our argument and then proceed to test some of its implications using

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a variety of state-level data. On the model side, we build on Besley and Coate(2003), Fernandez and Rogerson (2003) and others and consider an economy,meant to represent a state, divided into many geographically distinct localitiespopulated by agents with heterogeneous income. We consider two alternativesystems of public good provision. The first is a decentralized system in whicheach locality chooses its own level of the public good and pays for it using alocally administered head tax, our proxy for a property tax. An importantfeature of the head tax is that agents might choose not to pay, suffering a utilitycost. The second system is a centralized system in which an economy-wide levelof the public good is financed by means of a regressive sales tax. We show how,in the benchmark pre-Depression economy, the decentralized system is preferredby a majority of the population if the sales tax is sufficiently regressive.

After establishing this benchmark, we use the model to illustrate the impactof the Great Depression on the politico-economic support for centralization.We model the Depression as an income decline that affects a fraction of agentsin each locality. This shock leads to a rise in head-tax delinquency underdecentralized provision of the public good. In turn, the rise in tax delinquencyincreases support for centralized provision financed by sales taxation. The mainintuition for this result is that the sales tax allows the government to expandits tax base, effectively forcing otherwise (head) tax delinquent individuals tocontribute to the financing of public goods.

This theory is consistent with a number of accounts of these events byeconomic historians and economists alike. For example, the historian JonTeaford in his 2002 book The Rise of the States ascribes the process of central-ization by the states to taxpayer discontent towards the property tax and theemergency created by the inability of local governments to adequately fundexpenditures during the Depression.6 Among economists, in a related empiricalpaper, Rueben (1994) focuses on the determinants of the adoption of state sales

6Though he recognizes the large role played by the Federal government in providing reliefafter 1933, Teaford emphasizes the independent centralizing policies enacted by the states.For example, at least seven states began providing emergency relief prior to 1933 and almostevery state centralized school finance - an area in which the federal government was inactive- to some extent during the decade. We return to this latter point in Section 2.

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taxes during the 1930s. She finds support for “economic stress” theories of theintroduction of sales taxes, according to which the economic downturn inducedstate governments to seek out new sources of revenue to finance expenditures.Hartley et al. (1996) study voter support for the Riley-Stewart Amendment,a major fiscal reform passed by California voters in 1933.7 Its passage ledthe state government to adopt sales and income taxes while local propertytax levies were decreased. Based on their empirical investigation, Hartley etal. (1996, 666) conclude that the “passage of Riley-Stewart...emerged as aresponse to growing voter discontent over the property tax during the GreatDepression.”

While our interpretation is consistent with the studies cited above, othereconomists have emphasized other forces at work. Specifically, Wallis (1984)and Wallis and Oates (1998) argue that a key feature of the New Deal wasits use of state - rather than local - matching grants. Matching grants gaveincentives to state governments to raise new revenues while local governmentswere able to dial back their revenues and expenditures. Thus, according to thisview, it was not the Great Depression per se that led to centralization but thereaction of the federal government to it. It will be useful here and elsewhere toapply labels to these two channels. We label the Wallis (1984) and Wallis andOates (1998) thesis the “top-down” channel, which emphasizes the idea that thefederal government’s matching grant program led to state-level centralization.The channel that we model focuses instead on local fiscal distress as a causeof centralization so we label it the “bottom-up” channel. It should be stressedearly on that these two mechanisms are not necessarily inconsistent with oneanother. Quantifying their relative importance is an empirical matter to whichwe devote the second part of the paper.

On the empirical side, we test the key prediction of our “bottom-up” mech-anism that, all else equal, the magnitude of the peak-to-trough income declineexperienced by a state during the Depression should be systematically associ-

7The amendment required the state to expand its support for public education, authorizedthe state to raise new revenues to finance this expenditure, limited state and local expenditureincreases, and returned revenues from public utility property to local governments.

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ated with the likelihood that the state subsequently passed a blanket limitationon property taxes, introduced a sales tax, and increased its share of combinedstate and local tax revenues or expenditures.8 Overall, we find strong supportfor these key predictions of the model. We account for the “top-down” channelof Wallis and Oates by controlling for measures of federal aid received by astate during the 1930s. In order to address the potential endogeneity of federalaid, we instrument it using political and land variables that strongly predictthe allocation of New Deal money to the states (Wright, 1974; Wallis, 1984;and Fleck, 2008). Controlling for federal aid in this fashion has little effect onthe estimated magnitude of our “bottom-up” channel. In addition, federal aiddoes not have an economically or statistically significant impact on any of ourdependent variables.

In the rest of the introduction we briefly place our paper in the contextof the related literature. Among the empirical papers on fiscal policy duringthe Great Depression, our work is most strongly related to Wallis (1984) andRueben (1994). We discuss in detail the relationship between our results andtheirs in Sections 6.3.3 and 6.3.2 of the paper, respectively. While our resultsare consistent with Rueben’s, we extend her work in three new directions.First, we interpret the introduction of sales taxes within the broader contextof discontent with the property tax and changing intergovernmental relations.Thus, in addition to sales tax adoption we consider the effect of our “bottom-up”mechanism on measures of revenue and expenditure centralization and passageof blanket property tax limitations by the states. Second, in our regressions forsales tax adoption we control for the effect of federal aid, explicitly accountingfor the “top down” channel of Wallis and Oates. Last, we use a differentproxy for a state’s “economic distress” than Rueben. Instead of employmentdecline between 1929 and 1932 we focus on decline in income per capita inthe same period. We find that the latter variable is more strongly associatedwith the adoption of sales taxes than the employment-based measure. Interms of theory, our model is mostly related to the work of Besley and Coate

8See Section 2 for a definition of blanket tax limitations and a discussion of each of thesevariables.

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(2003). Differently from them, we emphasize the role played by property taxdelinquency and assume that in the centralized economy public good provisionis financed through a sales tax instead of a uniform head tax. Thus, the shiftfrom decentralized to centralized provision is accompanied by a shift in taxinstrument, i.e., from property to sales taxation. Nechyba (1997) provides thebasic argument justifying this assumption.9

The rest of the paper is organized as follows. Section 2 discusses theempirical trends and historical backdrop that are the focus of the paper.Section 3 introduces the basic model. Sections 4 and 5 evaluate the effect ofthe Great Depression on the model’s equilibrium and the politico-economicsupport for a more centralized system of public good provision. The empiricalanalysis is presented in Section 6. Section 7 concludes. The appendices containthe proofs of propositions and details on the data used in the empirical part ofthe paper.

2 Basic Trends and Institutional Setting

In this section we further motivate the paper by providing additional detailson government revenues and expenditures prior to the Great Depression andthe dramatic changes that occurred during the 1930s.

2.1 Before the Great Depression

As the statistics mentioned in the opening paragraph of the paper suggest,local governments were the most important level of government in terms ofexpenditures and revenue prior to the 1930s. Figure 1 shows the evolutionof state governments’ share of combined state and local own revenue and

9The paper is also related to the positive literature on the determinants of centralization.In this literature, Baicker, Clemens, and Singhal (2012), document the rise of the states in theU.S. since 1952. Strumpf and Oberholzer-Gee (2002) test the hypothesis that heterogeneouspreferences are associated with more decentralized policy-making using data on liquor control.Matsusaka (1995, 2000) finds that U.S. states with voter initiatives exhibit lower levels ofexpenditure centralization over the twentieth century. Panizza (1999) and Arzaghi andHenderson (2005) study the determinants of fiscal decentralization across countries.

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Figure 1: States’ Share of Total State and Local Revenue and Expenditures

(a) Including Highways

Exp.

Rev.

.15

.2.2

5.3

.35

.4.4

5.5

.55

.6

1902

1913

1922

1927

1932

1942

1950

1960

1970

1980

1990

year

(b) Excluding Highways

Exp.

Rev.

.15

.2.2

5.3

.35

.4.4

5.5

.55

.6

1902

1913

1922

1927

1932

1942

1950

1960

1970

1980

1990

Highway revenues are defined as motor fuel taxes and fees from motor vehicleand operators’ licenses. Own revenue refers to total revenue less revenue fromintergovernmental grants.Source: Historical Statistics of the U.S.

expenditure.10 At the turn of the 20th century state governments accountedfor less than 20 percent of aggregate local and state revenue and expenditure.Figure 1(a) shows that the states’ share of both variables had been increasingstarting in 1913. However, panel (b) of Figure 1 makes it clear that much ofthis early increase is attributable to rising expenditures and revenue collectionsfor new roads and highways.11

2.2 The Great Depression and the Developments of the

1930s

The Great Depression started in the late summer of 1929 and was characterizedby a very sharp contraction in production and income. From its August 1929peak to its trough in early 1933, industrial production declined by 47 percentand real Gross Domestic Product fell by 30 percent (Romer, 2004). In this

10Own revenue refers to total revenue minus revenue from intergovernmental grants.Expenditures include both direct expenditures and intergovernmental expenditures.

11The advent of the automobile led to an expansion of both local roads and roads connectingdifferent cities and localities within a state. The states played an important role in financingroad construction using gasoline taxes and licenses fees to finance this expansion (Wallis,2001).

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section we document the process of fiscal centralization by the states thatoccurred during the 1930s, emphasizing the key developments that led to therise in state centralization according to our “bottom-up” interpretation.

2.2.1 State-Local Centralization

It is evident in both panels of Figure 1 that the greatest increase in centralizationoccurred from about 1927 to 1942.12 In those fifteen years alone, the states’share of combined state and local revenues rose by about 23 percentage points.State-level data show that all state governments centralized revenue andexpenditures during the 1930s (see Table 2 in Section 6.2). The extent ofcentralization varied across states. Some of this variation is illustrated inFigure 2. The figure uses state-level data to show the evolution of the averagestate share of state and local expenditures as well as the 25-75 percentilerange.13

2.2.2 Key Elements of the Bottom-Up Interpretation

The “bottom-up” interpretation of the process of state centralization has, asits starting point, the effect that the contraction in income at the onset of theGreat Depression had on the ability of local governments to collect revenuethrough the property tax. Symptoms of the increased burden of the propertytax were the rise in delinquency and the success of referenda that imposedstrict restrictions on property tax rates in a state. The latter are typicallyreferred to as blanket property tax limitations. Sales taxes were adopted bystates in order to combat this crisis in local government finances that becameacute around 1932. By that time, tax delinquency, tax limits, and the growingdemand for unemployment relief and social services - which were at that timea local government responsibility - had pushed many local governments to a

12We use 1927 because it is the last pre-Depression year for which aggregate data isavailable.

13Figure 2 reports fewer observations than Figure 1 because it draws on data that isaggregated at the state rather than national level. The state-level data is, in fact, availablefor fewer years.

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Figure 2: State Share of State and Local Expenditures

.2.3

.4.5

.6.7

19

02

19

10

19

13

19

20

19

30

19

32

19

40

19

42

19

50

19

60

19

62

Light blue area represents 25-75 percentile interval of cross-sectional distribution ofstates. For expenditure share definition see Data Appendix. Source: Sylla, Legler,Wallis (1995).

breaking point.14 In what follows we present and discuss the relevant data oneach of the key points summarized above.

Property Tax Delinquency. When the Depression hit, incomes fellfurther and faster than property tax levies. As the quote in the Introduc-tion suggests, many taxpayers simply lacked the funds to pay their tax bills.Widespread property tax delinquency resulted. According to one study thatcompares pre-Depression delinquency rates to those observed during the GreatDepression in cities with a population greater than 50,000, the median taxdelinquency rate rose from 10.1 percent in 1930 to 26.3 percent in 1933 (Bird,1934, quoted in Beito, 1988).15 Beito (1988, 8) notes that - prior to the De-

14While, in principle, local government could have issued debt, new local governmentdebt issues fell 65.7% from 1929 to 1933. This is partly explained by the fact that manylocal governments were already deep in debt in 1929. Moreover, the decline in property taxrevenues undermined lenders’ expectations that bonds would be paid back. In 1933, 3.7% ofall municipal debt issuers were in default (Fons et al. 2008). Furthermore, different statelaws on borrowing were added or strengthened. For example, Ohio increased the majorityneeded to issue new school debt from a simple majority to 55% in 1931 and 65% in 1933(Tostlebe, 1945, 27).

15Detailed data on tax delinquency is scattered and incomplete. The first attemptsat systematic collection of data on tax delinquency began in response to Depression-era

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pression - governments could quickly collect delinquent revenues by selling taxtitles. The tax title market, however, ceased to function during the Depression.Lent D. Upson, Chief Statistician of the Census Bureau’s Division of RealEstate Taxation observed in 1934 that: “Today, however, the professional taxtitle buyer has generally retired from the market owing to curtailed bank creditand deflated realty values” (1934, 363).

Blanket Tax Limitations. The decline in income forced taxpayers todevote a larger share of their income to property taxes. This developmentspurred the rise an the anti-property tax movement organized around the goalsof achieving economy in government, widening the tax base, and decreasingproperty taxes. The most important consequence of this movement was thepassage of blanket property tax limitation laws (Beito, 1988). Blanket propertytax limits set a cap on the combined millage that all jurisdictions within a statecould levy on a single piece of property.16 Blanket limitations were effective atcurbing property tax collections and, therefore, at decreasing local governmentrevenues.17 Prior to the Depression, only North Dakota had a law resemblinga blanket limitation. Between 1932 and 1933, however, blanket property taxlimitations were adopted by popular vote in seven states, listed in Table 1.We therefore use the adoption of blanket limits as an indicator of populardiscontent with the property tax in the empirical analysis of Section 6.

Sales Tax Adoption. Prior to 1932 no state had a general sales tax.By 1938 the sales tax was in place in 28 states, listed in Table 1, togetherwith the year of adoption. The importance of the sales tax in state and local

delinquency. The Census Bureau’s Division of Real Estate Taxation issued a county-leveltabulation of tax delinquency on the levy of 1932-33. However, this data suffers from issuesof comparability across states (Woodworth,1934, 332). Moreover, there does not appear tobe state-level data on tax delinquency prior to the 1932-33 levy.

16For example, a 10 mill (1%) blanket property tax limit meant that a property ownerpaid no more than 10 mills in total in taxes. This meant that different jurisdictions hadto agree to divide the available millage among themselves. The school district may get 3.5mills, the city another 3.5, and the county 3.

17Though almost every state had some sort of law limiting property tax collections, theselaws were widely acknowledged to be ridden with loopholes. The negative effect of blanketproperty tax limits on municipal revenues is vividly captured in the essays on tax limits bymunicipal administrators and public finance experts collected in Leet and Paige (1934).

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Table 1: State Blanket Property Tax Limitations and Sales Tax AdoptionsBlanket Property Tax Limit Sales Tax AdoptionMichigan Washington 1932 Mississippi Pennsylvania*Indiana West Virginia

Ohio Oklahoma 1933 Arizona Illinois IndianaNew Mexico Utah Michigan North Carolina

Oklahoma California WashingtonNew York* South Dakota

1934 Missouri Iowa West VirginiaKentucky*

1935 Ohio Colorado Idaho*Wyoming Arkansas North DakotaMaryland* New Mexico

1936 Louisiana

1937 Alabama Kansas

Blanket Property Tax Limitation: North Dakota instituted a blanket property taxlimitation in 1919. Sales Tax Adoption: ∗ denotes states that allowed the sales taxto expire.Source: Tax limits: Mott and Suitor (1934). Sales Taxes: Jacoby (1938, Table 14)

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Figure 3: State Share of State and Local Own Expenditures

Other Taxes

Income Tax

Sales Tax

0.0

5.1

.15

.2.2

5.3

.35

.4.4

5.5

.55

1902

1913

1922

1927

1932

1942

1950

1960

The upper border of the “Other Taxes” area (i.e. the orange area) is the same revenueshare series that is displayed in figure 1a. The sales tax share includes both generalsales and excise taxes, which explains why the share is non-zero prior to 1932.Source: Historical Statistics of the United States.

public finance is illustrated by Figure 3. Sales taxes (including excise taxeson gasoline) accounted for 5.7 percent of all state and local revenues in 1927and 18.0 percent in 1942. This growth implies that sales taxes accounted forapproximately 53 percent of the growth in revenue centralization observed from1927 to 1942. By contrast, the share of combined state and local revenuescollected via state income taxes only grew by 2.1 percentage points from 1927to 1942, which implies that growth in income tax revenues only accounted forabout 9 percent of revenue centralization.18

2.2.3 Challenges to the “Top-Down” Mechanism

The empirical analysis of Section 6 attempts to disentangle the effects of the“bottom-up” and “top-down” mechanisms on centralization. Here we discusstwo independent pieces of evidence that suggest that the “top-down” channel isunlikely to represent the entire explanation for the evolution of state-local fiscal

18Sales tax and income taxes play a similar role in our “bottom-up” channel. The modelof Section 3 allows for both.

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relations during the 1930s. The first piece of evidence is that several statesenacted centralizing policies prior to 1933, the year in which the New Dealpolicies were voted by Congress and started to be implemented. Teaford (2002)mentions at least seven states whose governments initiated emergency reliefprograms in response to the Depression prior to 1933.19 Similarly, the earlyadoption of sales taxes by many states (see Table 1) in 1932 or 1933 casts somedoubt on the view that they represented a response to New Deal policies. Thesecond piece of evidence has to do with elementary and secondary educationfinancing. In 1927, the states provided on average less than 15 percent of fundsfor education. Most of education funding was provided by local governments(school districts) and financed through property taxation. Figure 4 shows thatthe share of funding coming from the states increased dramatically during the1930s, reaching a peak of over 35 percent in 1942. This trend is importantbecause elementary and secondary education was never a focus of the NewDeal nor of any other federal program during this period.20 Therefore, theincreased provision of education funds by the states cannot be ascribed to theirreaction to New Deal matching grants in this area.

3 The Model Economy

We illustrate our “bottom-up” channel through a simple model of decentralizedand centralized provision of local public goods. We focus on the interactionbetween income decline, property tax delinquency, and preferences for central-ization through a sales tax. In what follows we first present the model andthen in Sections 4 and 5 use it to analyze the effect of the Depression on thepolitical-economic support for sales taxation and centralization.

19New York, New Jersey, Rhode Island, Wisconsin, Pennsylvania, Illinois, and NorthCarolina (Teaford, 2002, 123-25). Other states studied centralizing policies early in thedecade but didn’t pass them until years later. See, e.g., Lutz (1930) on Georgia, the[Michigan] State Commission of Inquiry into Taxation (1930), and the Ohio School SurveyCommission (Mort, 1932).

20On the New Deal’s neglect of public education, see the discussion in Tyack et al. (1984,ch. 3) and Teaford (2002, 129-130).

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Figure 4: State K-12 Education Grants as Share of State and Local K-12Education Expenditures

.15

.2.2

5.3

.35

.4

1902

1913

1922

1927

1932

1942

1950

1960

Source: Historical Statistics of the U.S.

3.1 The Framework

The model economy, which is meant to represent a U.S. state, is populated by ameasure one of agents. Agents are differentiated by their income level y, whichis distributed in the population according to the density f(y).21 Let y denoteaverage income in this economy and assume that it lies above median income.The economy is divided into a continuum of geographically distinct localities ordistricts. Each district is assumed to be initially populated by a unit measureof individuals with the same income level y (see e.g. Fernandez and Rogerson,2003).22 We sometimes refer to district y as the district inhabited by individualswith income y. Agents have preferences defined over a private consumptiongoods c and a public good g according to the following logarithmic utilityfunction:

U = ln c+ λ ln g, (1)21It is worth pointing out that allowing for preference, instead of income, heterogeneity, as

in Besley and Coate (2003), would not change the mechanism we seek to emphasize, althoughsome of the details of the analysis would be different.

22Similarly to Besley and Coate (2003) and Fernandez and Rogerson (2003), the sorting ofindividuals across localities is exogenously given here.

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where the parameter λ > 0 indexes the relative weight of the public good.23

Within this basic framework, we distinguish between two distinct approachesto selecting and financing the provision of the public good g. The first approachconsists of district-level (local) choice of the quantity of the public good, financedthrough a head tax. We refer to this arrangement as “decentralized” provisionand we discuss its properties in Section 3.2. The second approach consists ofstate-level choice of the uniform quantity of the public good, financed by a salestax on the consumption good. We refer to this arrangement as “centralized”provision and we discuss its properties in Section 3.3. Section 3.4 discusses thepolitico-economic support for the decentralized system in the context of themodel, prior to the shock of the Great Depression.

3.2 Decentralized Provision

In this section we consider the “decentralization” case in which each districtselects its own policy, consisting of a head tax t and a level of the public good g.We interpret the head tax as a property tax in this setting.24 For our purposesthe key aspect of the property tax that is conveniently captured by a head taxis that when an individual’s income falls, its tax bill does not fall automatically,unless the agent moves to a cheaper house. This feature of property taxation- emphasized in the quote from the American Economic Review reported inthe Introduction - leads to the emergence of tax delinquency in the GreatDepression scenario considered in Section 4.1.

Given policies (t, g) , an agent’s private consumption in a district withincome y is:

c = y − t. (2)

Individuals may opt for not paying the head tax, in which case they cannot23Notice that, differently from Besley and Coate (2003)’s model, there are no spillovers

across districts associated with the consumption of the public good in our model. Spilloversof this sort would amplify the effect of our “bottom-up” mechanism, so we do not includethem in our analysis in order to keep the model as simple as possible.

24Hamilton (1975, 1976) argues that the property tax is equivalent to a head tax if localitiescan impose zoning restriction on the size of houses within their boundaries.

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be excluded from the consumption of the public good, but suffer a utility costk. This cost captures the consequences of tax delinquency for an individual,from social stigma to the threat of losing the title to one’s home.25 The keyassumption here is that the cost of tax delinquency is a utility cost that doesnot represent revenue for a local government.26 Tax delinquency plays animportant role in the Great Depression scenario. Here we establish a pre-Depression benchmark in which tax delinquency does not occur in equilibrium.For future reference, it is convenient to express the utility cost k in equivalentconsumption terms. To do so, define κ to be the maximum fraction of incomey that an agent is willing to give up to avoid being tax-delinquent:

ln (y − κy) = ln y − k.

Solving this expression for κ yields:

κ ≡ 1− exp(−k) < 1. (3)

In what follows we restrict κ (and thus indirectly k) to be sufficiently large sothat before the Great Depression agents find it to be optimal to pay the headtax in equilibrium:

Assumption 1. κ > λ/ (1 + λ) .

The equilibrium level of the head tax in each district is determined by itsrepresentative agent’s preferences over policies (t, g) , subject to the budgetconstraint:

t = g. (4)

The following proposition summarizes the politico-economic equilibrium.

25See Luttmer and Singhal (2014) for a discussion of nonpecuniary factors such as socialstigma in tax compliance decisions.

26Property tax delinquency usually involved local governments selling the title to one’shouse after some time. As explained by Beito (1988, 8), the tax title market effectivelyceased to function during the Depression. Hence, an individual’s failure to pay the propertytax did result in a loss of revenue for local governments.

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Proposition 1 (Equilibrium with decentralized provision). Under Assumption1, the unique politico-economic equilibrium of the economy with decentralizedprovision is such that the head tax and public good spending in a district y aregiven by:

t∗ = g∗ =λ

1 + λy. (5)

There is no tax delinquency in equilibrium.Proof: See Appendix.

The condition that the utility cost of tax delinquency is high enough(Assumption 1) guarantees that individuals prefer to pay the tax given by (5)rather than be delinquent. Notice that, in equilibrium, public good provisionand the head tax are increasing in the district’s income, with richer localitiestaxing and spending more.

3.3 Centralized Provision

As an alternative arrangement, which we label “centralization”, the public goodis financed at the state level and expenditures are equalized across localities.27

In addition, the state employs a sales tax on consumption, rather than thehead tax, to finance expenditures. The tax-expenditure mix at the state levelis decided by state-wide majority. We assume that individuals cannot avoidsales taxes so there is no issue of delinquency in this context. This assumptioncaptures an important asymmetry between property taxes and sales taxes anddeserves some discussion. The nature of this asymmetry reflects two aspects ofthese taxes. The first aspect is the magnitude of the payments involved. Yearlyproperty tax payments by the owner of property to the (local) government werelarge relative to the day-to-day transactions (such as purchasing food) that weresubject to sales taxation. Sales tax evasion, if detected, would have entailed afine whose magnitude was probably disproportionate relative to the amount of

27Besley and Coate (2003) argue that centralization does not have to imply uniformityand highlight, instead, “misallocation” and “uncertainty” as other costs associated with it.For our purposes, either of these two alternative costs of centralization would give rise toimplications similar to those implied by uniform provision.

19

the tax due. Therefore, a cost-benefit analysis would have discouraged salestax evasion because of the relatively small size of the transactions involved.The second important asymmetry between property and sales taxes in termsof opportunity for delinquency is the fact that, while property tax paymentsconsisted of direct transfers by the owner of property to the (local) government,the sales tax was, instead, collected by a retailer who then transferred it to the(state) government. The retailer acted as a tax collector on behalf of the stategovernment and might have refused a sale if a customer failed or refused topay the sales tax. More generally, tax delinquency would in this case requirethe willing participation of buyers and sellers, instead of the unilateral decisionof the property owner.

We model the sales tax as a regressive tax on consumption.28 The regressivenature of the sales tax plays an important role in determining the politicalsupport for its adoption and, more generally, for centralization. Formally, wecapture this essential feature of sales taxation while keeping the model analyti-cally tractable by adopting a formulation originally introduced by Benabou(2002) and recently employed by Heathcote et al. (2014). According to thisformulation, the consumption of an agent with income y is specified as:

c = ωy1+τ , (6)

so that the tax paid by the agent is equal to:

T (y) = y − ωy1+τ . (7)

The parameters ω > 0 and τ ≥ 0 in equation (6) determine the overall levelof the tax and its degree of regressivity, respectively.29 This tax scheme is

28The regressive nature of sales taxes was clearly emphasized by economists and commen-tators in the debates that occurred in the early 1930s. For example, Jacoby (1938, Table 31)lists food, water, gas, electricity as some of the items within the scope of retail sales taxes,and education tuition, domestic services, association and club dues as some items not withinthe direct scope of such taxes.

29We implicitly assume that the income distribution and tax parameters are such thatagents with higher income pay a higher sales tax, or T ′(y) > 0 for all y in the support off(y). We do not make these conditions explicit in order to avoid burdening the notation and

20

regressive - in the sense that the marginal tax rate is smaller than the averagetax rate - as long as τ > 0. When τ = 0 the tax scheme is equivalent to alinear income tax.30 The degree of regressivity τ is taken as a given feature ofsales taxation and is not chosen by agents in the politico-economic equilibrium.Agents, instead, are assumed to choose the parameter ω, which determines theoverall level of taxation, jointly with the public good level g, subject to thestate’s budget constraint:

g =

ˆT (y)f (y) dy. (8)

We are agnostic about the exact mechanism to aggregate individual pref-erences over the policy (ω, g) because the logarithmic structure of utilityimplies that voters are unanimous. Thus, we only require that a policy that isunanimously preferred is adopted. The following proposition summarizes thepolitico-economic equilibrium in this case.

Proposition 2 (Equilibrium with centralized provision). In an equilibriumwith centralized provision, the quantity of the public good is given by:

g∗∗ =λ

1 + λy. (9)

The associated tax parameter ω∗∗ is reported in the proof of the proposition.Proof: See Appendix.

Comparing equations (5) and (9), notice that the quantity of the public goodunder centralized provision is equal to the average (across localities) quantityunder decentralized provision. Thus, decentralized provision offers a smaller(larger) consumption of the public good to agents with income below (above)the mean relative to centralized provision. An equally important consideration,in order to determine the politico-economic support for decentralization, ishow the tax burden is shared among agents with different incomes. The next

exposition of the model any further. None of our results depends on these conditions.30As discussed in Section 2.2.2, income taxes played a more limited role than sales taxes

in generating revenue for the states during the 1930s.

21

section summarizes our findings on this question.

3.4 Comparing the Two Systems

In this section we determine how the politico-economic support for decentralizedprovision depends on the model’s parameters. As anticipated in the lastsection, the relative appeal of decentralization for an agent depends on how herconsumption of the public good and her tax burden vary across the two systems.The trade-off involved is as follows. A decentralized system allows high-incomeagents to benefit from a higher consumption of the public good relative toa centralized one. This gain is larger the larger is the preference parameterλ in the utility function (1). However, the regressive nature of the sales taximplies that high-income agents might benefit from centralized financing ofthe public good, since their share of aggregate sales taxes would be smallerthan their share of aggregate income. The gap between these shares increaseswith the degree of regressivity of the sales tax, indexed by the parameter τin equation (7). It follows that political support for decentralization dependson the relative magnitude of the parameters λ and τ, as summarized by thefollowing proposition.

Proposition 3 (Comparing the decentralized and centralized systems). Therelative preference for decentralization depends on the model’s parameters andon agents’ income in the following way:

1. If τ = λ, then the decentralized system is preferred by all agents.

2. If τ > λ, then all agents whose income is below a cut-off yd (defined inthe proof of the proposition) prefer the decentralized system. This is amajority of the population.

3. If τ < λ, then all agents whose income is above the cut-off yd prefer thedecentralized system. This group is a majority of the population if τ isclose to λ and becomes a minority as τ converges to zero.

Proof: See Appendix.

22

Notice that the case τ = λ represents the situation in which, from a pureredistributional perspective, the two systems are equivalent. The tax price ofthe public good is independent of income as the regressivity of the sales taxsystem fully offsets the potential from redistribution due to uniform provision.Given this, all agents prefer a decentralized system because, in this case, theyretain control over the quantity of the public good they consume. In otherwords, local provision is preferred because the quantity of the public goodselected locally exactly matches the preferences of each agent - a pure Tiebouttype of argument.

When the sales tax is sufficiently regressive relative to the taste for thepublic good (τ > λ), it is low income agents who prefer decentralization, whilethe opposite is true when the sales tax is not very regressive (τ < λ). In theformer case it is possible to conclude unambiguously that decentralization ispreferred by a majority because the agent with average income pays a largertax under the regressive sales tax system than under the decentralized one,while consuming the same quantity of the public good. However, when τ < λ

decentralization is preferred by a majority of high-income agents only if τ isclose to λ.31 As τ → 0, the sales tax becomes a linear income tax, and thecomparison between the two systems is the same as in Fernandez and Rogerson(2003). In this case the cut-off yd → y, and a majority of agents with incomebelow the mean prefer centralization because their public good consumption islarger and their tax payments are lower than under decentralized provision.

Prior to the Great Depression the decentralized system was the mostcommon form of provision of non-defense public goods in the U.S. We take thissituation to be our benchmark. Proposition 3 states that our model is able torationalize the popularity of decentralized provision among (at least) a majorityof the population as long as the sales tax regressivity parameter τ is not tooclose to zero. The next section shows how the events of the Great Depression- specifically the sharp income decline and the related rise in property taxdelinquency - created a situation in which the politico-economic support for

31Since when τ = λ, decentralization is unanimousy preferred, this is also the case when τis close to λ by a continuity argument.

23

the decentralized system declined.

4 Great Depression Experiment

We formalize the Great Depression as a negative income shock that affects afraction δ < 1/2 of the population in each locality. Specifically, an agent whosuffers a negative income shock experiences an income decline from y to θy,for some θ < 1. Notice that, after the Great Depression shock, each district’spopulation is divided into two groups based on income. For a fraction 1− δ ofthe district’s population income remains unchanged at y, while for a fraction δit declines to θy. This ex-post heterogeneity in income is a necessary ingredientto generate some tax delinquency in the decentralized equilibrium (see Section4.1).32 As a matter of notation, in what follows we keep referring to districty to indicate a district whose pre-Depression income was y, and where now afraction δ of its inhabitants has experienced a drop in income to a new level θy.

4.1 Decentralized Equilibrium and Delinquency

The option to not pay the head tax becomes more appealing for an agent asher income declines because of the higher marginal utility of consumption. Theequilibrium nature of the model is such that while individual tax delinquencydecisions depend on the magnitude of the head tax, the latter is endogenousand therefore depends on aggregate delinquency. In what follows we analyzeeach of these two channels in order to characterize the new politico-economicequilibrium.

Consider first the decision to be delinquent for an agent with income θy,given a tax t.33 The tax delinquency decision is based on the comparisonbetween the utility associated with being delinquent while consuming the entire

32Notice that we are keeping the distribution of population across localities constant afterthe shock occurs.

33The decision of an agent with income y is, of course, analogous. However, agents whoseincome does not decline do not find it optimal to be delinquent in equilibrium by virtue ofAssumption 1.

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income θy:ln (θy)− k,

and the utility associated with paying the head tax:

ln (θy − t) .

It follows that an agent chooses to be delinquent if the tax is sufficiently large:

t > κθy. (10)

While delinquency depends on the tax t, the converse is also true, throughlocal voting over taxes and public good provision. The assumption that δ < 1/2

guarantees that agents whose income does not decline are decisive in the choiceof (t, g). Consider the policy choice problem of these agents. They choose (t, g)

in order to maximize their utility subject to the following government budgetconstraint:

g =

(1− δ) t if t > κθy,

t if t ≤ κθy.(11)

This constraint reflects the fact that if the head tax is too large agents hit bythe income shock will choose to be delinquent. In what follows we impose asecond restriction on the parameter κ so that head tax delinquency emerges inequilibrium.

Assumption 2. κ < λ/θ (1 + λ) .

The following proposition summarizes the politico-economic equilibrium.

Proposition 4 (Decentralized provision in the Great Depression). Define thefollowing cut-off for the parameter δ:

δ ≡ 1− (1− κθ)1λ (1 + λ)

1λ+1 κθ

λ.

1. If δ < δ, under Assumption 2, the unique equilibrium tax and public good

25

provision in a district y are given by:

t∗ (δ) =λ

1 + λy, g∗ (δ) =

λ

1 + λy (1− δ) . (12)

In such an equilibrium, agents whose income declines to θy choose to bedelinquent on the head tax.

2. If δ ≥ δ, the unique equilibrium is such that:

t∗ (δ) = g∗ (δ) = κθy.

In such equilibrium, no agent is delinquent.

Proof: See Appendix.

In case 1 of this proposition, agents who are not affected by the recession arewilling to keep taxing themselves in the same amount as before the Depressionif the fraction δ of the population that is delinquent is not too large. Thefact that the tax itself does not depend on δ is a feature of logarithmic utility.Assumption 2 guarantees that the equilibrium tax in equation (12) satisfies theinequality in equation (10), inducing tax delinquency of agents with incomeθy. Alternatively, if δ is relatively large (case 2), the politically decisive agentsprefer to reduce the level of taxation to the point where all agents are willingto pay the head tax. In what follows we focus on case 1 (δ < δ), because taxdelinquency was, indeed, a prominent feature of the Great Depression.34

Assumption 3. δ < δ.

In the next section we consider the centralized equilibrium in the GreatDepression scenario.

4.2 Centralized Equilibrium

In the centralized equilibrium with a regressive sales tax, the consumption ofagents whose income y does not decline is still given by equation (6), while

34Notice that this assumption is consistent with our previous one that δ < 1/2.

26

consumption of the agents hit by the negative income shock and living in thesame district is:

c = ω (θy)1+τ . (13)

Per capita tax collection in district y is now:

T (y) = (1− δ)(y − ωy1+τ

)+ δ

(θy − ω (θy)1+τ

), (14)

reflecting the ex-post heterogeneity in income within the district. The budgetconstraint for the state as a whole takes the same form as in equation (8), withT (y) given by equation (14).

The preferred quantity of the public good for an agent with given income isobtained by maximizing her utility function (1) with respect to (ω, g), subjectto the relevant budget constraint (6) or (13).35 The logarithmic specification ofpreferences implies that all agents in the economy, irrespective of their incomelevel, prefer the same public good provision. This result is summarized in thefollowing proposition.

Proposition 5 (Centralized provision in the Great Depression). In the GreatDepression version of the economy, all agents agree on the following level ofpublic good provision:

g∗∗ (δ) =λ

1 + λ(1− δ + δθ) y. (15)

The corresponding tax parameter ω∗∗ (δ) is reported in the proof of this proposi-tion.Proof: See Appendix.

Comparing equations (9) and (15), we conclude that the quantity of thepublic good under centralization declines proportionately to average incomerelative to the pre-Depression scenario. However, comparing Proposition 4(case 1) with Proposition 1 shows that under decentralized provision theeconomy-wide provision of the public good declines proportionately more than

35Recall that the degree of regressivity τ of the sales tax is taken as given here.

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average income.36 This observation provides the key insight about the increasedsupport for centralization in our model’s Great Depression scenario relativeto the benchmark economy. A more detailed comparison is undertaken in thenext section.

5 Rising Support for Centralization during the

Great Depression

In this section we ask two questions related to our model and relevant forthe empirical analysis that follows. First, does the fall in income associatedwith the Depression increase the political support for centralization relativeto the pre-Depression scenario? Second, does support for centralization in theDepression scenario increase more the larger the income drop? The followingproposition summarizes our answer to the first question, while Proposition 7provides the answer to the second.

Proposition 6 (Increased support for centralization in the Great Depression).

1. A larger fraction of agents whose income does not decline supports cen-tralized provision of the public good in the Great Depression scenario thanin the benchmark economy.

2. A larger fraction of agents whose income declines supports centralizedprovision of the public good in the Great Depression scenario than in thebenchmark economy if and only if the degree of regressivity of the salestax is not too high:

τ <ln (1 + λ) (1− κ)

ln θ. (16)

Proof: See Appendix.36Specifically, while average income declines to a fraction (1− δ + δθ) of its pre-Depression

value, the average quantity of the public good under decentralized provision declines to afraction (1− δ) of its pre-Depression value.

28

Points 1 and 2 of Proposition 6 compare the politico-economic supportfor centralization in the pre-Depression and the Depression scenarios. Point 1deals with agents whose income remains constant and who therefore are notdelinquent in the Great Depression scenario. Those agents, who retain thepolitical control over the head tax in each locality, choose to keep the headtax constant (Proposition 4, part 1). However, they are worse-off because thehead tax delinquency by agents whose income falls leads to a reduction in localrevenue and expenditures. By contrast, the sales tax cannot be avoided andit allows the (state) government to tax individuals who would not otherwisecontribute to pay for the public good due to their delinquent status. In otherwords, the sales tax “forces” delinquent agents to pay for their share of thepublic good. This feature of the sales tax induces a greater portion of non-delinquent agents to support centralization of revenue collection through thesales tax in the Depression scenario.37

Point 2 of Proposition 6 considers the preferences over centralization ofagents whose income declines due to the Depression and who become taxdelinquent. Under condition (16), in all localities in which non-delinquentvoters support centralization, tax delinquent voters also support it. In addition,there are some localities in which non-delinquent voters oppose centralization,while delinquent ones support it. The reason why tax delinquent agents aremore strongly in favor of centralization than non-delinquent ones is that, whilethe former do not contribute to public good provision in the decentralizedequilibrium of the Great Depression scenario, they suffer the utility costs kassociated with being delinquent. If this utility cost is large relative to thedegree of regressivity of the sales tax - that is if equation (16) is satisfied -then tax delinquent agents are more strongly in favor of centralization thannon-delinquent agents with the same pre-Depression income.38

37More specifically, if τ > λ (τ < λ), statement 2 (3) of Proposition 3 applies with a cut-offlevel of income yd (δ) strictly smaller (greater) than yd, the cut-off in Proposition 3. If τ = λ,in the Great Depression scenario, agents unanimously support either decentralization (as inProposition 3) or centralization, depending on parameters.

38The degree of regressivity τ of the sales tax cannot be too large because in that caseagents whose income declines would see their marginal tax rate increase by a large amountunder centralization.

29

Our empirical analysis builds on the results of Proposition 6. However,instead of relying on a simple pre-post Depression comparison, we focus ona comparison across states between the magnitude of the income declineexperienced by a state and the likelihood of it passing a number of centralizingreforms. We view the model economy described above as representing aU.S. state. The magnitude of the income decline in a state is captured by theparameter δ, with higher values of δ leading to larger declines in average income.Proposition 7 then summarizes the prediction of our theory for the cross-statepattern of correlation between income decline and support for centralization.

Proposition 7 (Monotonic support for centralization). Voters’ support forcentralization increases monotonically with the extent of the decline in averageincome, indexed by δ.Proof: see Appendix.

Intuitively, as the magnitude of the income decline increases, more agentsbecome delinquent, exacerbating the problems with the head tax systemand increasing political support for centralization. The next section teststhis implication of the model using state-level data and various measures ofcentralization.

6 Empirical Analysis

Proposition 7 provides the foundation of our empirical analysis. Since we donot directly observe voters’ support for centralization, we proceed by relatingthe extent of the decline in per-capita income experienced by a state at theonset of the Great Depression with the subsequent adoption of the sales taxand with the increase in indicators of fiscal centralization. In addition, weprovide some more direct evidence for our mechanism and the role it ascribesto property taxation by showing that states that experienced a more severeincome decline were also more likely to adopt blanket property tax limitations,a strong indicator of popular discontent with the property tax.

30

6.1 Data and Descriptive Statistics

We now provide a brief description of the data used.39 Throughout our analysis,the basic unit of observation is a U.S. state. The data can be convenientlyorganized into four categories: outcome variables, regressors of interest, othercovariates, and instrumental variables. Summary statistics of the data, orga-nized in this fashion, are presented in Table 2. In this section we discuss thefirst two categories of data and postpone the discussion of additional controlsand instruments to Subsections 6.3.1 and 6.3.2.

Outcome variables. We consider three outcome variables. The first isthe adoption of blanket tax limit during the 1930s. This takes the form ofa zero-one dummy variable, with one denoting the adoption of a blanket taxlimitation by a state during the 1930s. As shown in Table 2, one in six statesadopted a blanket property tax limitation during the Depression.40 The secondpolicy variable - a dummy as well - is the adoption of a general sales taxduring the 1930s. Almost 60 percent of the states adopted a sales tax in thisperiod. Third, we seek to explain the increase in revenue and expenditurecentralization - measured by a state’s share of combined state and local revenuesand expenditures - between 1932 and 1942.41 The choice of these two yearsreflects constraints on data availability. The state-level fiscal data, provided byLegler, Sylla, and Wallis (1995) and based on the Census of Governments, isonly available for these two years. The earliest year of data available before1932 is 1913. The statistics on these indicators of fiscal centralization in Table 2reiterate the message of Figure 2: the states’ share of revenue and expendituresincreased by about 27 percentage points from 1932 to 1942.42

39The data is described in full in Appendix B.40The list of states that adopted blanket tax limitations or sales taxes is contained in

Table 1.41Our definitions of revenue and expenditures are consistent with our previous analysis

in Section 2 and Wallis and Oates (1988). Specifically, revenue refers to own revenues, i.e.revenues raised directly by the government and not derived from intergovernmental grants.Expenditures include grants made by the government to another level of government butsubtracts out the total grants received from other levels of government.

42Notice that this increase is somewhat larger than the corresponding increase (of about23 percentage points) between 1927 and 1942 based on national (as opposed to state) leveldata documented in Section 2.2.1. Notice also that in the interest of space, in Table 2 we

31

Regressors of interest. There are two regressors of interest. The maindriving force of our model and “bottom-up” mechanism is the income declineexperienced by a state. We measure the latter as the percent decrease in astate’s income per capita from 1929 to 1932. We compute the latter as thedifference in the logarithm of income per capita between 1932 and 1929 usingthe Bureau of Economic Analysis’ Regional Data. The income variable isconverted in real terms by dividing it by the national Consumer Price Index.43

We consider the decline from 1929 to 1932 because the National Bureau ofEconomic Research dates the peak of the business cycle in the third quarterof 1929 and the trough in the first quarter of 1933. Since we only have yearlyincome data at the state-level, we consider 1929-32 to be the contraction phaseof the cycle. This is consistent with, for example, Garrett and Wheelock(2006). Moreover, the policies we focus on - tax limitations and sales taxadoptions - were all enacted during or after 1932. Similarly, the revenue andexpenditures data we use to measure centralization refer to the 1932-1942period. To economize on language we will oftentimes just call this variable thestate income shock or income decline.

In addition to the decline in per capita income, we also consider an alterna-tive driving force of centralization, the New Deal grants received by a state(Wallis, 1984). We measure federal aid as the (logarithm of) the total realaid per capita received by a state from the federal government in the period1933–1939. To construct this meaure of federal aid we use data from the Reportof the Secretary of the Treasury.44

only report the change in the measures of centralization between 1932 and 1942. Althoughnot reported in Table 2, our three outcome variables tend to be positively associated inthe cross-section of states. For example, all seven states that adopted a blanket tax limitsubsequently adopted a sales tax. In addition, the average increase in the state’s share ofcombined state and local expenditures from 1932 to 1942 was 11.7 (7.8) percentage pointsgreater in states that adopted a tax limit (sales tax).

43Notice that since we are using the log difference in income, any variation in the pricelevel common to all states between 1929 and 1932 is absorbed by a regression constantor time effect. Thus, dividing the income data by the national CPI has no effect on theregression results. The inflation adjusted data of Table 2 are, however, more informativebecause they provide a sense of the magnitude of the income decline. As far as we know,consumer price indices for individual states are not available during this period.

44We have also employed a second measure of federal aid reported by Reading (1973), who

32

Table 2: Summary Statistics.

Mean SD Min MaxOutcome VariablesTax Limit Dummy 0.167 0.377 0.000 1.000Sales Tax Dummy 0.583 0.498 0.000 1.000Difference State Revenue Share, ’32-’42 0.274 0.072 0.131 0.432Difference State Expenditure Share, ’32-’42 0.272 0.082 0.112 0.495

Regressors of InterestLog Difference in Per Capita Income, ’29-’32 -0.364 0.101 -0.595 -0.166Log Federal Aid Per Capita, ’33-’39 4.974 0.428 3.995 6.175

Covariates% Renters, 1930 0.494 0.085 0.361 0.679% School ’27-’28 0.193 0.063 0.102 0.335% Urban ’30 0.460 0.199 0.166 0.924Log Income Per Capita ’29 6.347 0.377 5.583 7.048% Dem. ’28 0.434 0.125 0.271 0.914Non-White Pop. ’30 0.106 0.132 0.002 0.503Initiative State Dummy 0.438 0.501 0.000 1.000Debt Restriction Dummy 0.833 0.377 0.000 1.000Same Party Control Dummy 0.729 0.449 0.000 1.000Republican Control Dummy 0.125 0.334 0.000 1.000

Instrumental VariablesFederal Land per capita 0.039 0.148 0.000 0.998Non-Federal Land per capita 0.043 0.056 0.002 0.246Electoral Votes per capita 0.006 0.004 0.004 0.033SD Dem. Vote, ’96-’32 10.175 4.326 2.500 18.100

33

Table 3: Average Outcome Measures by Percent Growth in Per Capita Income.

Change in State’s Share

Tax Limit Sales Tax Revenue ExpenditureGrowth in per capita incomeHighest 3rd (−26%) 0 31 26 25Medium 3rd (−36) 13 56 28 28Lowest 3rd (−48%) 38 88 29 29

Statistics in columns 1 and 2 are percentages while columns 3 and 4 are percentagepoint differences.

6.2 Preliminary Analysis

Before moving to a formal regression analysis, we briefly illustrate the role ofincome decline in fostering centralization through simple conditional means.Specifically, we first partition the 48 states in three groups of 16 states each,based on their 1929-32 per capita income growth.45 We then summarize themean of each outcome variable for each group of states. The results are reportedin Table 3.

Notice that states differ greatly in terms of the decline in income theyexperienced. The average real income decline in the hardest-hit states was48 percent over the period 1929-1932 (see the bottom row of Table 3). Bycontrast, it amounted to 26 percent in the states least-affected by the GreatDepression (top row of Table 3). The magnitude of the income decline bearsa systematic association with our outcome variables. For example, none ofthe least-affected states passed a blanket property tax limitation, against 38percent of the most-affected states. Similarly, states with the highest declinein income were more likely to adopt a sales tax and centralize revenues andexpenditures than states with medium and lowest income declines. In the nextsection we analyze these patterns in a regression framework, which allows us

drew on a different government document, with nearly identical results. The correlationbetween the two variables is 0.93. A more detailed comparison of our aid variable andReading’s one is provided in appendix B.2.2.

45Recall that Alaska and Hawaii became states only in 1959 so data on these two statesbecame available only at that time.

34

to control for other economic forces.

6.3 Regression Results

In this section we present a number of regressions to illustrate and quantifythe magnitude of the “bottom-up” mechanism relative to the “top-down” oneand other economic forces in accounting for variation in our three outcomevariables. For clarity of exposition we consider each of these three in separatesubsections.

6.3.1 Blanket Property Tax Limitations

Property tax limitations were almost always adopted or strengthened throughvoter initiatives. A blanket property tax limitation, then, may be interpreted asa strong and direct indicator of voter discontent with the property tax. In thissection we ask whether states with larger decline in per capita income between1929 and 1932 were more likely to pass a blanket property tax limitation.Specifically, we run state-level probit regressions for the probability of passingtax limitations during the 1930s on measured income decline from 1929 to 1932and a number of control variables. We exclude from the latter the federal aidvariable both because the “top-down” mechanism does not naturally accountfor voters’ discontent with the property tax and because blanket tax limitationswere passed relatively early in the Depression, in 1932 and 1933, so it is highlyunlikely that they are explained by New Deal policies enacted in 1933 andimplemented over a number of subsequent years.46

Table 4 reports marginal effects of these regressions. Column 1 of Table4 suggests that the percent growth in per capita income from 1929 to 1932is indeed negatively correlated with the probability of adopting a sales tax.According to this estimate, a one (cross-state) standard deviation decrease in1929 to 1932 income growth - corresponding to about 10 percentage points -increases the probability that a blanket tax limitation will be adopted by 14.7

46Including federal aid in the regressions does not affect our results and the aid variablesare not significant.

35

Table 4: Marginal Effects for Property Tax Limitation Adoption (Probit).(1) (2)

% Growth in Per CapitaIncome, ’29-’32

-1.471*** -1.356***(0.511) (0.433)

% Renters ’30 -0.0859(0.992)

% School ’27-’28 -1.350**(0.642)

% Urban ’30 1.040**(0.478)

Log Income ’29 -0.530*(0.299)

% Dem. ’28 -1.506**(0.628)

Non-White Pop. ’30 -0.850(1.008)

Initiative State 0.0985(0.0891)

Observations 48 48

Robust standard errors reported in parentheses. Significance: *** 99% level, ** 95%level, * 90% level. Variable definitions: see text and data appendix.

percentage points.The effect of income growth on the adoption of property tax limitations is

robust to including a number of control variables emphasized in the literature onproperty tax limitations (e.g. Vigdor, 2001) that account for voters’ preferencesfor public good spending. They include the share of households in the statethat were renters in 1930 (% Renters ’30), the percent of voters that voted forthe Democratic nominee in 1928 (% Dem. ‘28), the share of the population ages10-19 enrolled in grades 7-12 in 1927-28 (% School ’27-’28), the share of thepopulation living in an urban area (% Urban ‘30), log real 1929 state incomeper capita (Income ‘29), and a dummy for whether the state permitted voterinitiatives.47 Results for this specification are reported in column 2 of Table 4.

47In many states, blanket tax limitations seem to have been a populist or grass rootsmovement (Leet and Paige 1934). If voter initiatives were permitted in a state it may havebeen more likely that a property tax limitation vote would occur and - perhaps - be passed.

36

Adding these controls does not affect significantly the estimated marginal effectof income growth on the adoption of tax limits. Thus, the results of Table 4are consistent with our hypothesis that the income decline of the Depressionled to a rising discontent with the property tax. The next section shows thatthe income decline induced governments to look for new sources of revenue insales taxes.

6.3.2 Sales Tax Adoption

Our model of sales tax adoption predicts that states experiencing larger incomeshocks are more likely to adopt a sales tax. Table 5 displays marginal effectsfrom probit regressions in which the dependent variable is sales tax adoption.In all regression specifications the income growth variable displays a statisticallyand economically significant association with the probability of adopting a salestax. States that experienced larger declines in per capita income were morelikely to adopt sales taxes. In column 1 of Table 4, the only explanatory variableis the percent growth in income. The marginal effect of income growth from1929 to 1932 can be interpreted by considering the effect on sales tax adoptionof reducing a state’s income growth by one standard deviation, or about 10percentage points (Table 2). This additional income decline is associated withan increase in the probability of adopting a sales tax by about 26 percentagepoints. In column 2 of Table 5 we add the federal aid variable to the regression.The latter is neither statistically nor economically significant. Moreover, themarginal effect of income growth is unaffected by the inclusion of federal aid.

Last, column 3 adds the variables included in Rueben (1994) in orderto facilitate a comparison with her results.48 The estimated effects of thesecontrol variables on sales tax adoption are consistent with Rueben’s. Examining

The effect of voter initiatives during the first half of the twentieth century is the subject ofMatsusaka (2000), which is also the source of data on voter initiatives.

48These variables include a dummy (Debt Restriction) for whether the state governmentwas legally prohibited from raising debt; a second dummy (Same Party Control) indicatesstates where a majority of both houses of the state legislature and the governor were inthe same political party; a dummy (Republican Control) set equal to one if Republicanscontrolled both houses of the legislature and the governor’s office; a dummy variable forsouthern states (Southern State); the logarithm of 1929 state income per capita.

37

Table 5: Marginal Effects for Sales Tax Adoption (Probit).

(1) (2) (3)% Growth in Per CapitaIncome, ’29-’32

-2.599*** -2.606*** -1.799***(0.423) (0.413) (0.497)

Log Federal Aid -0.045 -0.003(0.041) (0.042)

Debt Restriction 0.212*(0.112)

Same Party Control 0.461***(0.130)

Republican Control -0.115(0.144)

Southern State -0.044(0.159)

Log Income per capita,’29

0.417*(0.218)

Observations 48 48 48


38

column 3 of Table 5 we notice that, while the marginal effect of the state incomeshock has decreased somewhat relative to column 2, it is still statistically andeconomically significant. According to the specification in column 3, a onestandard deviation decrease in income from 1929 to 1932 is associated withan increase in the probability of adopting a sales tax by about 18 percentagepoints. The marginal effects of both federal aid variables remain economicallysmall and insignificant.

There are two main differences between our specification in column 3 ofTable 5 and Rueben (1994)’s, who first studied empirically the question of salestax adoption by the states. First, we use income growth between 1929 and1932, rather than employment growth for this same period as our “economicshock” variable. We prefer to use income growth because it corresponds directlyto the shock considered in our model. Moreover, the income variable includes- but is not limited to - labor income and thus is likely to provide a moreaccurate measure of the resources available to households in a given state thanemployment growth. We have also run the regression for sales tax adoptionusing employment growth (measured by the employment index in Wallis, 1989)instead of income growth. In the regression specification in column 3, we findthat a one standard deviation (10 percentage points) decline in employmentgrowth increases the probability of adopting a sales tax by 12 percentagepoints.49 By contrast, a one standard deviation decline in income growthleads to an increased probability of passing a sales tax by about 18 percentagepoints, according to column 3 of Table 5. Therefore, the results associated withthe income growth measure are quantitatively larger than those obtained byRueben (1994). The second difference with respect to Rueben’s specification isthat we include a federal aid variable in our regressions in order to account forthe “top-down channel” discussed in the introduction. This variable turns outnot to matter for sales tax adoption and does not affect the importance of theincome shock or employment index variables.

49This number is consistent with Rueben’s (1994, 12) finding that a decline in employmentgrowth by 5 percentage points increases the probability of passing the sales tax by 5 percentagepoints.

39

The last issue we address in this section is the potential endogeneity offederal aid in the regressions of Table 5, which would lead to inconsistentestimates.50 The ideal instrument exploits variation in federal aid receivedby a state that is uncorrelated with the unobserved determinants of sales taxadoption. Following the literature, we consider two instruments. The firstis based on the work of Wright (1974), who argued that federal grants wereallocated across states so as to increase Franklin Delano Roosevelt’s probabilityof reelection in 1936. Wright (1974) showed that the number of electoralvotes per capita and the within-state (time-series) standard deviation of theDemocratic vote share in presidential elections from 1896 to 1932 were powerfulpredictors of New Deal spending in a state.51 The second instrument is basedon the land area of a state. Reading (1973) hypothesizes that more grantsflowed to states with large amounts of federal land because relief projects onfederal land both improved the land and minimized the amount of bureaucraticmachinery necessary to get relief projects underway. More recently, Fleck (2008)points out that the amount of non-federal land in a state was an importantdeterminant of the amount of federal highway grants received by a state. Wetherefore consider both federal and non-federal land per capita as instrumentsfor federal aid.

Table 6 presents instrumental variable probit regressions using these instru-ments. Both political and land-based instruments affect the allocation of federalaid across states in the predicted way in first-stage regressions. The p-value

50While such endogeneity might occur for various reasons, an obvious one is reversecausation from sales tax adoption to federal aid.

51The premise of Wright’s (1974) argument is that the Roosevelt administration soughtto distribute discretionary aid dollars among states so as to maximize electoral votes whileminimizing costs. Assuming that a given amount of federal aid could buy a vote and thatthe distribution of this cost is equal across states, states with more electoral votes per capitacould be “bought” relatively more cheaply since each voter has more influence over whichcandidate the state’s electoral votes goes. States in which the standard deviation of theDemocratic vote share was low were either solidly Democratic or Republican; an aid dollarspent there would do little to change the outcome of the election. High standard deviationstates, however, could potentially be swung into the Democratic camp with more aid dollars.Notice that we would obtain similar results using Wright’s “political productivity index”(which is itself based on the electoral votes measure) as an instrument, rather than theelectoral votes variable.

40

Table 6: Marginal Effects for Sales Tax Adoption (IV Probit).(1) (2) (3) (4)

% Growth in Per Capita Income,’29-’32

-2.605*** -2.568*** -1.777*** -1.797***(0.412) (0.422) (0.473) (0.547)

Log Federal Aid -0.041 -0.012 -0.021 0.031(0.046) (0.049) (0.061) (0.042)

Debt Restriction 0.200* 0.227*(0.120) (0.120)

Same Party Control 0.436*** 0.513***(0.128) (0.126)

Republican Control -0.110 -0.111(0.140) (0.145)

Southern State -0.079 0.032(0.166) (0.152)

Log Real Income per capita, ’29 0.367* 0.503**(0.209) (0.220)

First-stage CoefficientsElectoral Votes per capita 209.983*** 197.214***

(57.585) (50.166)SD Dem. Vote, ’96-’32 0.062** 0.061*

(0.027) (0.033)Federal Land per capita 1.454** 1.995***

(0.543) (0.573)Non-Federal Land per capita 16.454*** 14.860***

(2.503) (2.497)

Observations 48 48 48 48p-value 0.000 0.000 0.000 0.000

First stage regressions also include % growth in per capita income,’29-’32 in columns1-2 and % growth in per capita income, ’29-’32, Debt Restriction, Same PartyControl, Republican Control, Southern State, and Log Real Income 1929 in columns3-4. Robust standard errors reported in parentheses. Significance: *** 99% level, **95% level, * 90% level. Variable definitions: see text and data appendix.

41

on the significance of the instruments rules out weak instruments problems.Examining the second stage regressions, we find that the estimated marginaleffects of both the federal aid variable and the income growth one on salestax adoption are very similar to the non-IV probit estimates of Table 5. Wetherefore confirm that the possible endogeneity of the federal aid variable isunlikely to affect our main results.

6.3.3 Fiscal Centralization

Our previous results concern the effect of income decline on discontent withproperty taxation and the adoption of the sales tax. In this section we considertwo direct indicators of state fiscal centralization - the state government’sshare of combined state and local revenue and expenditure - and assess theirassociation with the decline in state per capita income and New Deal aid. Thestate-level fiscal data are available in 1932 and 1942, allowing us to estimate adifference-in-difference regression of the following form:

zst = δs + d1942 · (α0 + α1 ·∆ys + α2 · aids) + εst, (17)

where zst is the share of revenue or expenditures in state s at time t = 1932, 1942;δs is a state fixed effect; d1942 is a dummy for t = 1942; and α0 is a year effect.The coefficients of interest are α1 and α2, which correspond to the effect of1929-32 income growth (denoted by ∆ys) and federal aid (denoted by aids) onthe change in the dependent variable between 1932 and 1942.

OLS estimates of equation 17 are presented in column 2 (revenue share) and4 (expenditure share) of Table 7. Columns 1 and 3 show analogous results forthe case in which we omit the federal aid variable from these regressions. Theeffect of the state income shock is negative in all four columns. The estimatedeffects are statistically significant at least at the 10 percent level. The pointestimates in columns 2 and 4 suggest that a one standard deviation decreasein income per capita was associated with about 1.72 and 2.05 percentagepoint increase in the growth of the state’s share of revenues and expendituresbetween 1932 and 1942, respectively. This corresponds to about a quarter of

42

Table 7: Fiscal Centralization (OLS).Revenue Share Expenditure Share(1) (2) (3) (4)

% Growth in Per Capita Income,’29-’32 ×1942

-0.160* -0.172** -0.195* -0.205*(0.093) (0.082) (0.109) (0.102)

Log Federal Aid ×1942 -0.017** -0.014(0.008) (0.009)

Observations 96 96 96 96R2 0.954 0.959 0.945 0.948State Fixed Effects Yes Yes Yes YesYear Fixed Effects Yes Yes Yes Yes


the cross-sectional standard deviation in these variables (see Table 2).Federal aid enters with the wrong (from the perspective of the “top-down”

view) sign in all regressions and the estimated effects are small. As for salestax adoption, one may be concerned that the results in Table 7 might fail toaccount for all factors that influence both centralization and federal aid. Wetherefore instrument federal aid using the political and state land variablesdiscussed in the previous section.

The results of the instrumental variables regressions are presented in Table8. The point estimates on 1929-32 income growth are essentially the same asin Table 7 but are estimated much more precisely. Now, all the coefficientson income growth are significant at the one percent level. The estimatedmagnitude of α2 remains quite small and with the wrong sign. For example, aone standard deviation increase in federal aid is associated with a decrease ina state’s revenue share of about half of a percentage point.

The small estimated effect of federal aid and its incorrect sign in regressionsfor states’ expenditure and revenue shares raises the question of why ourconclusions are different from those reached by Wallis (1984) and Wallis andOates (1998). The latter paper refers to the former, so we limit our commentsto the first paper here. In the interest of space we summarize our mainargument here while relegating a more detailed discussion to Appendix C.

43

Table 8: Fiscal Centralization (IV).Revenue Share Expenditure Share(1) (2) (3) (4)

% Growth in Per CapitaIncome, ’29-’32 ×1942

-0.170*** -0.168*** -0.199*** -0.200***(0.057) (0.058) (0.072) (0.072)

Log Federal Aid ×1942 -0.014** -0.011** -0.006 -0.007(0.006) (0.006) (0.006) (0.006)

First-stage CoefficientsElectoral Votes per capita×1942

209.983*** 209.983***(57.585) (57.585)

SD Dem. Vote, ’96-’32×1942

0.062** 0.062**(0.027) (0.027)

Federal Land per capita×1942

1.454** 1.454**(0.543) (0.543)

Non-Federal Land per capita×1942

16.454*** 16.454***(2.503) (2.503)

Observations 96 96 96 96p-value 0.000 0.000 0.000 0.000State Fixed Effects Yes Yes Yes YesYear Fixed Effects Yes Yes Yes Yes

First stage regressions also include % Growth in Per Capita Income, ’29-’32. Coeffi-cients from IV regressions reported. Robust standard errors reported in parentheses.Significance: *** 99% level, ** 95% level, * 90% level. Variable definitions: see textand data appendix.

44

The regression in Wallis (1984) that is closest to our equation (17) is hisregression for local expenditures (page 157). The latter is also a difference-in-difference specification for the change in local expenditures between 1932 and1942 across states. Instead of using federal aid as independent variable as wedo, Wallis’ main regressor of interest is the intergovernmental aid received bylocal governments in a state.52 The latter is instrumented using Wright’s (1974)political variables, the same variables we use to instrument federal aid. Hefinds that states in which local governments received more intergovernmentalaid experienced a relative reduction in local governments’ own expenditures. InTable C1 of Appendix C we show that we can replicate this result adopting asimplified version of Wallis’ regression equation. That is, intergovernmental aidto local governments has a negative and statistically significant effect on theshare of expenditures accounted for by local governments.53 Two issues, however,make us think that this analog of Wallis’ result should be interpreted withcaution. First, when we introduce our income decline variable in this regression,the intergovernmental aid variable loses its statistical significance at the 5percent level, while the income decline variable is significant with the predictedsign. Second, and more important, we find that in the first-stage regression ofintergovernmental aid on Wright (1974)’s political variables, states with moreelectoral votes per capita experienced a smaller increase in intergovernmentalaid received by local governments. This result questions the direction of theconnection between federal aid to the states and intergovernmental aid receivedby local governments postulated by the “top-down” view. Overall, our resultssuggest that the evidence in favor of the “top-down” mechanism for statecentralization is not robust.

52 A second difference between Wallis (1984)’s regression specification and ours is that heconsiders as dependent variable the level of local expenditures from own revenue, rather thanthe share of expenditures accounted for by local governments. Notice also that our results arenot comparable with Wallis’ regression for state (rather than local) expenditures (equation 1in Wallis, 1984, page 150, with results in his Table 3) because the latter does not includeeither state or year dummies and therefore is not a difference-in-difference specification.

53We use the share rather than the level of local expenditures to be consistent with therest of our analysis.

45

7 Conclusion

In this paper we have analyzed one of the most striking changes in intergovern-mental fiscal relationships in U.S. history. During the Great Depression thestates’ share of combined state and local revenue and expenditures increasedgreatly. Our main hypothesis was that this shift was brought about by thedifferent mix of taxes available to state and local governments and by howthese tax instruments interacted with the sharp income decline of the earlypart of the 1930s. We introduced a model of fiscal centralization to illustratethe mechanism through which income decline leads to increased support forsales taxation and fiscal centralization. Finally, we demonstrated empiricallythat states that experienced larger declines in income in 1929-32 were morelikely to to pass blanket limitations on property taxation, introduce a generalretail sales tax, and, more generally, to centralize revenue and expenditures inthe hands of state governments during the 1930s.

The lesson of the Great Depression is still relevant to the current world forat least two reasons. First, many of the fiscal policies that emerged from it -such as sales taxation and state centralization - have persisted for many decadesafter the end of the Depression. While a complete account of this “hysteresis”is outside the scope of the paper, one hypothesis is that the severity of theDepression enabled the type of institutional reform that requires a very broadpolitical consensus. After the economic crisis passed, support for centralizationmight have declined, but the politico-economic coalition favoring a return tothe pre-Depression status-quo was not sufficiently large.54

A second reason for why the lesson of the Great Depression is still relevant isthat politico-economic mechanisms reminiscent of those of the 1930s continue tooperate decades later. For example, during the 1970s, California experienced asharp rise in housing values that outpaced many households’ income growth. Asa consequence, property tax bills increased as a fraction of income, forcing manyhouseholds to sell their homes and move elsewhere. According to O’Sullivan,

54In Section D of the Appendix we offer a formalization of this argument based on themodel of Sections 3–5.

46

Sexton and Sheffrin (1995) these events were a powerful force behind thepassage of Proposition 13, which marked the beginning of modern propertytax revolts in the U.S.55 Since the property tax is the main tax controlled bylocal governments, the passage of Proposition 13 and equivalent measures inother states was instrumental in further increasing fiscal centralization by stategovernments at the expense of local ones. Thus, the mechanisms we focuson in this paper, linking income decline and property tax discontent to swiftpolitico-economic change, are still relevant to understand more recent fiscaldevelopments.

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50

(Appendices not meant for publication.)

A Appendix: Proofs of Propositions 1–6

A.1 Proposition 1

Assuming no agent is delinquent, the government’s budget constraint is

g = t.

Using this relationship, the optimal policy choice solves the problem:

maxg{ln (y − g) + λ ln g}

yielding the solution in equation (5). Given this solution, an agent chooses notto be delinquent if

ln (y − g∗) ≥ ln y − k

which holds under Assumption 1.

A.2 Proposition 2

The preferred policy bundle (ω, g) by an agent with income y solves the problem:

maxω,g

{lnωy1+τ + λ ln g

}s.t.

g = y − ωy,

where the term y is defined as follows:

y ≡ˆy1+τf (y) dy.

51

The first-order condition is

1

ω=

λy

y − ωy

yielding as a solution ω∗∗ = y/ [(1 + λ) y] and g∗∗ given by equation (9).

A.3 Proposition 3

To compare the two systems, compute the indirect utility associated with each.The decentralized one yields:

V dec = lny

1 + λ+ λ ln

λy

1 + λ

while the centralized one:

V cen = lny

(1 + λ) y+ (1 + τ) ln y + λ ln

λ

1 + λy.

Comparing these two, we obtain that V dec > V cen if and only if:

yτ−λ <y

y1+λ. (18)

If τ = λ, this inequality is always satisfied because, by Jensen’s inequality:

y > y1+τ .

Thus, in this case there is unanimous support for decentralization.If τ > λ, the inequality (18) becomes

y < yd ≡(

y

y1+τ

) 1τ−λ

y (19)

where the termy

y1+τ> 1

because of Jensen’s inequality since τ > 0. It follows that the cut-off in equation

52

(19) is larger than y. Thus, given that median income is less than mean income, amajority of the population with relatively low income supports the decentralizedsystem.

Finally, if τ < λ, the inequality (18) becomes:

y > yd

where (y

y1+τ

) 1τ−λ

< 1.

Thus, ifyd < median income, (20)

a majority of the population with relatively high income supports decentral-ization, while if the inequality in equation (20) does not hold, supporters ofdecentralization are a minority of the population with relatively high income.As τ → λ, the term: (

y

y1+τ

) 1τ−λ

tends to zero and (20) is always verified and a majority of the population favorsdecentralization. As τ → 0, it is straightforward to verify that yd → y. Sincemedian income is always assumed to be below mean income, the inequality inequation (20) is never verified as τ → 0, and a majority supports centralization.

A.4 Proposition 4

We assumed that δ < 1/2, which implies that the decisive voter at the districtlevel will have income y. We derive the optimal (t∗, g∗) pairs for this decisivevoter with and without a positive delinquency rate and then derive conditionsunder which it is optimal to choose a policy (t∗, g∗) that induces delinquencyin equilibrium.

In an equilibrium in which all agents whose income declines are delinquent

53

on their head tax, the decisive voter achieves the following utility:

V1 ≡ maxt

ln(y − t) + λ ln[(1− δ)t].

Note that this problem is identical to that faced by the voter in Proposition1 with the exception of an added constant. It can be shown that the solutiontakes the same form as in Proposition 1:

t∗ (δ) =λ

1 + λy.

Under Assumption 2, t∗ (δ) > κθy which leads to tax delinquency by agentswhose income is θy. Thus, t∗ (δ) is the optimal tax rate in the equilibrium withpositive delinquency. The expression for g∗(δ) is then obtained from the localgovernment’s budget:

g∗(δ) =λ

1 + λy(1− δ).

Consider now an equilibrium with no delinquency. The decisive voter solves:

V0 ≡ maxt∈[0,κθy]

ln(y − t) + λ ln t.

The objective function is monotonically increasing for all t in the constraintset. Therefore, the optimal tax in this equilibrium is t∗ (δ) = κθy and publicgood provision is just g∗(δ) = κθy.

The decisive voter chooses the equilibrium that gives her the highest utilitylevel. Thus, the equilibrium with tax delinquency is chosen if and only ifV1 > V0. It is straightforward to verify that this condition is equivalent to thefollowing constraint on δ:

δ < δ ≡ 1− [(1 + λ)(1− κθ)]1λκθ

λ(1 + λ) .

Alternatively, if δ ≥ δ the equilibrium without delinquency is selected.

54

A.5 Proposition 5

Under centralized provision, the public good consumed by each agent is givenby the following state government’s budget constraint:

g(ω) = ((1− δ) + δθ) y − ω((1− δ) + δθ1+τ

)y.

An agent with income y thus solves

maxω

ln(ωy1+τ

)+ λ ln g(ω)

to determine her preferred level of (ω, g) . Solving the first-order condition forω yields

ω∗∗(δ) =1− δ + δθ

1− δ + δθ1+τy

(1 + λ)y(21)

and replacing ω∗∗(δ) into g(ω) yields:

g∗∗(δ) =λ

1 + λ(1− δ + δθ)y.

Notice that these quantities are independent of income. An agent with incomeθy solves:

maxω

ln(ω (θy)1+τ

)+ λ ln g(ω).

This objective function is the same as that of an agent with income y,up to an additive constant. Thus, also this type of agent prefers the policy(g∗∗(δ), ω∗∗(δ)).

A.6 Proposition 6

We provide a separate proof for each of the two statements. It is convenient todefine the following terms:

Γ1 ≡1− δ + δθ1+τ

1− δ + δθ,

Γ2 ≡1− δ

1− δ + δθ.

55

Note that since θ < 1 and τ > 0 the following are true:

Fact 1. Γ1,Γ2 < 1

Fact 2. ∂Γ1/∂δ < 0, ∂Γ2/∂δ < 0.

Consider now each claim of the proposition.

A.6.1 Support for centralization increases among agents whose in-come does not decline

The indirect utility functions of agents whose income does not decline underdecentralization and centralization are:

V decy = ln(y − y λ

1 + λ) + λ ln((1− δ)y λ

1 + λ),

V ceny = ln

(1

Γ1

y

(1 + λ)yy1+τ

)+ λ ln

(λ

1 + λ(1− δ + δθ)y

).

Combining the log terms and taking a positive monotonic transformationyields equivalent indirect utility forms:

V decy =

λλ

(1 + λ)1+λ(1− δ)λy1+λ

V ceny =

1

Γ1

λλ (1− δ + δθ)λ

(1 + λ)1+λy1+λ

yy1+τ

There are two cases of interest.

Case τ > λ Centralization is preferred to decentralization if and only ifV ceny > V dec

y . That is, if

y1+λ(1− δ)λ < (1− δ + δθ)1+λ

1− δ + δθ1+τy1+λ

yy1+τ

y >(Γ1Γ

λ2

) 1τ−λ

(y

y1+τ

) 1τ−λ

y

y > yd (δ) ≡(Γ1Γ

λ2

) 1τ−λ yd, (22)

56

where yd is defined in equation (19) in Proposition 3. Notice that Fact 1and the condition τ > λ imply that the term

(Γ1Γ

λ2

) 1τ−λ < 1. It follows that

yd (δ) < yd, so support for centralization increases in the Great Depressioneconomy.

Case λ > τ Using the same setup as in the previous case, it is straight-forward to derive an analogous condition:

y < yd (δ) =(Γ1Γ

λ2

) 1τ−λ yd.

The discussion from the previous subcase implies that(Γ1Γ

λ2

) 1τ−λ > 1. Thus,

in this subcase the range of income such that agents support centralizationin the Great Depression economy is wider than in the benchmark economy.Support for centralization is therefore higher in the Great Depression economy.

Case τ = λ. Centralized provision is preferred to decentralized provision(V dec

y < V ceny ) if:

Γ1

[1− δ

1− δ + δθ

]λy

y1+λ< 1. (23)

We know that

Γ1

[1− δ

1− δ + δθ

]λ< 1

and that y > y1+λ, so condition (23) might or might not be satisfied dependingon parameters. That is, it is not always the case that decentralization is alwayspreferred as was the case in the pre-Depression economy (case δ = 0, in whichcase the inequality (23) is always satisfied).

A.6.2 If the sales tax is not too regressive, then support for cen-tralization is higher among agents whose income declines inthe Great Depression

If there is positive delinquency then it must be the case that t∗(δ) > κθy.

The indirect utility functions of an agent whose income declines to θy under

57

decentralized and centralized public good provision are:

V decθy = ln(θy) + λ ln((1− δ)y λ

1 + λ)− k,

V cenθy = ln

(1− δ + δθ

1− δ + δθ1+τy

(1 + λ)y(θy)1+τ

)+ λ ln

(λ

1 + λ(1− δ + δθ)y

).

By combining the log terms and using a positive monotonic transformationwe get equivalent formulations:

V decθy = θ

((1− δ)λ

1 + λ

)λe−ky1+λ,

V cenθy =

1

Γ1

[(1− δ + δθ)λ]λ

(1 + λ)1+λy1+λ

y(θy)1+τ .

Case τ > λ A delinquent voter supports centralization if V decθy < V cen

θy ,

that is, if:

y >

((1 + λ) e−k

θτ

) 1τ−λ

yd (δ) . (24)

Notice that (24) is (22) times a constant. Equation (16) in the main textof the paper implies that (1 + λ) e−k/θτ < 1. Thus, the income cut-off fordelinquent agents to support centralization is lower than for non-delinquentagents. The claim in the proposition therefore holds.

Case λ > τ The analogous condition for support of centralization is:

y <

((1 + λ) e−k

θτ

) 1τ−λ

yd (δ) ,

where the term that multiplies yd (δ) on the right-hand side of this inequality isnow larger than one because λ > τ. Thus, as in part A.6.1 the range of incomessuch that delinquent agents support centralization in the Great Depressioneconomy is wider than the range in the benchmark economy. In other words,support for centralization is strictly larger in the Great Depression economy.

58

Case λ = τ Centralization is preferred by delinquent agents when:

Γ1

[1− δ

1− δ + δθ

]λy

y1+λ(1 + λ) e−k

θλ< 1.

This condition is implied by the analogous condition for non-delinquent agents(equation 23) since (1 + λ) e−k/θτ < 1 by equation (16).

A.7 Proposition 7

If λ 6= τ, we need to show that the income cut-off yd (δ) defined in equation(22) is monotonically decreasing in δ when τ > λ and monotonically increasingin δ when τ < λ. This is straightforward to verify because Fact 2 guaranteesthat Γ1Γ

λ2 is decreasing in δ. When τ = λ, the proposition’s statement requires

the term

Γ1

[1− δ

1− δ + δθ

]λto be declining in δ. This is the case because Γ1 declines in δ (Fact 1).

B Data Appendix and Definitions

We discuss the data and variable definitions in terms of: outcome variables(B.1); regressors of interest (B.2); control variables (B.3); instruments forfederal aid (B.4). The sources of all variables are summarized in Table B3 ofB.5.

B.1 Outcome Variables

B.1.1 State Budget Shares

State revenue and expenditure shares were both derived from the 1932 and1942 Census of Governments, which were collected by Sylla, Legler, and Wallis(1995). State revenue shares in our analysis are defined ownrevenue shares,i.e. they only include revenue raised by the government directly and do not

59

include intergovernmental grants. The data that we used, instead, includesintergovernmental grants in the total revenue figure. Thus, some adjustmentswere necessary. Suppose RL and RS represent total revenues for local andstate governments, respectively. Denote intergovernmental grants to localgovernments (by state governments) and to state governments (by the federalgovernment) by IL and IS. Then, the state’s share of combined state and localown revenues, RO

S , is given by

ROS ≡

RS − IS(RS − IS) + (RL − IL)

.

In constructing the state expenditure shares we attribute intergovernmentalgrants to the granting government. The data that we used counts grantsto other governments as a part of total expenditures but we still need tosubtract out expenditures paid for by grants from other levels of government toavoid double counting. Let EL and ES denote expenditures by state and localgovernments, respectively, and use the same notation for intergovernmentalgrants as above. Then the state expenditure share, EO

S is given by

EOS ≡

ES − IS(ES − IS) + (EL − IL)

.

The 1932 Census of Government reports expenditure and revenue figuresfor states, counties, cities and towns, school localities, other civil divisions, andtownships. We sum expenditures, revenues, and grants across counties, citiesand towns, school districts, other civil divisions, and townships to generateEL, RL, and IL, respectively. State expenditures, revenues, and grants onlyinclude the state government figures. The ISO codes used by Sylla, Legler, andWallis (1995) for each of these variables for 1932 is given in appendix Table B1.

The 1942 Census of Government only reports total local government andstate government figures. The total expenditure figure includes “Provision forDebt Repayments”, an item not included in other years. Sylla, Legler, andWallis (1995) advise that this item be removed from expenditure totals for1942 in order to make them comparable across years. We follow this advice in

60

Table B1: ISO Codes for Computing Variables From Legler, Sylla, Wallis(1995)

Variable Year ISO Code

E

{1932

1942

00030003

R

{1932

1942

00010001− 4100

I

{1932

1942

23002350 + 2361

For state governments ISO = 2361 (“Aid From State Government Only”) is alwaysequal to zero in 1942.

computing expenditures for 1942. The 1942 Census also provided more detailon intergovernmental grants received. In particular, it includes total grants andgrants from state governments. This is reported in Sylla, Legler, and Wallis(1995) as aid “From Federal Government” (ISO = 2350) and “Aid From StateGovernment Only” (ISO = 2361). The data providers assume that the statesonly received aid from the federal government, which - in their words - is “aninaccurate assumption, but not too far wrong” (Sylla, Legler, and Wallis, 1995).For our purposes this does not present a problem since aid “From FederalGovernment” is the same as total aid for states and it is total aid that we areafter. These details are documented in appendix Table B1.

B.1.2 Sales Taxes

There are two ways to count sales tax adoptions. The first only counts thosestates that instituted a permanent sales tax. There were twenty-three suchstates. This is the criteria used by the Advisory Commission on Intergovern-mental Relations (1993). The second approach - used by Jacoby (1938) andfollowed by Rueben (1994) - counts both permanent and temporary sales taxadoptions as sales tax adoptions. When this criteria is used twenty-eight statesare counted as sales tax states. We list all states who adopted a sales tax atany time from 1932-1940 in Table 2 of the main text. States that only had

61

temporary sales taxes are marked with an asterisk. Our results hold whetherwe use twenty-three or twenty-eight states.

B.1.3 Tax Limitations

Tax limitations were adopted en masse during the early years of the Depression.They are detailed in tables 1, 2 and 3 of Mott and Suiter (1934). Though thisdocument was compiled in the midst of the Depression, the New York Times(1939) confirms that the states mentioned in the Mott and Suiter article werethe only states to pass tax limitations during the Depression.

B.2 Regressors of Interest

B.2.1 Economic Indicators: State-Level Income and Employment

From 1929 onward, personal income data are available on an annual basis fromthe Bureau of Economic Analysis. We use this data to generate our percentdecline in personal income variable for 1929-1932. Wallis (1989) presents indicesof employment, manufacturing, and non-manufacturing for 1929-1940. Allseries for all states have values of 100 in 1929.

B.2.2 Federal Aid to States

Our variable for federal aid to states is taken from the Report of the Secretaryof the Treasury for the years 1933 to 1939.56 For all years and for each statewe collect the grand total of all federal aid to the state. We then correct thefigure for inflation (using 1932 as a base year). We sum the annual aid figuresover all years. Finally, to put the variable in per capita terms, we divide totalaid by the total population of the state over the same period.

The decision to count all federal aid rather than only those that wereexplicitly for New Deal programs was prompted by this observation fromReading (1973, 793):

56The exact name and table number differs by year. We provide the table numbers here:1933: 49, 1934: 47, 1935: 48, 1936: 52, 1937: 54, 1938: 59, 1939: 61.

62

Some New Deal Programs were established to meet a specific emer-gency; others were directed toward aiding depressed areas for theduration of the depression; still others were permanent and lasting.Some programs were the creation of New Deal planners; otherswere holdovers from the previous administrations. The RooseveltAdministration viewed many well-established programs (the Bu-reau of Public Roads, the Veterans’ Administration, the Bureau ofReclamation) as vehicles for and methods of increasing employment.

Reading followed this reasoning in constructing his own set of federal aidfigures from a report by the Statistical Section of the Office of GovernmentReports entitled Federal Loans and Expenditures (1940). Subsequent work onNew Deal Aid has used Reading’s data, generally dividing the total aid figureby each state’s 1930 population to get a per capita figure. This work includesWright (1974), Wallis (1984, 1987, 1998), Anderson and Tollison (1991), andFleck (2001, 2008). Wallis (1998) provides an insightful and entertainingoverview of the history of this data.

Our decision to use a slightly different aid variable was prompted by a fewconcerns. First, by collecting yearly data we are able to account for the wideswings in prices that occurred during the Depression. The Reading data is innominal terms. Yearly data also allows us to correct for population growth.Finally, we were unable to locate the original document used by Reading (onlyaggregate figures are reported in the 1973 paper). Thus, a key advantage ofthe Treasury data is that we can see the breakdown of federal aid by program.Wallis (1984) used the same Treasury data used here to supplement Reading’sdata.

It should be noted that our federal aid data is not merely a transformedversion of Reading’s. It was not possible to replicate the Reading figures byvarying the process we used to generate total per capita federal aid. Eachvariable is summarized in Table B2.

The correlation between these two variables is strong (0.9333) but theTreasury data has consistently smaller means. If we exclude Nevada - a

63

Table B2: Federal Aid Variables

Source Construction Mean SD Min MaxOfficeof Gov-ernmentReports

Sum of federal aidto state (1933-39,nominal) divided by1930 population.

293.44 178.14 147.31 1130.76

U.S. Trea-sury

Sum federal aid tostate (1933-39, real1932 dollars) di-vided by weightedaverage 1930/1940population.

159.7 82.73 54.33 480.8

consistent outlier - the estimated fitted line between these two variables is

AidReading = 17.36 + 1.34 · AidTreasury.

The robust 95% confidence interval on the slope coefficient is [1.04, 1.65]; thedifference in the aid variables is larger for states that received large amounts ofaid.57

Although these differences in federal aid variables are important they donot affect our results. The general finding that the amount of federal aidprovided by the government was not significantly correlated with the change incentralization in a state holds whether we use our preferred variable, Reading’svariable, or New Deal spending only.

B.3 Control Variables

B.3.1 Debt Limitations

We count only constitutional debt limitations. There are two conflicting sourcesfor this data. Shawe (1936) reports that all states except Delaware, Mississippi,

57The coefficient is larger if Nevada is included.

64

Vermont, Massachusetts, Tennessee, Maryland, New Hampshire, Connecticut,North Carolina, and North Dakota had a tax limitation. Heins (1963) presenteda list equivalent to Shawe but also counted North Carolina and North Dakotaas having a tax limitation. This discrepancy might be attributed to differingopinions of what constitutes a debt limit.58 North Carolina was limited toborrowing 7.5% of its assessed valuation but borrowing below that limit could beauthorized by the legislature, a far less stringent process than the constitutionalamendment required by other states. The North Dakota legislature was alsoallowed to issue debt but “Not in excess of $2,000,000 unless secured by a firstmortgage” (Shawe 1936, 125). Rueben (1994) uses the list provided by Heins(1963). Our results are similar using either list.

B.3.2 Single Party Control

Single party control variables are computed from data provided by Burnham(1985). Following Rueben (1994), we say that a state exhibits single partycontrol if a majority of both houses of the legislature and the governorship areoccupied by politicians from the same party in 1932. The majority of stateshold elections on even years and, therefore, report the relevant figures in 1932.Three states - Mississippi, Kentucky, and Virginia - held elections in odd yearsand only report the relevant figures in those years. When this is the case weuse the figures from 1931. One state - Maryland - only reported the relevantfigures for 1930; the unified variable for Maryland is constructed from thisdata. Finally, Nebraska and Minnesota had non-partisan legislatures duringthis period. These states are counted as not having single party control.

B.4 Instruments: Political and Land Variables

The political variables used as instruments to predict New Deal aid were firstintroduced by Wright (1974). Robert Fleck (2008) was kind enough to provideus with this data as well as the land variables data.

58Heins (1963) also reports the year of adoption of tax limitation so the discrepancy is notattributable to a change in the law between the thirties and the sixties.

65

B.5 Source Summary

Table B3 summarizes the sources used for all variables in the empirical analysispresented in section 6.

C Detailed Comparison with Wallis (1984)

In this appendix we compare in detail our results with those in Wallis (1984),trying to reconcile our different findings. Recall that Wallis’ hypothesis isthat exogenous variation in federal grants - especially matching grants - tothe states, would lead to an increase in expenditures by state governments.Further, state governments transferred some of the funds received by the federalgovernment to localities inducing them to reduce expenditures financed throughlocal taxation.

Consistent with this narrative, in his paper Wallis runs two types of regres-sions. The first type of regression (Table 3, page 154) links state expendituresin a given year to federal aid received by that state in that year, for the years1937–1940.59 The federal aid variable is instrumented using Wright’s politicalproductivity measure and the standard deviation of the Democratic vote share.Wallis finds that an exogenous increase in federal aid is associated with anincrease in state expenditures (see column 2 of Table 3). In the second set ofregressions, appearing on page 157 of his paper, Wallis relates the 1932–1942change in aggregate local expenditures in a state to total intergovernmentaltransfers received by local governments in that state. Notice that while localgovernments received transfers from both states and the federal government, thegreat majority of these transfers came from the states. In this second regression,Wallis instruments the intergovernmental transfers variable using the sameinstruments he had used for federal aid to a state in the first set of regressionsdiscussed above. The underlying logic here is that politically motivated (and

59Specifically, the equation being estimated is equation (1) in Wallis (1984, page 150)The choice of years was dictated by data availability issues, as discussed by Wallis (1984,page 152): data pertaining to state government expenditures is available for 1932 and thenbetween 1937 to 1940. No local government expenditure or revenue data is available between1933 and 1941.

66

Table B3: Source Summary

Variable SourceTax Limit Mott and Suiter (1934)Sales Tax Jacoby (1938), SFFF (1993)Difference State Revenue Share,’32-’42

Sylla, Legler, and Wallis (1995) [ICPSR 6304]

Difference State ExpenditureShare, ’32-’42

Sylla, Legler, and Wallis (1995) [ICPSR 6304]

% Change in per capita income,’29-’32

BEA

Federal Aid per capita, ’33-’39(Treasury)

U.S. Treasury (various years)

Federal Aid per capita, ’33-’39(Reading)

Reading (1973)

% Renters, 1930 Haines (2010) [ICPSR 2896, part 29]% School ’27-’28 U.S. Office of Education (1930, pp. 984ff.)% Urban ’30 Haines (2010) [ICPSR 2896, part 26]Income ’29 BEA% Dem. ’28 Leip (2014)Non-White Pop. 1930 Haines (2010) [ICPSR 2896, part 28]Initiative State Matsusaka (2000)Debt Restriction Heins (1963), Shawe (1936)Same Party Control Burnham (1985) [ICPSR 00016, DS4]Republican Control Burnham (1985) [ICPSR 00016, DS4]Federal Land per capita Fleck (2008) from Rand McNally (1992) and United

States Committee on Appropriations (1939)Non-Federal Land per capita Fleck (2008) from Rand McNally (1992) and United

States Committee on Appropriations (1939)Electoral Votes per capita Fleck (2008) from Wallis (1998)SD Dem. Vote, ’96-’32 Fleck (2008) from Wright (1974)Wright Index Fleck (2008) from Wright (1974)

67

therefore plausibly exogenous) transfers from the federal government to thestates induced the latter to increase aid to local governments. Wallis finds (seepage 157 of his paper) that local spending declined in relative terms between1932 and 1942 in states that were exposed to larger exogenous increases infederal aid (to state governments).

These two sets of results appear consistent with Wallis’ top-down channel.Moreover, they appear inconsistent with our finding (Table 8) that exogenousvariation in federal aid does not appear to affect the relative expenditure shareof state governments.

The following three observations should help to explain why our findingsare different from Wallis’.

1. Wright (1974)’s instruments for federal aid vary only across states bynot over time. Hence, the only variation that identifies the effect offederal aid on state spending in Wallis’ first regression (Table 3 of hispaper) discussed above is cross-sectional. In other words, despite usingdata for multiple years (1937–1940) for each state, Wallis is not using adifference-in-difference estimator in this regression (Table 3).60 It followsthat his first set of results cannot be compared directly with ours. Hence,we focus our discussion on his second set of results (those at page 157 ofhis paper).

2. Wallis’ second estimated equation (appearing on page 157 of his paper)has a difference-in-difference form, in that he regresses the change inexpenditures by a state’s local governments between 1932 and 1942 onthe change in intergovernmental transfers received by local governmentsfrom (mostly) state governments. The latter is instrumented using thepolitical variables that generate exogenous variation in federal aid tothe states. Here, we show that we can in fact replicate Wallis’ secondset of results by running a version of his regression (page 157 of hispaper). The version we run relates the local of spending (relative to the

60Notice that the fact that the instruments do not vary over time prevents Wallis fromincluding state fixed effects in the regression.

68

Table C1: Expenditure Centralization (IV).

(1) (2)

Log Intergovernmental Transfers to Local -0.054** -0.040*(0.023) (0.024)

% Growth in per capita Income, ’29-’32 0.164**(0.065)

First-stage CoefficientsElectoral Votes per capita -74.973*** -75.692***

(13.206) (15.731)SD Dem. Vote, ’96-’32 0.024 0.025

(0.022) (0.023)

Oberservations 96 96R2 0.953 0.955

First stage regressions also include % growth in per capita income as well as stateand year fixed effects. Robust standard errors reported in parentheses. Significance:*** 99% level, ** 95% level, * 90% level.

state-local combined share) to the intergovernmental transfers per capitareceived by local governments in that state, using Wright’s variables asinstruments. Notice that, while the explanatory variable is the same asWallis, we consider the local expenditure share, instead of the level oflocal expenditures.61 Table C1 shows our results.

The table shows that an exogenous increase in intergovernmental transfersto local governments is associated with a decline in local government’sexpenditure share. Here, consistent with our analysis (see discussion inthe paper in Section 6.3.2), we use the state’s electoral votes per capitaand the standard deviation of the Democratic vote share as instrumentsfor intergovernmental transfers. The estimated coefficient on intergov-ernmental transfers to local governments is -0.054 with a p-value of 0.02.In column 2 of this regression we include our 1929-32 income decline

61The share approach is consistent with our previous analysis. Our results do not dependon focusing on the share rather than the level. Notice that the local expenditure share isone minus the state share.

69

measure in this regression. Notice that the coefficient on intergovern-mental transfers drops from −0.054 to −0.04 and its p-value increases to0.09. Also, the coefficient on the income decline has the expected sign, amagnitude comparable to that reported in Table 8, and a p-value of 0.01.Thus, part of the reason for Wallis’ second set of findings is the omissionof the 1929-32 income decline variable from the regression equation heestimated.

3. The third observation is the most important. As described above, in Wal-lis’ second set of regressions, intergovernmental aid to local governmentsis instrumented using Wright’s political productivity measure and thestandard deviation of the Democratic vote share. The logic behind thisinstrument is that politically motivated transfers to the states by thefederal governments should result in higher intergovernmental transfersfrom the states to their local governments. In other words, in the first-stage regression, higher values of the instruments should be associatedwith higher values for the intergovernmental transfer variable. Table C1reports the results of this first-stage regression. The analogous result isnot reported in Wallis (1984).

Notice that the only statistically significant instrumental variable is theelectoral vote one. Its t-stat is about 5.7. However, this variable enterswith the “wrong” sign in the first-stage regression. That is, everythingelse equal, states with higher electoral votes per capita were characterizedby smaller increases in intergovernmental transfers per capita to localgovernments. This negative partial correlation fundamentally questionsthe logic of the “top-down” channel because it leads to the conclusion thatstates that received more federal aid for political (and therefore plausiblyexogenous) reasons were characterized by a smaller increase in transfersto local governments, and therefore (second-stage of the regression inTable C1) by smaller declines in the share of expenditures accounted forby local governments.

70

D Hysteresis

Sales taxation and state centralization persisted long after the economic ef-fects of the Depression lessened and income recovered and surpassed its pre-Depression peak. Few of the states that adopted sales taxes during the 1930ssubsequently abolished them.62 It thus appears that a temporary, althoughvery severe, economic downturn led to long-term institutional changes thatstill persist after many decades. In this section we use the framework weintroduced in Sections 3–5 to discuss this phenomenon, sometimes referred toas “hysteresis”. Our argument is based on the intuitive idea that institutionalchange of the extent experienced during the Great Depression requires conver-gence of a broad coalition of political actors. In other words, while intensivemargin variation in a policy instrument, say a tax rate, might require only asimple majority of votes, an extensive margin shift toward a different tax orcentralization of expenditures decisions will require a broader consensus.

We capture this idea in our model environment by postulating that a shiftfrom decentralization to centralization, or viceversa, requires support from afraction p of the population where p > 1/2. In the pre-Great Depression period,the decentralized system represented the status-quo and might have enjoyed acertain popular support of say q percent of the population with 1/2 < q < p.

In words, a majority of the population preferred the decentralized system,but support for it did not exceed the threshold p. Proposition 3 shows thatthis situation is consistent with a broad set of parameters, only ruling out asituation in which τ and λ are sufficiently close to one another to generate aunanimous support for decentralization.

Proposition 6 shows that the Great Depression increased political supportfor sales taxation and centralization. From the perspective of the model, thisshift must have been supported by at least a fraction p of the population in

62Five states (17%) that adopted a sales tax in the thirties allowed them to expire (seeasterisks in Table 1). From 1940 to 1995 seventeen further states–including the five statesthat allowed their 1930s-vintage taxes to expire–adopted the sales tax. These includedConnecticut (1947), South Carolina (1951), and Idaho (1965) (U.S. Advisory Commission1993).

71

order to displace the old set of institutions.63 Thus, the economic shock ofthe Great Depression gave rise to a new status-quo in which the states hadmuch more power vis-a-vis local governments. The key question is then whythis balance of power did not revert itself back to the original pre-Depressionsituation after the end of the economic depression in the 1940s and beyond. Inthe context of our model, we interpret the end of the Depression as a returnto an economic situation in which δ = 0. Under this circumstances, head taxdelinquency rates should be zero and the decentralized system enjoys supportof q percent of the population. While this is a majority, it is not broad enoughto reach the minimum support needed (p percent) to revert back to an economycharacterized by local control and financing of public goods, because q < p.Therefore, the new status-quo persists despite the fact that more than half ofthe population would prefer the alternative regime.

This narrative is consistent with the related and often-mentioned idea thata status-quo might persist simply because an organized minority of individualsare able to block a reform that would benefit a majority (e.g. Olson, 1965).We capture this view, in the context of our model, by requiring a support of ppercent of the population for a reform to occur. We add to this idea the insightthat large economic shocks - such as the Great Depression - might temporarilylead to an increased support for certain reforms which then persist long afterthe economic shock and the additional political support for reform are gone.

Additional References

Anderson, Gary M., and Robert D. Tollison. “Congressional Influence andPatterns of New Deal Spending, 1933-1939." Journal of Law and Economics34 (1991): 161.

Burnham, W. Dean. Partisan Division of State Governments, 1834-1985.Conducted by Massachusetts Institute of Technology. ICPSR ed. AnnArbor, MI: Inter-university Consortium for Political and Social Research[producer and distributor], 1984.

63In the data, referenda that limited the property tax passed in many states with verylarge majorities.

72

Fleck, Robert K. “Population, Land, Economic Conditions, and the Allocationof New Deal Spending." Explorations in Economic History 38, no. 2 (2001):296-304.

Heins, A. James. Constitutional Restrictions Against State Debt. University ofWisconsin Press, 1963.

Leip, David. “1932 Presidential General Election Data - National by State.”Accessed July 9, 2014. http://uselectionatlas.org/RESULTS/.

Office of Government Reports, Statistical Section. Federal Loans and Expendi-tures, Vol. II, Washington D.C. 1940.

Olson, Mancur. The Logic of Collective Action: Public Goods and the Theoryof Groups. Cambridge, MA: Harvard University Press, 1965.

Rand McNally. The New Cosmopolitan Worl Atlas. Chicago: Rand McNally,1992.

Shawe, Earle K. “An Analysis of the Legal Limitations on the Borrowing Powerof the State Governments." FERA Monthly Report, June 1936.

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Documents

Fiscal Centralization: Theory and Evidence from the Great Depression