Dedicating Tax Revenue: Constraining Government or Masking Its Growth?

June 8, 2012

The practice of dedicating a portion of tax revenue to a specific expenditure category is a popular fiscal tool for state governments.  This practice, also known as earmarking, should theoretically have no effect on the size or composition of government expenditure.  However, new research indicates earmarking has inherently deceptive qualities that, among other things, work to expand the role of government, say George R. Crowley, an assistant professor of economics at Troy University, and Adam J. Hoffer, an assistant professor of economics at the University of Wisconsin-La Crosse.

In order to appreciate this phenomenon, it is crucial to understand two principles of government budgeting:

  • The Flypaper Effect -- when tax dollars are earmarked for a specific expenditure category, only a fraction of that funding is actually used for that purpose (due to the fungibility of money).
  • The Fungibility of Money -- tax dollars allocated to a specific expenditure often simply substitute for general fund dollars for that same expenditure, allowing those general fund dollars to flow elsewhere.

This effect of earmarking can be seen on the state government level for a number of expenditure categories (it is most popular for funding for local governments, education and highways).  For example:

  • Suppose education funding last fiscal year was set at $100 million from general tax dollars.
  • Now, a state lottery will be introduced, the proceeds of which are estimated at $50 million and will be allocated exclusively to education.
  • While one might suppose the new education budget will be $150 million, the fungibility of money suggests that a fraction of previous general funding (say, $20 million) will vacate education funding.
  • In this case, the new education budget would be $130 million (instead of $150 million) and the Flypaper Effect would be estimated at 0.60 (indicating that 60 cents of every dollar actually sticks).
  • In empirical studies of the Flypaper Effect, estimates tend to range from 0.30 to 0.70, with a median of around 0.45.

How does this expand the size of government?  Politicians can use earmarking for politically popular programs in order to raise government revenues while avoiding unpopular general tax increases.  However, as demonstrated above, these two policy actions have the same effect of expanding the scope of the general fund and expanding the size of government.

Source: George R. Crowley and Adam J. Hoffer, "Dedicating Tax Revenue: Constraining Government or Masking Its Growth?" Mercatus Center, May 2012.

For text:

http://mercatus.org/sites/default/files/Dedicating-Tax-Revenue.pdf

 

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