Setting house taxes by Italian municipalities: what the data say

1. Setting house taxes by Italian municipalities: what the data say Fabio Padovano Dipartimento di Istituzioni Politiche e Scienze Sociali and CREI Università Roma Tre Workshop slides

2. Introduction • This “research report” has 4 goals • Discussing main hypothesis on the interaction among local governments in setting tax rates; • Reviewing empirical tests based on data about Italian municipalities; • Presenting a new data set on the fiscal variables of Italian municipalities - all municipalities for 1993-2001 • Performing some preliminary tests using this data set. Workshop slides

3. Theories of tax setting • Spillover models (externality) • Resource flow models (transfer of resources) • Problem of observational equivalency Workshop slides

4. Spillover models • Each jurisdiction i chooses the level of a decision variable zi (tax rate, welfare expenditures) • Jurisdiction is also affected by the z’s chosen elsewhere – externality of some sort Workshop slides

5. Model structure • Objective function • FOC • Reaction function • Slope of the reaction function depends on nature of preferences – can be positive or negative Workshop slides

6. Yardstick competition • Information spillovers across jurisdictions • Voters look at public services and taxes in other jurisdictions to evaluate whether their government is wasting resources • Information spillover affects voting behavior Workshop slides

7. BC&R critique • Politicians aware of voters’ calculations and react strategically • An incompetent government forced to behave more like other governments in order to avoid being detected • More pooling behavior, unless YC features a separating technology Workshop slides

8. BC&R empirical testing strategy • Term limit is (possibly) a separating technology • Two equations must be estimated: • Standard tax setting equation • Vote popularity function Workshop slides

9. Resource flow models • Jurisdiction cares about the amount of a particular “resource” that resides within its borders. • Distribution of this resource among jurisdictions depends on the z choices of all jurisdictions. • Jurisdiction i indirectly affected by z-i • Tiebout model Workshop slides

10. Model structure • Objective function • Resource function • Reduced form same as in spillover model • Consequence: observational equivalency Workshop slides

11. Testing for strategic interaction • Estimating equation • Weights define contiguity – flow of information • Coefficient to be estimated Workshop slides

12. Two problems • Endogeneity of the zj Because of strategic interaction, z values in different jurisdictions jointly determined. Linear combination of the zj endogenous and correlated with the error term εi. • Spatial error dependence Arises when ε includes omitted characteristics of jurisdictions that are themselves spatially dependent Workshop slides

13. Econometric solutions • Maximum likelihood methods • IV methods • Others? Workshop slides

14. Italian empirical studies - 1 • Bordignon, Cerniglia and Revelli (2002, 2003) and Fedeli and Giannoni (2004) • BC&R theoretically correct but sample size limited (171 municipalities of Milan province) • BC&R basically a cross section • No convergence to steady state – business cycle unaccounted for Workshop slides

15. Italian empirical studies - 2 • F&G theoretically less precise but larger data set (all Italian municipalities 1998-2001) • Ordered probit model: estimates probability that ICI rate fits 1 of 3 cathegories • Significant loss of information- Choice of these classes is arbitrary and unnecessary • Focus on the variability of the ICI rates is at best an indirect evidence of strategic interaction;at worst ARCH Workshop slides

16. 7 Single/Business property rate 6.5 mean 6 Domestic property rate 5.5 5 4.5 4 1995 1993 1997 1999 2001 years ICI rates: evolution of national averages Workshop slides

17. ICI rates: average per province 1993 Workshop slides

18. ICI rates: average per provinces 2001 Workshop slides

19. ICI per capita revenues Workshop slides

20. Mean-variance relationship ICI rates Workshop slides

21. Preliminary estimates - 1 • Only tax setting equation • ICI business tax rate depends on: • structural characteristics of the jurisdiction: area, population, and urbanization rate; • socio-demographic characteristics of the resident population: percentage of youngsters, percentage of elderly people, and rate of unemployment; • fiscal variables: grants from central government and disposable income per capita; Workshop slides

22. Preliminary estimates - 2 • Political variables, 3 dummies, 1 %: • ideological differences between right-wing and left-wing governments; • election year (opportunistic behavior of incumbents in election years); • term limit - potential differences in tax setting between first term and second term mayors. • confidence of re-election dummy, share of the votes obtained by the incumbent in the previous election. Workshop slides

23. Preliminary estimates - 3 • Yardstick competition variable: • neighboring governments’ property tax rates • Different model specifications to sort out YC-type of behavior Workshop slides

24. Model specification • Begin with 2 estimating equations: • Mod1: Spatial error Accounts for endogeneity of the zj • Mod2: spatial error dependence Accounts for simultaneity bias Workshop slides

25. Regressions – Mod 1 & Mod 2 Workshop slides

26. Main results -1 • No systematic differences between right-wing and left-wing governments • Tax rates lower in election years • Area positive and significant • Population negative and significant - economies of scale in public service provision • Urbanization positive effect • Unemployed, elderly and young negative effect Workshop slides

27. Main results - 2 • Fiscal variables apparently do not impact on the tax rate – conflicting effects • Mod1 yields statistically insignificant estimates of spatial coefficient • Mod2 yields an IV estimate of the spatial coefficient φ = 0.23, statistically significant at the 99% level. • Mod2 more appropriate Workshop slides

28. Problem • Mod2 compatible with: • Yardstick competition • Spatially correlated shocks to tax setting behavior with no behavioral significance • Estimate Mod3: allows for different behavior of mayors, based on term limit. Workshop slides

29. Mod3 – Term limit - 1 • Mod3 specification • Matrix D equals 1 incumbent faces term limit, 0 otherwise. • If mayor faces term limit, his interaction with neighboring jurisdictions’ policies captured by parameter φ1 • If mayor runs for reelection, spatial interaction captured by φ2 Workshop slides

30. Mod3 – Term limit - 2 • Theoretical prediction: φ1=0 and φ2≠0 • If φ1=φ2= φ = Mod2. Workshop slides

31. Regression results – Mod3 - 1 Workshop slides

32. Regression results – Mod3 – 2 Workshop slides

33. Main results - 1 • Little difference in behavior (see constant term): 2 reasons • First term mayors bound by election prospects, second term mayors a selected sample of better than average mayors - do not tend to raise tax rates. • Unexpectedly: both kinds of mayors tend to set lower tax rates in election years – party discipline? Workshop slides

34. Main results - 2 • Only evidence of yardstick competition • Mayor with binding term limit: no evidence of spatial auto-correlation in tax rates. • Parameter φ1 not significantly different from zero. • Mayors that run for re-election: significantly affected by neighbors’ tax rates. • Parameter φ2 = 0.5 at 99% level of confidence Workshop slides

35. What else should be done? • Econometric improvements (ML techniques alongside IV) • Information about spending and other fiscal instrument levels at the municipal level (such as the income tax surcharge) • Estimation of vote-popularity function alongside tax setting equation Workshop slides