Local Tax Structure and Redistributive Policy: Evidence from Europe

In many EEA countries, municipalities possess substantial autonomy to invest in local social programs. However, the level of expenditure varies widely. This paper explores the degree to which these patterns are shaped by the constraints and incentive structures imposed by local government revenues. Specifically, I argue that the enthusiasm with which local governments invest in social policy is conditional on the structure of local tax revenues (“own revenues”). In contexts where local revenue is dependent on real estate, policymakers gain countervailing incentives to maximize property values. As a result, they will be hesitant to engage in actions that may negatively influence local property valuations, moderating tendencies to invest in redistributive policy. In contrast, where revenues are primarily derived from income taxation, these financial constraints are absent, and policymakers are free to enact generous policies (for electoral gain) without fearing a corresponding loss in local revenues. I test this argument in two stages. First, to establish external validity, I draw on panel data from across the OECD, and demonstrate that increases in the revenue share of property taxation are associated with stasis or short-term declines in the level of local social spending. Second, to investigate the internal validity of these relationships, I examine the redistributive output of local governments in Italy and Switzerland, where municipalities exercise considerable discretion over cash transfers to the local poor. More importantly, localities in both countries have experienced exogenous variation in the structure of municipal revenues, permitting credible causal estimates. Examining panel data, I identify the effect of tax structure on local redistributive spending. The findings strongly confirm the hypothesis, and suggest that a reliance on property taxation reduces the volume of local cash transfers. These findings have important implications for the consequences of decentralization across states with different financing mechanisms.