NCPA - National Center for Policy Analysis

Studies Find Taxes Do Affect Economic Growth

January 1, 1996

A new study from the Federal Reserve Bank of Atlanta provides fresh evidence that high taxes are bad for a state's economic health. Writing in the March/April issue of the bank's Economic Review, economist Zsolt Becsi overcomes many of the obstacles that have prevented earlier analysts from drawing firm conclusions on the relationship between taxes and growth. He found that "relative marginal tax rates have a statistically significant negative relationship with relative state growth."

Many previous studies had failed to find a strong relationship between taxes and growth because they were unable to isolate the impact of tax rates from other factors affecting growth. For example, some people and businesses may not mind paying high taxes if they get quality services in return. But not all tax increases lead to increases in government services. Therefore it is necessary to separate taxes from the budget in order to study the tax effect alone.

Another problem analysts have had is separating the effects of marginal tax rates and average tax rates. The average tax rate is simply taxes paid as a share of income, while the marginal rate is the rate on each additional dollar earned. In states with progressive tax rates the marginal rate will always be higher than the average rate. Since the marginal rate is the one that affects economic incentives, it is important analytically to look mainly at marginal tax rates.

Once Becsi was able to isolate taxes from the budget and marginal tax rates from average tax rates, he found that taxes have large and permanent effects on economic growth. "If long-term growth rates seem too low relative to other states," Becsi concludes, "lowering aggregate state and local marginal tax rates is likely to have a positive effect on long-term growth rates."

This conclusion is consistent with the latest research on state taxation. For example,

  • A 1991 study by Leslie Papke in the Journal of Public Economics found that state tax rates had a significant impact on new business startups.
  • A 1994 Business Week magazine study found that job growth in low-tax states was 65 percent higher than in high-tax states.
  • And a 1995 study by Richard Vedder of Ohio University found that on average a 1 percent increase in state and local taxation lowered personal income growth by three and one-half percent.

One reason taxes affect growth is that investors increasingly look at tax rates to guide not only direct investment decisions, but portfolio investment as well. In other words, many investors now look at taxes in a particular state in deciding whether or not to buy the stock of a company located there.

A company in the business of advising investors about the impact of state taxes on stock prices, A.B. Laffer, V.A. Canto & Associates, recently published an investment advisory analyzing the impact of recent state tax changes on particular stocks. They concluded that companies based in Arizona, Connecticut, Georgia, Indiana, Mississippi, New Jersey, New York, Ohio and Utah would tend to outperform those in other states because of declining tax burdens in those states. At the other end of the spectrum, companies based in Idaho, Louisiana, Missouri, New Mexico, North Dakota, Rhode Island and Vermont are likely to underperform the market due to rising tax burdens. In all other states taxes were unchanged.

The states are important laboratories for different economic policies. The growing evidence from these labs increasingly suggests that those states that allow their taxes and spending to get out of line with their neighbors will suffer as a result.

Source: Bruce R. Bartlett, Senior Fellow, National Center for Policy Analysis, January 1, 1996.


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