Tax Briefing Book | |
Taxes and Growth |
Economist Adam Smith in the 18th century observed that tariff rates beyond a certain level were self-defeating because they reduced imports and hence tariff revenue. One reason was that high tariffs encouraged smuggling. Smith's interest in an inverse relationship between tax rates and government revenue reappeared in the 20th century among those who have been termed supply-side economists. Economist Arthur Laffer, who devised the Laffer Curve, popularized the idea that high tax rates give people incentives to not report or underreport income or to simply earn less taxable income.
The Laffer Curve. Laffer and his disciples noted that beyond a certain point government realizes less revenue when the tax rate rises. This new look at a 200-year-old finding was the basis of the supply-side revolution and furnished the impetus for the Reagan administration's cuts in marginal tax rates. These cuts were responsible for a tremendous expansion of the economy during the 1980s. Both tax compliance and tax revenue rose. At lower tax rates, people are encouraged to realize more taxable income, base their investments on economic rather than tax considerations and spend less on wasteful tax avoidance.
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| "We should tax just enough to maximize economic growth." | But the thrust of supply-side economics was misfocused. Rather than determining what rates would maximize tax revenues to the government, conservative economists should have concerned themselves with what levels of taxation would maximize economic growth. Economists have done comparatively little work on this subject, and much of the research that has been done has concentrated on the various disincentives and distorting effects of taxation that cause efficiency losses. However, determining the tax rates that lead to the greatest creation of private wealth is the key to solving some of the major economic problems of our time.
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That American productivity has slid since the 1950s is a fact. Annual productivity growth rates that were in the 3.0 to 3.5 percent range have fallen below 1 percent. As a result, many Americans have suffered a decline in their living standard. Many excuses and rationalizations for the productivity slowdown have been offered, including inadequate physical and human capital formation, too much regulation (especially environmental regulation), low research and development expenditures and the energy crisis. There is considerable evidence, however, that the underlying cause is the growth in the size of government since World War II and the accompanying increase in taxes. How Taxes Affect Saving and Investment. In our tax code, interest on savings is taxed as ordinary income (rare among industrial nations). This lowers the return on saving and tends to reduce the amount saved. Until recently we subsidized consumer credit by making it deductible. We heavily subsidize home ownership by making interest payments deductible. While perhaps laudable as social policy, this leads to more investment in housing and less in other productive activities than would be the case in the absence of the subsidy. On the investment side, if capital expenditures are financed with borrowed money, the interest is deductible. If they are financed with equity issues, they are not deductible. This leads to a distortion in debt-equity ratios for business. Also, tax depreciation schedules differ for different assets and bear little relationship to economic depreciation. And since these schedules are not indexed for inflation, investment in long-lived assets is discouraged.
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| "Tax the last hour worked more heavily than the first and the result is: less work." | How Taxes Affect Labor. Taxes drive a wedge between work and leisure. Moreover, the U.S. taxes effort (income) progressively, so that the income from the last hour worked is taxed more heavily than the income from the first hour worked. The net effect is to discourage people from working. In addition, antipoverty programs that subsidize not working have consumed $5 trillion (constant 1992 dollars) since the War on Poverty began during the Johnson administration.
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The Effects of Regulations. Further distortions arise because different assets are subject to different regulations. A regulation is an implicit tax on an asset. For example, current regulations require gasoline stations to bury gasoline tanks in concrete bunkers and provide access to continuous inspection and monitoring. This adds about $250,000 to the cost of being in the business, not a small sum for a marginal business. Partly as a result of stiffer environmental regulation, the number of gas stations has dropped by half in a generation or so. In general, air and water quality standards have differing impacts on different industries. As a result, less polluting industries yield more output and more polluting ones yield less. The Costs vs. the Benefits of Government Activities. Most people acknowledge that at least a minimum of government is necessary to the functioning of a free society and a growing economy. By providing a common defense against foreign enemies, a criminal justice system that promotes law and order and perhaps other "public goods," government expenditures contribute positively to private economic activity. Beyond some level, however, government becomes a net drain on the private sector. Resources in a society may be allocated privately through the market system or politically through government. When resources are allocated privately, they tend to be allocated to the highest-valued use as entrepreneurs and capitalists seek the highest economic rate of return on their assets. When politicians (or central planners) allocate resources, they seek the highest political return (e.g., votes and campaign contributions). Additionally, public choice literature shows that collective choice (through government) leads to the overproduction of public goods and the expansion of "rent-seeking" activities. The government is the only entity that can use legal coercion to create a right that can be licensed or sold (e.g., a monopoly, tariff or subsidy). Those activities create permanent rents for special interests -- a source of income that would be competed away in an unregulated market. Government-sanctioned exclusivity in a line of business can lead to a very high rate of return in that activity. For example, until recent years network-affiliated television stations in the 100 top markets had annual operating profits in excess of 35 percent.
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| "The optimal size of government is the size that maximized growth." | The Growth Curve. Thus government expenditures and the taxes necessary to finance them both benefit and cost the economy. National defense, a legal system, roads, airports and harbors are likely to make private economic activity more productive. Therefore, taxes collected to pay for these public expenditures are likely to increase the rate of economic growth over some range (see Figure II-1). However, beyond some level taxes lower the rate of economic growth.
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This line of reasoning suggests that there is an optimal size of government. It further suggests that the optimal size is defined by the level of taxation that maximizes economic growth (or what is the same thing, private wealth creation). Using data from standard statistical sources, economist Gerald Scully has developed a simple but reliable econometric model to calculate the growth-maximizing tax rate -- the rate at which increased taxes and spending cease to increase economic growth and begin to decrease it. The parameters of the model were estimated using established econometric techniques, and the equations of the model can then be solved. For the United States, the model found that:
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| "Our economy is not growing as fast - or producting as much - as it could have." | The optimal tax rates derived from this model are consistent with previous studies that concluded that an optimal size of government is 19 percent of GNP and that government spending of 20 percent of GNP maximizes productivity. All of these estimates imply that the economic growth rate and hence the level of GNP is far below what would have been achieved had the nation's total tax rate been kept at its 1949 level.
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In 1929 federal, state and local taxes combined consumed a 10.9 percent share of GNP. In 1949, they were 21.7 percent of GNP -- roughly the optimal tax rate calculated from the econometric model. By 1969 the tax share broke the 30 percent barrier, and it has been rising slowly since then. Real GNP was $1.563 trillion in 1949 (in 1993 dollars). By 1989, real GNP was near $6.2 trillion, reflecting a compound growth rate of 3.5 percent per year. The path of real GNP is shown in Figure II-2. Loss of Personal Income. The model shows that the optimal tax rate is at most 22.9 percent of GNP. At the 22.9 percent level, the corresponding real compound economic growth rate would have been 5.56 percent instead of the actual 3.5 percent.
Cumulative Loss of Income. From the time the tax rate exceeded the optimal point, more and more American resources have been devoted to less and less productive uses. The annual loss of income accumulates over time. Because taxes have been too high since 1949, the resulting lower economic growth and failure to maximize wealth have robbed the nation of almost $95 trillion worth of output. Specifically:
In general, the U.S. economy has sacrificed $2 worth of income for every $1 of tax paid beyond the level of optimal taxation. The implications of this finding are staggering.
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| "We have lost the equivalent of $100,000 for each American household." | Loss of Personal Wealth. If received, most of the lost income would have been consumed. But a fraction would have been saved, adding to the average family's wealth over time. Because the wealth that would have been generated will never be seen, it is difficult to visualize what it would have meant. To put it into perspective, consider that:
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Government Tax Revenues Lost. Exceeding optimal size has been costly to government at all levels, too. Over the period from 1949 to 1989, federal, state and local governments collected a real total of $43.5 trillion in taxes. But if the total tax rate had been limited to 22.9 percent of GNP, government would have been collecting taxes on a far larger GNP, thanks to a higher growth rate. As a result, the combined governments would have collected a real total of $55.1 trillion. This implies that:
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| "If the optimal tax rate had been in effect, we would have no federal debt." | One might ask why citizens have allowed this destruction of private wealth through excessive taxation and why politicians have given up $11.6 trillion in real taxes since 1949. There are several explanations.
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Taxpayers Are Unaware. First, and perhaps foremost, people generally are cognizant only of their actual earnings, not of their potential earnings. They do not miss the lost 2.1 percent growth in real output because they never had it. Also, many are ignorant of the intimate link between taxation, incentives and economic efficiency. Moreover, because of the compulsory deduction of taxes from wages, many workers are unaware of their actual tax burden. Most people have no idea how much of their total income goes to taxes because the taxes are hidden or are a negligible portion of an individual transaction. Growing Demand for Government. Second, we do not have a very good theory of why government grows. As mentioned above, government has grown at times by distinct jumps (World War I and World War II each yielded a permanent 50 percent or so increase in the tax burden) and at times incrementally (e.g., the Roosevelt years, 1932-40, and during Johnson's Great Society of the 1960s). Patriotism silenced objections to higher tax rates and expansion of the tax base during the wars. The Great Depression conditioned people to the idea of a larger role for government. New and expanded government redistribution programs tend toward what might be called creeping incrementalism. For example, the food stamp program began in the early 1960s as a modest $175 million effort and now costs $28 billion. Another discrete jump in the size of government is on the horizon if it assimilates the $1 trillion health industry -- an act equivalent to government absorption of the fifth largest economy in the world. Politicians' Priorities. Third, politicians face a different set of priorities than do other citizens and often fail to appreciate how the world works. Since most politicians are lawyers, whose function is to redistribute income between the equivalent of plaintiffs and defendants, they misunderstand how productive activities occur and how their decisions affect such activities. For example, for 200 years politicians have been told of the benefits of free trade, yet with a couple of exceptions (e.g., Britain in the 19th century and the United States after World War II), politicians and the public have preferred protectionism. For 200 years, from Adam Smith's observations about tariffs and smuggling to the supply-siders' observations about marginal tax rates, politicians have been warned that excessive taxation promotes inefficiency and discourages compliance. The deleterious effect of massive regulation on productivity is well known, yet the burden grows. Henry Manne, dean of the law school at George Mason University, has suggested that the amount of law, mainly statutes, is 100 to 1,000 times greater today than in 1933.
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| "Politicians impose taxes to fund programs to please special interest groups - to get reelected." | Tax Rates Tend Toward Political Equilibrium. Most Americans, scholars included, subscribe to the Anglo-American public finance tradition of thinking of government as benign. From this point of view, policy choices often seem irrational and enigmatic. Public choice theorists see the behavior of politicians and the constituencies that elect them as rational, self-interested and self-serving, having more to do with reelection and rent-seeking than with economic efficiency. In this view, excessive taxation may arise simply because the tax rate consistent with political equilibrium among competing special interest groups exceeds the rate that maximizes economic growth.
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During debate on President Clinton's 1993 tax increase, prominent economists such as Professor Martin Feldstein of Harvard predicted that the legislation would raise little, if any, additional revenue. People would adjust their behavior, they said, to minimize the tax bite by working fewer hours, taking longer vacations, investing less and making greater use of tax shelters. People could not fully adjust their behavior because the tax increases were retroactive to the beginning of 1993. However, IRS data on tax collections in 1993 confirm the economists' predictions. According to the IRS, adjusted gross income (AGI) increased just 2.3 percent in 1993 after rising by 4.8 percent in 1992, and taxable income increased just 2.2 percent. By contrast, gross domestic product (GDP) rose by 5.4 percent and personal income increased 4.3 percent. And because prices went up by 2.7 percent, this means that both AGI and taxable income actually fell in real terms.
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| "After the 1993 tax increases, millionaires paid taxes on 11.4 percent less income." | The falloff in real taxable income was greatest among those most affected by the higher tax rates. (The top tax rate went from 31 percent to 36 percent for couples earning over $140,000 and to 39.6 percent for those earning more than $250,000.) Thus while real taxable income rose by 8.6 percent for those earning between $100,000 and $200,000, it rose just 0.2 percent for those earning between $200,000 and $500,000. For those earning between $500,000 and $1 million, real taxable income actually declined by 4.7 percent, and for those earning over $1 million it fell by 11.4 percent.
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During the tax-cutting years of the 1980s, when the top tax rate fell from 70 percent to 28 percent, real AGI and taxable income rose sharply. The tax base expanded as people worked more, invested more, took money out of tax shelters and put it into taxable investments. Between 1983 and 1989 real AGI expanded by an average of 4.6 percent per year. Unfortunately, in 1990 President Bush reversed President Reagan's tax-cutting strategy and unwisely attempted to balance the budget by raising tax rates. In 1993 President Clinton compounded President Bush's error. As a result, real AGI was flat for four straight years. In fact, real AGI was actually lower in 1993 than it was in 1989, and taxable income fell from 49.6 percent of personal income in 1989 to just 43 percent in 1993. Over this same period real GDP rose by more than 6 percent. Despite a decline in the tax base, however, tax revenue did increase in 1993. This is mainly because the tax hike was retroactive, making it harder for people to adjust their behavior. The fraction of income that Americans save is well below the saving rate of other countries. We also save less than the amount we need to invest in order to sustain even moderate economic growth. Given that we want economic growth, we have two choices. Americans must either import funds for investment from other countries or increase our saving rate.
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| "We must either save more or hope foreigners keep investing in America." | Decline in Saving Rate. In recent years the domestic saving rate in the United States has been inadequate to finance domestic investment. In 1993, for example, gross saving (including the retained earnings of corporations) amounted to $787.5 billion and gross private domestic investment came to $882 billion. Thus the United States was forced to import $92.3 billion in investment funds from other countries.
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The decline in personal saving has been going on for some time. The personal saving rate in the United States fell from more than 8 percent in the early 1980s to about half that level by 1994. (See Figure II-3.) Getting the saving rate back up to 8 percent -- which would still be low by international standards (see Figure II-4) -- would add more than $180 billion annually to the supply of national savings. This would eliminate the need for capital imports and add close to $100 billion to the capital stock annually. Role of Government Deficits. The federal budget deficit usually receives the blame for our saving problem, on the theory that government borrowing to finance the deficit takes funds that otherwise could have been invested and diverts these funds to spending programs that mainly expand consumption. However, saving decisions by households are more important than the deficit. For example, personal savings fell from $247.9 billion in 1992 to $192.6 billion in 1993. This $55.3 billion decline was greater than the $42.8 billion decline in the budget deficit over the same period. Less saving was available to finance investment in 1993 than in 1992, despite a 17 percent decline in the deficit. As a consequence, U.S. imports of foreign capital increased. Role of Tax Policy. Although there are many reasons for our low saving rate, including social and demographic factors, economists have identified tax policy as a major culprit. In particular, the income tax greatly increases the cost of saving relative to consumption. This is because the benefits of consumption -- pleasure, satisfaction or well-being -- are not taxed, whereas the returns on savings (interest, dividends, etc.) are taxed. Thus there is an inherent tax bias against saving. In order to eliminate this bias and treat saving and consumption equally, individuals should be allowed either to deduct savings from their taxable income or to receive the income from savings tax-free. Either method would provide tax neutrality -- ensuring that the decision to save or consume one's income would not be affected by the tax law. Expanded opportunities to make deposits to Individual Retirement Accounts (IRAs) are a proven way of encouraging more savings.
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| "Individual Retirement Accounts Increase the rate at which people save." | Have IRAs Increased Savings? Under current law, contributions to IRAs are deducted from gross income, and the return on IRA savings is allowed to grow tax free. Note that even IRAs do not fully provide tax neutrality because contributions are limited to $2,000 per year and restricted by income. In addition, all withdrawals are fully taxable and withdrawals before age 59-1/2 are penalized.
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Critics claim that individuals shift funds from taxable accounts to IRAs without increasing their total savings. While some shifting may occur, especially among those with high incomes, it is limited because most people don't have many financial assets to begin with. According to the Federal Reserve, the median value of financial assets for all U.S. families is just $13,100 -- a figure that includes IRAs. Consequently, the vast majority of Americans have a limited capacity to shift funds into IRAs from other savings. Although they may shift funds initially, after a few years they would have to increase their saving rate in order to get the maximum tax saving from an IRA. Studies by Professors Steven Venti of Dartmouth, David Wise of Harvard, Glenn Hubbard of Columbia and Jonathan Skinner of the University of Virginia have clearly shown that IRAs increase the rate of personal saving. These studies show that as much as 80 cents of each dollar deposited to IRAs represents new savings. Do IRA Deposits Cause Revenue Losses for Government? NCPA studies show that IRA tax incentives more than pay for themselves. The initial loss of tax revenue is more than offset by additional revenue produced by the greater output that results from increased investment. The Internal Revenue Service is an agency under siege. On the one hand, it is under continuous pressure from Congress to collect every last dollar owed to Uncle Sam, in order to reduce the deficit and lower the burden on law-abiding taxpayers. On the other hand, it is continually criticized by Congress for using heavy-handed tactics, bullying and harassing taxpayers and overstepping its bounds. Clearly, the IRS is caught between the proverbial rock and a hard place. If it is to increase the compliance rate for tax collections, it must use ever more draconian methods. But when it such employs methods, it faces a backlash from irate taxpayers and their elected representatives. According to the latest estimates, in 1992 the IRS collected between 83.1 and 83.6 percent of the individual income tax revenue it believes it was entitled to, and between 81.1 and 88.1 percent of the corporate revenue. This left a tax gap of between $110 billion and $127 billion uncollected. Three-quarters of the individual tax gap came from unreported income, mainly from self-employment. While much of the debate over tax compliance involves questions about audit rates, modernization of IRS computers and other technical issues, tax rates also play a critical role. A number of academic studies have shown that the higher tax rates are, the greater evasion is. This stands to reason because the higher tax rates are, the greater the profit in tax evasion.
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| "When tax rates are cut, fewer people evade or avoid paying." | Conversely, lower tax rates reduce the incentive to evade. And increased enforcement of high tax rates may be self-defeating. As James Alm of the University of Colorado put it in a January 1988 article in the Public Finance Quarterly, "Government policies that reduce evasion may not increase the tax base because the individual may respond by increasing the amount of tax preferences, and tax rate reductions may be a more powerful tool for generating tax base increases because rate reductions make both evasion and avoidance less attractive.
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The relationship between tax rates and unreported income is illustrated in Figure II-5. It is based on the differences between Department of Commerce calculations of AGI derived from the National Income and Product Accounts, and IRS data on AGI reported on tax returns. It shows that as the income tax rate rises, unreported income tends to rise; and as tax rates fall, so does unreported income. This suggests that tax cuts might do more to increase compliance than hordes of new IRS agents. Tax amnesties have also been shown to be effective in reducing tax evasion. For almost 200 years, the principal concern of economics was growth. From Adam Smith to John Maynard Keynes, economics was basically about how to increase the economic growth rate and thereby improve living standards. Why Growth Was Ignored. However, beginning in the mid-1950s -- under the influence of Robert Solow of the Massachusetts Institute of Technology, who won Nobel Prize for his work in 1987 and advised Bill Clinton in 1992 -- economic growth was no longer central to economic theory. Concerns such as business cycles and inflation increasingly moved to center stage. Economic growth ceased to be the main concern of economists because Solow showed that little if anything could be done to raise the long-run growth rate. In his model, long-run growth is mainly a function of technological changes, which government has little to do with. Economists say they are "exogenous," coming from outside the system.
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| "For a generation many academics believed we could not boost long-term growth." | Thus in the Solow model virtually all government policies are impotent in affecting long-term growth rates. Growth rates can be affected over the short-run and policies can affect the overall size of the economy, but the growth rate is essentially given. This view was incorporated into textbooks and has dominated academic thinking about economic growth for a generation.
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Growth Theory. In recent years, growing numbers of economists have become dissatisfied with the Solow view. They have argued that policies such as taxation and education can affect long-term growth. Their growth theory is called "endogenous" -- meaning from within the system. Proponents such as Paul Romer of Stanford point to dynamic Asian economies in which domestic policies appear to have sharply raised growth rates for many years. An article in the December 1996 issue of the National Tax Journal looks at the effects of tax policy on growth in light of endogenous theory. Eric Engen of the Federal Reserve staff and Jonathan Skinner of Dartmouth describe ways taxation impacts growth.
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| "Tax cuts can raise long-run growth rates - and American living standards." |
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The Engen-Skinner results were confirmed by Congress's Joint Committee on Taxation, which asked leading economists to estimate the impact on GDP of switching to a flat-rate consumption tax system. All found significant positive effects. The median (average) estimate was an increase in real GDP of about 3 percent within a decade. The Clinton administration takes the view that taxes do not affect growth. The Council of Economic Advisers concluded last year that Clinton's policies were already doing everything possible for economic growth. The council did not mention tax policy; but the latest research demonstrates that tax policy may be the key to growth. Alan Blinder of Princeton, a Clinton appointee to the Council of Economic Advisers and then to the Federal Reserve Board, says that the rapid economic growth of the 1980s had nothing to do with Ronald Reagan's policies. The economy grew so rapidly between 1983 and 1990, he wrote in the New York Times, "because the nation was snapping back from a deep recession, not because trend growth was higher. To prove his point, Blinder made an interesting calculation. He claimed there is a rule of thumb stating that each percentage point of unemployment costs the economy 2 percentage points of real growth. Therefore, the 4.1 percent decline in unemployment from 9.6 percent in 1983 to 5.5 percent in 1990 accounts for 8.2 percent of the total growth in real gross domestic product over that period. He then subtracted this cyclical growth to determine the underlying growth rate. Doing so lowers the average annual growth rate between 1983 and 1990 from 3.5 percent to 2.4 percent -- comparable to Clinton's record, he implied. This argument is silly because it presupposes that unemployment is independent of the GDP growth rate. But if Blinder wants to make it, then fairness dictates that we apply the same methodology to the Clinton era -- something he neglected to do. Between fourth-quarter 1992 and second-quarter 1996, real GDP grew 2.6 percent per year. But over that same period, the unemployment rate fell by 1.9 percentage points, from 7.3 percent to 5.4 percent. Therefore, using Blinder's rule of thumb, the decline in unemployment alone accounts for 3.8 percent of total GDP growth. Subtracting it out drops the underlying average annual growth rate to a minuscule 1.5 percent per year under Mr. Clinton. Other economists have used a variation of the Blinder argument. The 1981-82 recession, they say, was the deepest of the postwar period, whereas the 1990-91 recession was the shallowest. Therefore, one would expect a more rapid recovery after 1982 than after 1991, thus explaining the more rapid growth of the 1980s and the slower growth of the 1990s. But in fact the 1990-91 recession was comparable to the 1981-82 recession, with real GDP declining by a total of 2 percent in the former and 2.8 percent in the latter. By contrast, real GDP declined by 1.6 percent during the 1960-61 recession and 3.6 percent during the 1973-75 recession. In short, this focus on the business cycle is nothing but a smoke screen to obscure the poor record of growth during the current recovery. At the heart of the 1994 Republican Contract With America was a firm commitment to economic growth. At the heart of the opposition to the Contract was a commitment to the politics of redistribution of income. Opponents succeeded in the 104th Congress because they kept the focus on redistribution, not growth, and they have won on substance as well. In their efforts to compromise, the Republicans gave up more than half of their pro-growth tax cuts measured in static terms (that is, ignoring the economic effects of growth). And they gave up much more than half when measured by the dynamic ability of the tax cuts to stimulate the economy. In addition, Republicans who believe that balancing the budget should take priority over measures to increase economic growth were willing to reduce the tax cuts further to get a budget deal.
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| "The best way to reduce welfare spending is to increase everyone's income." | This is unfortunate for both sides. There is no way to reduce the deficit more efficiently and more painlessly than with a higher rate of economic growth. And there is no way of reducing the need for welfare spending more rapidly and more permanently than by achieving higher incomes for everyone. It would be politically catastrophic to give up the principle of economic growth in exchange for a patchwork of spending reduction promises spread over seven years.
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The administration is committed to a growth path of 2.5 percent per year, compared with the 3.3 percent growth rate registered in the last five years of the 1980s. The difference between 2.5 and 3.3 may not seem like much, but it amounts to $2.3 trillion of additional output over the next five years, including $520 billion of additional revenue for the federal government. A rising tide really does lift all boats. The additional revenue a 0.8 percent higher growth rate would generate would pay for all the tax cuts in the 1995 House Republican plan, including the $500 per child tax credit -- and leave about $150 billion for deficit reduction or new spending. An even higher economic growth rate is not out of the question. By some estimates, the original tax reduction proposals in the Contract would have increased the economic growth rate by 2 full percentage points. A successful budgeting process must include two elements. Slowing the growth of government spending is one. But encouraging economic growth is a higher priority, for it creates jobs and increases take-home pay, while also reducing the deficit through greater tax receipts.
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| "With tax economic growth from a tax cut, we can shrink the deficit and grow personal wealth." | Tax cut opponents cite the Reagan tax cuts as budget busters. But the Reagan tax cuts had nothing to do with the increase in federal budget deficits during the 1980s.
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While real growth averaged 3.9 percent per year in the 1982-89 period, it has crept at a snail's pace in the 1990s -- just 1.6 percent per year. The American people were better off during the low-tax l980s than they are in the high-tax 1990s.
Although the budget deficit has been reduced in the 1990s, increasing real incomes is vastly more important. And if a future tax cut stimulates the economy, as tax cuts almost always do, the nation can have deficit reduction coupled with a renewed increase in household wealth. A study from the Federal Reserve Bank of Atlanta provides evidence that high taxes are bad for a state's economic health. In the March/April 1996 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. 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 focus on 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. Becsi concludes that "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:
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| "Personal income growth slows by 3.5 percent for every 1 percent hike in state and local taxes." |
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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.
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| "States are fine test facilities for economic policies." | Investment advisors A.B. Laffer, V.A. Canto & Associates recently published an analysis of 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.
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The states are important laboratories for testing different economic policies. The evidence from these labs increasingly suggests that states that allow their taxes and spending to get out of line with their neighbors will suffer as a result. | |
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