Although I support the tax cuts, budgetary restraint, and other fiscal policies adopted by the North Carolina General Assembly and Gov. Pat McCrory over the past two years, I have repeatedly urged policymakers and commentators alike to avoid making grandiose claims about their immediate effects on North Carolina’s economy.
It’s not that I think legislative decisions about state budgets are irrelevant to economic growth. On the contrary, my reading of the past 25 years of academic research on state economic growth suggests that state policy has a statistically significant relationship with measures such as job creation and income gains. All other things being equal, states with smaller governments, lower taxes, and less regulation have healthier, faster-growing economies than other states do. There are exceptions. But that’s the general tendency.
However, these effects are most evident over time, as changes in incentive and outlook lead to changes in the behavior of entrepreneurs, investors, professionals, workers, and consumers. States lack the tools — and ought to lack the intent — to manipulate the economy in the short run. They can’t run operating deficits and have no power to inflate the money supply (thank goodness).
How state governments can contribute to economic prosperity is by delivering high-quality, growth-enhancing services. The real state policy debate, in North Carolina and elsewhere, is about the definitions of the terms “high-quality” and “growth-enhancing.” For liberals, the modifiers seem to have no real meaning. Virtually all government spending is good for the economy, they suggest, which means that virtually all tax cuts that have the effect of constraining government spending must be bad for the economy.
Their position is logically incoherent and empirically flawed. We all know from our own personal experience that some of our expenditures are intentionally frivolous, some are intended to serve our long-term interest but don’t turn out that way, and some actually boost our future security, happiness, or earnings. As imperfect human beings, we can try to do our best and still err. The same is true for any institution created and run by human beings, including government.
Empirically, the Left’s position may have been plausible decades ago. But the past quarter-century of academic research has simply demolished it. Most studies find no positive relationship between state spending and economic growth. In fact, the only category of state spending for which most studies find positive economic effects is public safety — law enforcement, fire protection, and the court system. Even for major state functions such as infrastructure and education, the evidence is mixed. While increasing mobility and literacy are obviously valuable goals, states often pursue them ineffectively. They squander money on low-priority projects or initiatives. The economic costs of taxing households and businesses to finance these projects and initiatives are larger than the scant benefits they produce.
The real reason, then, to reduce public-sector tax burdens and spending levels is not to engineer some kind of short-term stimulus. It is, rather, to maximize investment in assets that enhance growth in the long run — by which I mean the sum of private investment (the result of taxpayers keeping and deploying more of what they earn) and public investment (the result of governments cutting back on wasteful spending in order to finance high-demand infrastructure or truly effective education reforms, both requiring many years to come to fruition).
A study just published in the journal Econometric Reviews by University of Chicago professor Arnold Zellner and University of Pretoria professor Jacques Kibambe Ngoie provides an excellent case study of how this process works. They found that reductions in personal and corporate tax rates in the U.S. were followed by higher rates of economic growth. Here’s how they explained the result: “The private sector is allowed to manage a larger portion of its revenue, while government is forced to cut public spending on social programs with little growth-enhancing effects. This broadens private economic activities overall.”
North Carolina’s economy continues to improve. Indeed, our recent economic performance exceeds regional and national averages. These are promising trends, certainly, but it remains too early to declare outright victory (or defeat) for the state’s recent changes in fiscal policy.
John Hood is chairman of the John Locke Foundation.