Does state tax policy affect state economic growth? Fiscal conservatives tend to say yes. Fiscal liberals tend to say no.
No big surprise there. People with different philosophies of government and approaches to public-policy analysis will tend to form different conclusions about what government ought to do.
The existence of this disagreement about tax policy doesn’t concern me, then. What does concern me are frequent assertions by liberals that there is absolutely no empirical basis for the belief that state taxes affect state economic growth. This is simply false. Whether the falsehood stems from ignorance of the available evidence, or something else, is a question I’ll set aside for a later date.
Just in the past decade, there have been dozens of econometric studies, published by academic journals or university-based centers and institutes, that probe the relationship between policy variables such as state taxes and economic measures such as unemployment, income growth, or job growth. Some of these studies have shown that higher tax burdens or rates correlate with lower economic growth. Some of these studies have found no relationship between the two.
In my 2012 book Our Best Foot Forward, I discussed this literature in great detail. I was careful to note that there were some studies with conclusions contrary to my policy preferences — studies that found higher government spending resulted in faster economic growth, for example. I also explained that differences in research design often explained difference in results.
Some of the strongest relationships between tax rates and economic growth, for example, are found in studies that match nearby states rather than just play with national numbers. This result may be attributed to regional differences in state economies that nationwide models don’t adequately capture. Another important decision has to do with the measurements chosen. Studies that model overall tax burdens (total tax collections divided by either population or personal income) tend to reveal less of a relationship to economic performance. Studies that model effective or marginal tax rates (the taxes paid on the next dollar of corporate or investment income, for example) are more likely to uncover a link between state taxes and growth.
While there remains a great deal of room for debate, here are policy conclusions with strong empirical support:
• If state lawmakers “pay” for lower taxes by spending less on transfer programs such as Medicaid or unemployment insurance, the tax cut is likely to generate higher economic growth in the future. What is more debatable is whether tax cuts “paid for” with lower spending on public safety, infrastructure, or education have similarly positive economic effects.
• Marginal tax rates matter more than average tax burdens. How states raise their revenue matters as least as much as how much revenue they raise. A 1996 paper from the Federal Reserve Bank of Atlanta explains this issue well.
• State tax cuts don’t help the economy by stimulating short-term demand, since governments would otherwise spend the same money on something else that would boost short-term demand (i.e., paying public employees or buying supplies). The main way state economies can benefit from lower or more-efficient state taxes is by reducing the effective tax rate on private capital formation (i.e., dividends, capital gains, and retained corporate earnings). More capital formation in the private sector translates into more companies, locations, technology, jobs, and income growth.
If you want to read about these matters in greater detail, I have a book recommendation. In addition, consider these recent academic studies with a variety of interesting results:
• A 2013 paper in the Journal of Entrepreneurship and Public Policy found a strong correlation between a commonly used index of entrepreneurial activity and state economic growth. The author concluded that state policies such as tax reduction and property-rights protections would boost entrepreneurship and, thus, growth.
• A 2013 paper in the urban-affairs journal Growth and Change found that for most business categories, government-cost variables such as taxes and regulatory compliance are of greater significance to business-location decisions than policy variables such as school quality, public transportation, job training, or proximity to universities. The one area of government spending that did rank high was infrastructure, particularly roads. Of course, non-policy variables such as labor availability were among the highest-ranked factors.
• A 2012 paper in the journal Papers in Regional Science found that state and local taxes had significant effects on business-location decisions, particularly in rural areas.
• A 2012 paper in the International Journal of Economics and Finance found that states with greater economic freedom — including lower tax rates and regulatory burdens — attract more foreign investment in new and existing businesses.
• A 2012 paper in the National Tax Journal looked at fiscal and other policies in Canadian provinces. It found that higher corporate income tax rates were associated with lower rates of private investment and economic growth.
• A 2012 paper in the journal Contemporary Economic Policy found that lower state tax burdens were associated with higher rates of state economic growth, with the effect much more pronounced when looking at state income taxes alone.
• A 2012 paper in the journal Economic Letters found that state tax rates significantly affect state economic growth in the long run. However, contrary to other research findings, this paper found major negative effects from property and sales taxes, not income taxes.
• Similarly, a 2012 paper in Economic Development Quarterly found that local property and sales taxes had “significant, negative effects on business employment.”
• A 2012 working paper from the National Bureau of Economic Research found that state corporate income taxes influence the structure of corporate debt and equity — demonstrating that they are a significant consideration for business executives.
• A 2011 paper in the Journal of Economic Surveys found that government size is negative correlated with economic growth, all other things being held equal. How do some state or national economies prosper despite having relatively high spending and taxes? The authors concluded that these places typically offset the negative effects of bigger government with pro-enterprise policies in other areas such as regulation.
The next time you hear some claim that there is no basis for associating state taxes with state economic growth, urge them to broaden their reading list.