States can generate powerful economic growth by cutting income tax rates.
That, at least, is the theory behind a recent wave of tax cuts, or proposed tax cuts, around the country. Kansas has cut taxes repeatedly in recent years. So has Wisconsin. In Maine, Governor Paul LePage vows to repeal his state’s income tax entirely. But does economic research support the claim? Can a state boost growth by cutting income tax rates, especially top tax rates. Or conversely, would it retard growth by raising them?
A new paper by my Tax Policy Center colleagues Bill Gale, Aaron Krupkin, and Kim Rueben concludes the answer is “no” to both questions. In the cautious language of academic research: “Our results are inconsistent with the view that cuts in top state income tax rates will automatically or necessarily generate growth.”
But Bill, Aaron, and Kim also have a warning for those who assert that cutting state taxes is good for growth or raising them is bad: All taxes are not alike. It turns out that while individual income taxes don’t matter much at all, and corporate taxes may actually boost growth a bit, higher property taxes do seem linked to slower growth though even that relationship seems to change over time.
The relationship between state individual tax rates and economic growth is enormously controversial, not only among policymakers but also among economists. There has been much research but little consensus. For instance, Will McBride at the Tax Foundation reviewed the literature and concluded that tax cuts are unassailably good for growth. Michael Mazerov at The Center on Budget and Policy Priorities looked at studies and found no clear benefit.
To better understand the effects of state taxes on growth, Bill, Aaron, and Kim tried an experiment. They started with a model developed by Bob Reed (then of the University of Oklahoma, now at the University of Canterbury in New Zealand—btw, good choice on his part). Reed wrote a National Tax Journal paper in 2008 called The Robust Relationship Between Taxes and U.S. State Income Growth that has become something of a touchstone for backers of state tax cuts. By using a series of five-year observations from 1970 to 1999, Reed found that increasing tax state revenues correlate to slowing economic growth.
The TPC authors first redid Reed’s analysis for 1977-2001, but then made several adjustments. They added two more observations for each state—for 2006 and 2011--which covered a period of strong economic growth and the Great Recession. They also looked more closely at what was going on inside the time period, broke down revenue changes by different kinds of taxes, and adjusted state tax rates for federal deductibility of state taxes. Finally, they looked at the effects of all these tax changes on business creation and employment.
And they found…a muddle.
For instance, from 1977-2001 (roughly the period Reed studied) high state tax revenues did slow firm formation. But when they looked out to 2006 or 2011, the effects largely disappeared.
When they looked at top marginal rates, the story was even more confusing. In some years, increases in these rates seemed to slow new business creation. In other years, start-ups increased even when rates rose.
The evidence for employment was just as shaky. High tax revenues do correlate to weak employment in most years, but barely. And the longer the time frame, the less important they seem. Raising marginal tax rates doesn’t matter either.
The one exception: Property tax revenues, which did seem to have a statistically significant impact on growth. The authors suggest more research to learn what’s going on, and why.
As policy analysis, this paper tells an important story: The effects of state taxes on economic growth are ambiguous at best. Those who firmly believe that tax cuts solve all woes will be disappointed.
If this paper were a novel, it would be terrible. No drama. But it is still an important read for policymakers and tax wonks. Maybe somebody should send a copy to Paul LePage before it is too late.
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