Taxes count, but their effects are complicated

  • Updated: October 22, 2010 - 10:21 AM

Tax cuts are overrated, and whether governments use revenues in ways that boost economic growth may make all the difference.

Complexity doesn't play well in election campaigns. Simple answers to big problems are appealing. So we're told: "We must cut (or never raise) taxes or we will lose jobs and business growth" or "Tax increases won't make a bit of difference to the economy."

We think Minnesota voters are smart enough to handle the truth -- that there's ambiguity around how the state might best balance its budget with the least negative impact on economic performance.

Economists agree, in theory, that taxes can reduce economic growth. Any tax that affects behavior (which is just about every tax) imposes economic inefficiencies. Productive resources get redirected as individuals and businesses take steps to avoid the tax.

But it's very difficult to test the theory by measuring tax-driven consequences in the real world.

That's partly because diverse state economies and policies defy direct comparison. Also, taxes, spending and the economy don't move independently in states -- but neither do they move in lockstep.

For example, when a state's economy starts to contract, tax revenues drop. And because a state must balance its budget, one result may be tax increases. This relationship might look like "higher taxes slow economic growth" But another way to put it is "slow economic growth leads to higher taxes."

In other words, while evidence may show an association between high taxes and slow growth, it doesn't tell us which caused the other.

The body of research we reviewed for a recent study of state fiscal policy and economic growth generally supports the long-held consensus of economists that a state should make its tax base as broad as possible so as to keep the marginal rates as low as possible.

The evidence also suggests that, all other things being equal, states with above-average taxes (measured as tax revenues as a percentage of personal income) do not do as well as states with average or below-average taxes, in terms of personal income, employment or growth.

In other words, when it comes to taxes, Minnesota may not want to be well above average.

However, all other things are often not equal, so there are some important limits in drawing conclusions from studies that compare states to gauge the impact of taxes on growth.

Political rhetoric inflates state disparities. Differences in economic activity among states that appear associated with taxes are likely to be small. In Timothy Bartik's distillation of 48 studies, economic activity declines, on average, 3 percent with an increase in taxes of 10 percent. Michael Wasylenko's review finds smaller estimates, clustering between zero and 2.6 percent.

The findings leave room for interpretation. For example, in 24 of the 34 business studies Wasylenko surveys, higher business taxes were associated with slower economic activity, while the results of personal tax studies are more balanced -- some showing higher personal taxes at odds with employment growth and others finding no significant relationship. Could the impacts of business and personal taxes differ?

How states balance taxes and spending matters. There is some evidence that the apparent negative impact of a higher tax burden will be reduced if spending rises for "productive" investments.

A 1985 study of 48 states by L. Jay Helms reports negative impacts on state personal income from higher taxes. But it also reports positive impacts -- larger than the negative tax effects -- from spending on education, health and highways.

This suggests that only states raising taxes and spending the increase on less productive investments are likely to experience declines in average personal income.

A study of manufacturing employment by Mofidi Alaeddin and Joe A. Stone found significant positive impacts on employment growth for spending on education, health and highways -- holding taxes constant. However, increased spending, when funded by a tax increase, had little or no impact on manufacturing employment.

Tax cuts are overrated. Attempts to spur growth by enacting large, sustained tax cuts do not appear to produce the hoped-for results.

The studies we've cited above use statistical methods that may not measure tax-driven consequences accurately and therefore must be taken with a grain of salt. It's rare to be able to isolate the impact of tax changes on economic activity.

One study that did so examined New Jersey Gov. Christine Todd Whitman's reduction of personal income taxes by a cumulative 30 percent. Researchers W. Robert Reed and Cynthia L. Rogers found that about 75 percent of the mid-1990s economic growth enjoyed in New Jersey in the wake of the cuts was shared by surrounding states, and that the tax cuts had no significant, specific impact on New Jersey employment growth. They conclude that the Whitman policy experiment does not support the case for tax cuts stimulating growth.

All these findings suggest that debates about taxes should cool both the "job-killer" and the "magic-wand" rhetoric. They should focus instead on the merits of specific public investments in human capital and physical infrastructure.

Marsha Blumenthal, professor emerita of economics at the University of St. Thomas, and Charlie Quimby, a retired small-business owner, collaborated on a recently released policy brief: "State Fiscal Policy and Economic Growth: Do Taxes Make a Difference?" for Growth and Justice, a Minnesota-based policy research organization.

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