To Grow Their Economies, Cash-Strapped States Need to Cut Tax Rates

Published November 1, 2007

With real U.S. gross domestic product (GDP) growth falling to only 0.7 percent in the first quarter of this year after an anemic 2 percent pace for the second half of 2006, the U.S. economy has already shifted into a “growth recession.”

Instead of a strong recovery producing better-than-expected tax revenues, the current slowdown will produce much weaker revenues. Such surprises could, in turn, provoke new policy mistakes as states attempt to cope by raising tax rates.

We recently released a new study (“Fiscal Realities for the States: Economic Causes and Effects”) to help policymakers avoid mistakes that could cause more harm than necessary. We highlight two-way budget/economy linkages–causes and effects. We provide specific rules of thumb quantifying how economic forces impact budgets and how various tax methods differently impact job and income growth.

Economic Causes

In the short run, the economy is a dominant influence on state and local tax revenue growth. This point is hardly new, but the strength of the relationship has been grossly underappreciated because it has been obscured by the tendency to raise taxes in recessions and cut them when the economy is strong.

States Should Observe Optimal Tax Strategies
If tax increases must occur, income taxes are the least damaging
  Rating Criteria
Fairness and Progressivity National Recession Impact Net Burden on State
Personal Income Tax Best Best Best
General Sales Tax Average Worst Average
Business Profit Tax Average Average WORST
Specific Excise Tax WORST WORST WORST

Our research takes account of this “noise” and demonstrates tax collections are closely, systematically tied to readily available measures of the business cycle such as the state unemployment rate.

Moreover, the economy also exerts substantial influence on state and local expenditure growth through prices for goods and the wages for employees, which are partly beyond government control.

Economic Effects

Tax rate changes can also have large impacts on a state’s economy through competition from other states. The long-run damage is great if a state is recognized as levying a high tax burden. Long-established economic theory and our empirical analysis demonstrate corporate profits, sales, and excise taxes are particularly damaging.

These taxes motivate the locations of both employment and consumer purchasing.

Entrepreneurs have nearly complete freedom of location when they launch their new ventures. And the executives running existing businesses have almost equally great freedom as they decide in which county, state, or even country they should build a modernized facility, locate new employees to meet rising demands, or, in extreme cases, relocate an existing business.

The research provides “evergreen” principles for policymakers to aid their decision making:

1. Revenue Is Volatile

State tax revenue growth rates can be assumed to move more dramatically than the percentage change in the state’s unemployment rate–which is the most available and practical way to track the economy. Typically, overall revenues fall by a full 5 percent (relative to long-run trend growth) for each 1 percent rise in the unemployment rate.

Stated in terms of GDP growth, each 1 percent shift in state output growth relative to trend causes a far-greater-than-proportional 2.0 to 2.5 percent swing in state tax growth.

2. Long Run Is Key

State spending should be managed in line with long-run affordability rather than short-run revenue availability. Programs must be permanently affordable, not just when revenues are booming.

Likewise, pay increases for government employees should track the private sector instead of following boom-bust cycles. Unfortunately, the reverse has been true over the past decade as state and local pay increases have substantially exceeded those in the private sector, creating major budget problems.

3. High Taxes Lose Jobs

Tax policy choices have profound long-term consequences for state growth. States compete for business investment and consumer dollars. As a result, a high total tax burden demonstrably causes a state to lose jobs.

Each extra percentage point of sales, excise, or profit taxation cuts state income and employment growth by an estimated 2 to 3 percentage points in the ensuing decade.

4. Some Taxes Especially Harmful

Equally important, businesses and consumers are shown to react very differently to the types of taxes emphasized in a state. Long-term job and output growth is weakest in states emphasizing business profit, excise, and sales taxation over personal income taxation.

Roger Brinner ([email protected]) is a partner and the chief economist with the Parthenon Group LLC, a strategic advisory firm serving leading firms and public-sector institutions. Joyce Brinner ([email protected]) is a senior principal with Global Insight, Inc., a leading economics research and forecasting organization.

For more information …

“Fiscal Realities for the States: Economic Causes and Effects,” by Roger E. Brinner and Joyce Brinner, is available through PolicyBot™, The Heartland Institute’s free online research database. Point your Web browser to and search for document #21999.