Taxes

Laboratories for Prosperity

A comprehensive study confirms that free-market principles work outside Washington.

|


Over the past three decades, America's state and local governments have experienced a large and underappreciated divergence. Some places, usually but not always led by Republicans, have become friendlier to free enterprise. Other places, usually but not always led by Democrats, have become friendlier to big government. Some political scientists call it the Big Sort. You can see the self-selection manifest itself in polls, in voting behavior, in migration patterns, and in policy outcomes.

Think of it as a vast natural experiment in economic policy. Because states have a lot otherwise in common-cultural values, economic integration, the institutions and actions of the federal government-testing the effects of different economic policies within America can be easier than testing them across countries. Governors, state legislators, and other policy makers have dutifully supplied the experimental data. And scholars have been studying the results.

I head the John Locke Foundation, a state policy think tank in North Carolina. A recent change in our state's political leadership prompted us to assemble a summary of all that diverse academic research for legislative leaders and our new governor, Pat McCrory. Setting aside studies published by think tanks, we limited ourselves to scholarly articles about economic policy published in academic or professional journals. At present our database contains 528 articles published between 1992 and 2013. On balance, their findings offer strong empirical support for the idea that limited government is good for economic progress.

Taxes Matter

Of the 112 academic studies we found on overall state or local tax burdens, for example, 72 of them-64 percent-showed a negative association with economic performance. Only two studies linked higher overall tax burdens with stronger growth, while the rest yielded mixed or statistically insignificant findings.

On smaller categories of taxation, the trend was similar: There was a negative association between economic growth and higher personal income taxes in 67 percent of the studies. The proportion rose to 74 percent for higher marginal tax rates or tax code progressivity, and 69 percent for higher business or corporate taxes.

Some of the strongest negative results appeared when scholars were able to isolate policy variables from background effects. For example, a 1996 study in the American Economic Review exploited the fact that some foreign countries gave domestic tax credits to companies that pay taxes in the United States, so those companies would be expected not to care much about state tax rates. In other countries, companies didn't receive such credits and would thus be subject to greater variation in state tax burdens. By looking at the behavior of firms based on their home country, author James Hines of the University of Michigan found that "state taxes significantly influence the pattern of foreign direct investment in the U.S." A 1 percent change in the tax rate was associated with an 8 percent change in the share of manufacturing investment from taxed investors.

Another study, published in Public Finance Review in 2004, zeroed in on counties that lie along state borders. Because territories in such close proximity often share characteristics that might not be captured in other measurements, this is a promising approach for isolating the effects of state policy. Studying 30 years of data, the authors concluded that states that raised their income tax rates more than their neighbors had significantly slower growth rates in per-capita income.

Similarly, economists Brian Goff, Alex Lebedinsky, and Stephen Lile of Western Kentucky University grouped pairs of states together based on common characteristics of geography and culture. This is the economic equivalent of studying identical twins to probe the relative importance of genetics and environment. Writing in the April 2011 issue of Contemporary Economic Policy, the authors found "strong support for the idea that lower tax burdens tend to lead to higher levels of economic growth."

Liberal analysts often argue that isolating variables such as tax rates misses the point. States would be better served, they suggest, adopting a growth strategy that maintains or increases current tax burdens to fund education, infrastructure, or other government programs. Whatever economic cost may come with higher taxes, they say, is more than offset by the economic benefits of the amenities that government spending provides.

This argument may seem plausible in theory, but it lacks empirical support. Of the 43 studies testing the relationship between total state or local spending and economic growth, only five concluded that it was positive. Sixteen studies found that higher state spending was associated with weaker economic growth; the other 22 were inconclusive.

Admittedly, economic benefits may not be evident for total state budgets, which combine three different categories of spending: protective (law enforcement and the courts), productive (education and infrastructure), and redistributive (health, welfare, and other transfers). Although a few Keynesian bitter-enders insist that transfer programs such as Medicaid boost the economy via multiplier effects, most proponents of government spending as an economic development tool prefer to emphasize the potential benefits of schools, roads, and other infrastructure. That's wise: Nearly three-quarters of the relevant studies found that welfare, health care subsidies, and other transfer spending are bad for economic growth.

States Don't Invest Effectively

That said, the empirical evidence isn't overwhelmingly friendly toward "investments" in education and infrastructure either. While most relevant studies found that measures of education outcomes, such as test scores or college attainment, are correlated with economic growth, the same can't be said for expenditures. Of 79 research findings on the relationship between education spending and economic growth, only 30 were positive, with 34 findings of mixed or insignificant results and 15 negative. (In the latter cases, any economic gains from additional education spending are more than offset by the economic losses from the taxes required.) Of the 84 studies examining infrastructure spending, 44 percent found positive results, but most studies still found either inconclusive or negative relationships.

One recent paper deserves special attention. In the Winter 2013 issue of the Journal of Education Finance, two political scientists, Norman Baldwin of the University of Alabama and William McCracken of the Ohio State University, published one of the most carefully designed studies of education spending I've seen. For example, they built in time lags to account for the fact that education spending is cumulative-its net effects show up years later, when pupils become workers or entrepreneurs, not in real time. So in evaluating overall higher-education spending, Baldwin and McCracken used a seven-year lag to allow for university students to obtain degrees, find employment, and adjust to their new jobs. They used a 13-year lag for K-12 spending. Neither variable demonstrated a consistent relationship with state economic growth. A separate measure of state spending on academic research did show a positive effect from 1988 to 1996, but the effect turned negative for the 1997-2008 period.

One common fallacy is to assume a close correlation between public spending and the quality of the programs or assets it funds. Some states with generously funded public schools, for example, have relatively high levels of educational achievement. But other high-spending states produce miserable results. Both national and international research suggests that other factors explain differences in school achievement or completion.

Some of those factors, such as family background, lay largely outside the scope of government action. To the extent that public policy makes a difference, a 2007 paper in the Peabody Journal of Education found that countries with high-performing students don't necessarily rank high in spending; instead, they tend to devolve personnel and instructional decisions to localities and to encourage competition among public and private schools. Similarly, a 2012 study in the Southern Economic Journal found that countries with greater central-government involvement in schooling experience both lower student performance and lower economic growth.

Another fallacy is to mix up average and marginal effects. There is strong support for the proposition that some government spending does foster economic growth. The strongest case for net economic benefits from state action involve public safety and a legal system for protecting property rights and adjudicating disputes, though the number of studies testing that relationship isn't large. But there is a point of diminishing returns.

In a 2006 paper in Contemporary Economic Policy, economists Lori Taylor of Texas A&M University and Stephen Brown of the University of Nevada-Las Vegas discussed the evolution of the scholarly literature on the subject. While "early research suggests some increases in state and local government spending more than offset the negative effects of the tax increases needed to fund them," Taylor and Brown wrote, "more recent research finds the growth of state and local government generally discourages private-sector growth."

The Taylor/Brown study suggested that the trend was explained partly by the starting point of governments' size. As state governments have grown over time, adding new programs and services, the economic value of additional tax dollars spent has diminished, then turned negative.

The same authors, along with the Southern Methodist University economist Kathy Hayes, had published an earlier study probing the growth effects of every major program of state government: public safety, education, transportation, housing subsidies, health care, and public assistance. According to their findings, published in 2003 in the Review of Regional Studies, raising state taxes from modern levels to fund additional spending almost always harms economic growth. Indeed, the study suggested that if states slowed their spending growth, even on education, and used the savings to reduce tax rates, the net result would be higher levels of private investment and employment.

Regulation is at least as important as taxes and spending. There are 123 scholarly articles in our database that looked at state or local regulatory policy in some form; 31 articles studied broad indexes of state economic freedom that mix both fiscal and regulatory variables. Scholars found a positive economic effect for less regulation 67 percent of the time and for economic freedom 77 percent of the time.

In the most recent example, economists Lauren Heller and Frank Stephenson of Berry College used the Fraser Institute's Economic Freedom of North America index to explore state economic growth from 1981 to 2009. They found that if a state adopted fiscal and regulatory policies sufficient to improve its economic freedom score by one point, it could expect unemployment to drop by 1.3 percentage points and labor-force participation to rise by 1.9 percentage points by the end of the period studied.

Economic Freedom Works

To the extent that the national media notice this natural experiment, they tend to oversimplify it as a contest between Texas and California. To be sure, it's easier to find a job in Texas (it had an 6.1 percent unemployment rate in November 2013) than in California (with an 8.5 percent rate the same month). And yes, the Lone Star State has a much freer economy than the Golden State. But the Big Sort is going on across the country, not just across the Grand Canyon.

In the past year alone, Indiana has abolished its estate tax and cut its marginal tax rates on personal and corporate income. Wisconsin collapsed tax brackets and sunset its death tax. Kansas trimmed its top income tax rate by a quarter, while New Mexico cut its corporate tax rate by a fifth. On the other hand, Minnesota just jacked up its top income-tax rate, and a number of "blue" states are adopting new regulations aimed at combating climate change, low-density development, and obesity.

Here in North Carolina, the new McCrory administration and its legislative allies replaced the state's graduated income tax, which had topped out at 7.75 percent, with a flat tax of 5.75 percent; they also slashed the state's corporate tax from 6.9 percent down to as low as 3 percent (if future revenue targets are met). They required all state regulations to undergo regular reviews every 10 years. Rules that no longer comply with state law, or produce more benefits than costs, will automatically expire.

In education, the new administration re­placed teacher tenure with multi-year contracts, introduced merit pay, expanded charter schools, and created two choice plans that will provide private-school scholarships to as many as 13,000 students within three years. And on transportation, they followed the Reason Foundation's recommendations by rewriting the state's funding formula and using tollways to add new highway capacity.

In other words, in the great debate about how best to promote economic growth, North Carolina has come down clearly on the side of fiscal conservatism, competition in public services, and a more limited government. It was a bold choice based on the best available research about what makes economies prosper. The nation's capital should follow suit.