State Tax Burdens and Growth Rates

This is my first post… I apologize for any formatting errors….

Tax reduction seems to be a signature policy of the GW administration, and there has been time to see how well it has worked (or not). Despite the rising chorus, the data just doesn’t seem to be cooperating with the administration or its supporters – real tax collections in 2005 were less than in 2000 according to the Office of Management and Budget, despite a growing economy and population. Before this administration took office, you would have had to go back to the Reagan administration’s tax cutting experiment to find a time when real tax collections were less than they had been five years earlier. One would think that would make it tough to argue that the tax cuts are “working”, but regular Angry Bear readers are treated to a periodic skewering of National Review who insist on trying anyway.

Another way to look at the tax issue is by comparing tax rates and economic performance across jurisdictions. Each of the fifty states has its own tax policies. If the tax cut crowd is correct, states with lower taxes should grow faster than states with higher taxes, for two reasons. The first is that the low taxes leave more money in people’s pockets, giving them more to spend and invest. The second is that people will vote with their feet, as per the Tiebout hypothesis.

The BEA website reports real gross state product from 1990 to 2005. Combined state and local tax burden for each state from 1970 to 2006 is available from the Tax Foundation. Because the Tax Foundation has impeccable credentials among the tax-cutting crowd, use of its data should be kosher for them.

The correlation between each state’s percentage change in Gross State Product and its tax burden for every year from 1991 to 2005 can be summarized as follows:

minimum……………………-64.2%
25th percentile…………….-24.9%
median………………………….8.4%
75th percentile……………..27.0%
maximum……………………..73.3%

average……………………….. 0.7%

What this means is that the state with the lowest correlation between its percentage change in GSP and its tax burden has a correlation of –64.2%, the state with the highest such correlation shows a correlation of 73.3%. A negative correlation indicates that higher taxes are associated with slower growth rates, and a positive correlation indicates that higher taxes are associated with higher growth rates. Half of states fit into the interquartile range, with correlations between –24.9% and 27%. Additionally, the median correlation is 8.4% and the average is 0.7%. This first pass doesn’t seem to indicate much of a relationship between tax burdens and growth rates, and, if anything, since both the median and average correlations are positive, in at least half the states, lower tax burdens are associated with lower, not higher growth rates.

However… perhaps this isn’t true of states with high growth rates? Is it possible the fast growing states have discovered something about tax burdens that other states have not? Or perhaps the slow growth states are missing something obvious? The table below shows the same statistics for the states that have grown the fastest from 1990 to 2005, and for the states that have grown the slowest over the same period:

………………5 fastest growing…….5 slowest growing
minimum…………..-25.1%……………….-64.2%
25th percentile……-18.3%……………….-54.7%
median ………………..19.2%……………….-24.6%
75th percentile…….30.4%………………..28.9%
maximum…………….35.7%………………..43.4%

average…………………8.4%……………….-14.2%

On average, for fast growing states, there is a more positive correlation between growth rates and tax burdens than for states in general. Conversely, for the slow growing states, there actually is the negative correlation between tax burdens and growth rates that the tax-cutting crowd would have predicted for all states.

But maybe it takes time for tax cuts to work their magic? After all, people don’t decide to start a business or relocate overnight… A summary of the correlation between growth rates and tax burdens in the previous year is shown below:

…………..all states…….5 fast growing…….5 slow growing
minimum………..-63.8%…………..-19.3%…………….-63.8%
25th percentile.-15.5%…………..-15.4%…………….-54.0%
median………….11.6%……………18.3%…………….-28.0%
75th percentile…..32.7%……………21.7%……………..34.3%
maximum………….65.3%……………65.3%……………..54.9%

average…………..5.5%…………….14.1%……………-11.3%

Hmmm… perhaps not. Similar relationships persist lagging tax burdens by 2 years, 3 yeas, 5 years, 10 years and 20 years (beyond that I got bored), though, if anything, the average correlation between growth rates and lagged tax burdens has a slight tendency to increase as the lag length increases.

Thus, the data doesn’t seem to support the idea that lower taxes are associated with faster growth rates. In fact, the opposite is true, especially for the fastest growing states. One way to interpret this is to conclude that taxes are actually below their optimal rates, and therefore, at the margin, the government is actually more efficient than individuals at converting its spending into growth. Society needs a certain amount of public goods (infrastructure, public health, confronting the Canadian menace, etc.) for businesses to thrive, and perhaps we currently have too little provision of public goods rather than too much.