| April 10, 2012

Economic theory says tax rates affect growth

How much money do you want in your pocket? The Oklahoma Legislature is considering changes to the state income tax that would affect both your current and future take-home pay.

A recent report from OCPA and Arduin, Laffer & Moore Econometrics (ALM) on the relationship between state income taxes and economic growth rates found that states with no income taxes grow faster than states with income taxes.

The Institution on Taxation and Economic Policy (ITEP) presents different results, reporting that the correct measure is income divided by population. ITEP asserts that states with no income taxes do not grow faster than states with positive income taxes when you focus on per capita income. This is a different question with a different answer.

Dr. Cynthia Rogers of the University of Oklahoma asserts that the OCPA/ALM finding is a correlation, which is correct. The economic data is generated from the economy, and various things affect economic growth rates. There is no way, short of a years-long controlled experiment treating people like lab rats, to control for enough factors to ensure a researcher has identified the “true” effect of taxes on economic growth rates. But Rogers overstates the truth when she asserts that the academic literature does not find evidence of a systematic relationship between tax rates and state economic growth. One of Dr. Rogers’ co-authors on another project, Professor Mark Skidmore, authored a study (along with Nicole Bradshaw) for the Show-Me Institute concluding that “more recent research findings support the hypothesis that there is an inverse relationship between taxation and various measures of economic activity…”

Once the correlations are obtained, economic theory seeks to explain the observations. The more things a theory can account for, the better the theory. The OCPA/ALM economic theory is elegant: higher income tax rates mean lower returns to work and to capital, thereby reducing the equilibrium amount of those inputs employed. With lower inputs, total income declines. This does not mean income falls; it means that income is lower than it would have been with lower income tax rates.

Rogers makes a valid point but overstates the conclusion. It is critical to explain why changes in equilibrium prices would not also change equilibrium quantities. She may be right, but until she offers an improved model, such claims are just naked assertions.

Grant Casteel and I studied what would happen if Missouri eliminated its state income tax and replaced it with a broad-based sales tax. There were no changes in state spending. Our model has been used to explain economic growth for more than 20 years. By eliminating the income tax rate, inputs employed by businesses increased, as did incomes. A higher sales tax increased consumer goods prices; however, we found that people preferred the lower income tax rate and the economic growth to the current tax structure. People happily traded higher prices for goods and services to obtain faster-growing incomes.

Oklahoma is doing things a little different than Missouri. Correspondingly, the price of faster growth is different. As I understand the Oklahoma proposal, the income tax rate will be phased out and there is no attempt to offset the income taxes with other taxes. The implication is that the price paid for faster economic growth is smaller state government than it would be otherwise, at least until the growth allows state government purchases to have caught up to the path that spending is currently on. The tradeoff, therefore, involves the loss of state government goods in the near term. Eventually, faster income growth will offset lost state revenues as other tax bases increase over time. Indeed, compared with the Missouri plan, consumer spending in Oklahoma will not fall since no sales tax rate increase is being implemented.

The most important part of this debate is ensuring it is transparent and honest. Armed with careful analysis, Oklahomans can make sensible decisions and ensure hard-earned money stays in individuals’ pockets.

An economics professor at the University of Missouri-Columbia, Joseph Haslag is chief economist at the Show-Me Institute, which promotes market solutions for Missouri public policy.

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