St. Louis Post-Dispatch columnist David Nicklaus, in his column “Missouri tax cuts aren’t a magic formula for economic growth,” cites a report by Leachman, Mazerov, Palacios, and Mai that the Center on Budget and Policy Priorities published. In the report, the authors present evidence and then interpret it as indicating that changes in income tax rates are positively correlated with economic growth.
First, the evidence is that six states enacted large personal income tax cuts in the years before the Great Recession. Three of these six states reported economic growth rates that were lower than the nation’s growth rate while the other three reported growth rates that exceeded the nation’s growth rate. The three faster-than-nation states were major oil-producing states, benefiting from the sharp run-up in oil prices that occurred after the tax rate changes were implemented.
Leachman et al. are correct in pointing out that multiple events affect each state’s economic growth rate. But the analysis is so perverted that it is more politics than economics.
Let’s try to be objective about the effects associated with a reduction in the income tax rate. First, the partial effect of a decrease in the income tax rate means that the after-tax returns to factors of production will increase. In other words, the return to workers and to those people taking risks as entrepreneurs and business owners. As the after-tax returns increase, the aggregate supply increases at a faster rate. This is how lower income tax rates, holding everything else constant, result in faster income growth. Leachman et al. do not present a new economic model that overturns this reasoning, so this point is indisputable.
What they must have in mind is the next round of effects associated with smaller state budgets. In the near term, state spending shrinks because the product of the tax rate and the tax base initially shrinks when the tax rate is reduced. The Leachman et al. argument is essentially that the government spending is on public goods — infrastructure, schools, and other capital investments — that offer a higher average return than private citizens could possibly realize from investing on their own. Honestly, this may be true. However, states purchase lots of things that are not about infrastructure, schools, and other capital investments. It may be a hard choice, but if there are fewer resources poured into state coffers, then the state must allocate those to the public projects that offer the highest return to its citizens.
The other part to this dynamic analysis is what happens when income grows faster because of the lower income tax rate. Because of this effect, over time, the state budgets will also grow faster, meaning that the path of state government future spending will exceed the high-tax-rate path. Leachman et al. do not even consider this.
Now, back to the evidence. Their interpretation is the worst kind of science. Ideally, a scientist would like to run a controlled experiment, isolating the treatment that they are considering and then compare results from the control group with the treatment group. Leachman et al. start off by recognizing that no such controls exist. Then they pervert their analysis by using the absence of the controls to argue that oil-producing states benefited only from their oil. Shame on them!!! What they cannot tell you is whether the non-oil producing states would have grown even slower if the income tax rates had been left at their higher levels. Now that would be a comparison.
There are other objective ways to rip their analysis. For example, they focus on a short time horizon. No growth theorist relies on data less than a decade old to try to infer what the growth-rate effects are. Yet Leachman et al. boldly assert the causality from just a few years of data.
You do not have to trust me. You can read the literature on factors affecting economic growth. At the state level, it is important to spend resources on public goods that are most valuable to people living within those boundaries. The next objective is to collect taxes from these people in the way that does the least harm; that is by creating the smallest distortions. Such taxing principles will result in higher living standards and happier people than for one group to nakedly claim their sense of fairness is the right tax structure.
The debate is too important to not carefully think about the best approach. Let’s think carefully.