Commentary

Holding the Line on State Taxes

This article was published in the Kansas City Star, June 9, 2003.

Across the nation, large budget gaps are forcing state governments to make important policy choices. To balance budgets, many states are turning to tax increases rather than pursuing budget cuts. That is unfortunate because higher taxes impose “budget cuts” on families for their own expenses, which they must meet in a stagnant economy with few wage gains.

But that’s only part of the problem with tax increases. Higher taxes reduce economic growth over the long run, and thus impose a second loss on family incomes. This can be seen by ranking the 50 states by their overall tax burden and comparing state income growth from 1980 to 2000. Real personal income increased an average 96 percent during this period for the 10 states with the lowest state/local taxes (measured as a percent of income), but just 52 percent for the 10 highest-tax states. New Hampshire is notable as the lowest-tax state in the country and its 117 percent real income growth during the period.

One reason for these growth differences is that capital and skilled labor are increasingly mobile across state and international borders. High tax rates on profits and incomes drive away businesses and highly paid workers. One study by Deborah Swenson of the University of California-Davis in 2001 looked at how investment flowing into the United States was affected by state taxes. She found that states with higher taxes attracted fewer new investments and plant expansions from foreign companies than did lower-tax states.

Consider that yesterday’s industries, such as steel and mining, were stuck in particular locations, such as near rivers, ports, or mineral deposits. Today, industries are much more footloose. Service industries, such as finance, and high-tech industries, such as software, can locate nearly anywhere. As a result, states need to work much harder to create a business-friendly environment to lure such desirable activities.

Many factors go into making a good business climate, but recent Irish experience shows how important taxes can be. Ireland has flourished since it began cutting taxes in the 1980s. A centerpiece 10 percent corporate tax rate attracted large foreign investments in manufacturing and finance. High-tech giants such as Hewlett-Packard and Intel have poured hundreds of millions of dollars of investment into Ireland. This small island went from being one of Europe’s most backward economies to having one of the highest per-capita income levels in the world today.

In this country, Nevada, not Massachusetts, is perhaps the most Irish of the states — at least in terms of competitive tax climates. Nevada has neither an individual nor corporate income tax, and has grown at the fastest rate of any state in the last two decades. Nevada employment rose 66 percent during the 1990s, compared to overall U.S. employment growth of 20 percent.

Unfortunately, politicians do their best to kill the goose that lays the golden egg of prosperity. In Nevada, Gov. Kenny Guinn is pushing for a new broad-based business tax and has increased the previously low costs of setting up new businesses, which had been a state advantage. Still, many state leaders today realize that high business and income taxes have a negative effect, and we generally haven’t seen as many broad-based tax hikes as we saw during the recession of the early 1990s.

Instead, states are raising narrower and less unpopular taxes, which they assume don’t cause any damage. The favorite target currently is cigarette consumers, who faced tax hikes in 20 states in 2002. But higher taxes even on this demonized product causes serious side effects. Cigarette taxes are not innocuous pro-health levies — they spawn large black markets creating a funding source for terrorists and organized crime.

Recent state and city cigarette tax hikes in New York have pushed the combined tax rate up to $3 per pack. That steep tax will create a field day for cigarette smugglers, but a nightmare for police who will have to waste resources on a futile effort to squelch emboldened cigarette mobsters. Meanwhile, armed crooks will target New York convenience stores for their valuable inventory of cigarette cartons that are now worth thousands of dollars more.

I admit that I oppose all state tax increases. After all, total state/local spending is already at an all-time high of 15 percent of personal income. Instead, politicians should take the very generous tax allowance we provide them and make the tough spending trade-offs that they are elected to make.

Chris Edwards is director of fiscal policy at the Cato Institute.