Magazine | September 22, 2014, Issue

State Capitols vs. Capitalism

An Inquiry into the Nature and Causes of the Wealth of States: How Taxes, Energy, and Worker Freedom Change Everything, by Arthur B. Laffer, Stephen Moore, Rex A. Sinquefield, and Travis H. Brown (Wiley, 368 pp., $29.95)

In the first chapter of this book, its co-authors offer the economic history of New Jersey as “a colorful example of opportunity wasted.” During the 1950s and 1960s, New Jersey’s population growth exceeded the national average. “Then, in 1966, New Jersey adopted the sales tax,” they write, “and in 1976 the income tax. Fast-forward.” At this point, the authors — supply-side guru Arthur Laffer, Heritage Foundation chief economist Stephen Moore, investor Rex Sinquefield, and consultant Travis Brown — describe New Jersey’s fiscal meltdown in 2009 under Governor Jon Corzine, which they attribute to “years of tax increases, welfare expansion, and regulatory overreach.”

I tend to agree with them about New Jersey’s plight. Unfortunately, their book is unlikely to persuade as many as it could have. The authors’ purpose is not simply to argue that states would grow faster if they taxed and regulated less. That argument is correct and validated by scholarly research. It is also an argument that Art Laffer and Steve Moore, in particular, have spent many years promoting through books, reports, articles, and speeches — important work that deserves praise and gratitude. But much of the present book is also devoted to the proposition that state income taxes are an original sin that must be expurgated. To support it, the authors offer page after page of statistical claims. But repeatedly serving cups of weak tea doesn’t make it taste better.

Consider the case of New Jersey — and the use of the telling phrase “fast-forward.” While New Jersey enacted its income tax in 1976, nearby Connecticut waited until 1991. Yet their growth rates followed remarkably similar patterns. From 1951 to 1966, New Jersey and Connecticut posted modestly faster population growth and modestly slower income growth than the national average. From 1966 to 1991, both states posted significantly slower population growth and modestly faster income growth than average. Since 1991, both states have underperformed.

Obviously these outcomes depend on much more than whether a state has an income tax. In the early stages of the Baby Boom, many young families formed in or moved to new suburbs in New Jersey and Connecticut. But then, as housing prices in the Northeast soared, comparable families found more attractive options in the South and West, where the cost of living was lower and the quality of life was rising. More recently, states with energy reserves or other exploitable resources have outperformed even former Sun Belt pacesetters. Of the ten states with the fastest-growing economies from 2002 to 2012, two (Texas and Wyoming) have no state income tax. Two (Montana and Oregon) have no state sales tax. And one, Alaska, has neither. (South Dakota, another state without an income tax, ranked 11th.)

Liberal professors and policy wonks have gleefully attacked Art Laffer and his colleagues for downplaying the role of housing prices and other factors in order to exaggerate the effects of tax policy. Fairness demands that we point out that the authors never claimed that income taxes, or state policies in general, were the only factors that explained growth differentials. Moreover, some of the variables that liberals point to, such as housing prices and energy production, are themselves influenced by state policies such as regulation — an observation that The Wealth of States effectively explores in detail.

Still, none of the authors’ statistical work controls for non-policy factors — not even in their chapter titled “Why Growth Rates Differ: An Econometric Analysis of the Data.” That’s a mistake. To produce meaningful policy advice requires not simply looking for a correlation between, say, taxes and growth. It requires exploring how strong the link is, what causes what, and what the likely effects of a policy change would be. These questions are difficult enough to answer with sophisticated regression analysis. They are impossible to answer without it.

Because there are nine states that lack taxes on wage and salary income, the authors structure much of their analysis of state tax options on comparisons between nine states at one extreme and nine at the other extreme. “It’s the exceptional cases that prove the rule,” they write. By focusing on only 18 states at a time, however, the authors make their results highly sensitive to their specifications.

For example, to identify the nine states with the heaviest income-tax burdens, the authors use top marginal rates as of January 1, 2013. They then compare growth rates from 2002 to 2012 for such measures as population, income, and GDP. But why use 2013 tax rates to group the states? Wouldn’t it make more sense to use the rates in place at the start of the series, in 2002, or perhaps an average across the decade? When I reran the GDP comparison using the 2002 tax rates, the no-income-tax states still outperformed the high-tax states — but the gap was far smaller.

#page#Furthermore, while the authors used top tax rates to rank states on income taxes, they used average tax collections as a share of income to rank states on sales taxes. Having done so, they found that states with high sales-tax collections outperform states with low sales-tax collections — a finding consistent with their preferred tax reform, replacing income taxes with sales taxes. But when I reran the numbers using sales-tax rates, the composition of the sample changed, as did the result: States with higher sales-tax rates grew more slowly than states with low or no sales taxes.

I share the authors’ view that governments ought to tax consumption, not total income. But to insist that state politicians accomplish this by abolishing income taxes in favor of broadened sales taxes is to set them up to fail. No state has pulled this off (the only state to ditch its income tax, Alaska, has a tiny population and gargantuan oil revenues). Attempts to broaden retail-sales taxes to professions such as doctors, lawyers, and bankers almost always fail. Even attempts to tax less powerful service providers usually fail, because small-business owners call their legislators and scream bloody murder. Meanwhile, those legislators face damaging attacks by the Left for seeking to raise taxes disproportionately on the poor to fund tax cuts disproportionately for the wealthy.

A better approach would be to zero in on the main reason that income taxes are destructive — their effect on savings and investment. Income equals consumption plus savings (plus a sliver of gift-giving). Consider (1) a properly structured flat-rate sales tax that applies to all goods and services sold at retail and (2) a properly structured flat-rate income tax that exempts either the principal or the return on savings. Both would tax essentially the same base over time: total consumption. States can move gradually but steadily toward taxing consumption within an income-tax framework by consolidating multiple rates, reducing the double taxation of dividends and capital gains, and expanding tax-free savings accounts. This would allow state politicians to address regressivity concerns directly by adjusting personal exemptions or per-child tax credits (which act as a write-off for family investment in the future taxable income of children, by the way).

I’m critical not because I disagree with the book’s goals but because I think a more rigorous approach would have advanced them further. Gleeful as they may be in attacking Laffer’s methodology, liberals truly are woefully misinformed about these issues. High state-tax burdens do harm economic growth. So do heavy regulatory burdens. In fact, the Left is even more wrong than you’d think if all you knew about the subject were what you read in The Wealth of States.

Over the past quarter-century, hundreds of peer-reviewed studies on state economic growth have been published in academic or professional journals. These studies use conventional statistical techniques and control for non-policy variables. Most find no statistically significant relationship between government spending on education or other services and either service quality or economic growth. At the same time, about two-thirds of them find that higher state taxes are associated with lower growth. Unfortunately, this vast literature is inadequately discussed in The Wealth of States.

What conservatives should be arguing is not that tax reform will produce more net revenue to spend on government, as The Wealth of States unwisely asserts (by using the wrong metric), but that government spends too much already, getting a poor rate of return. States should spend less, which will allow them to tax less (and less foolishly), which will then create more jobs and higher incomes.

There is plenty of rigorous research to buttress these points, produced not just within academia but also at scholarly think tanks such as the Tax Foundation and the Beacon Hill Institute. During July 2014 alone, the Mercatus Center published a high-quality regression analysis linking high state taxes (but not the existence of income taxes) to weaker growth, and the Competitive Enterprise Institute published a high-quality regression analysis linking right-to-work laws to stronger growth. Such work is less vulnerable to methodological attacks. Not coincidentally, it also produces more modest claims about the magnitude of tax effects than those you’ll read in The Wealth of States. As William Penn observed, “Truth often suffers more by the heat of its defenders than the arguments of its opposers.”

– Mr. Hood is the chairman and president of the John Locke Foundation, a state-policy think tank in North Carolina.

John Hood is a syndicated columnist and the president of the John William Pope Foundation, a North Carolina–based grantmaker.

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