The Agenda

Mitch Daniels on Resetting State Governments

Also in today’s WSJ, an excellent, tart missive from Mitch Daniels. I agree with virtually everything Daniels says in the piece. His basic argument is that state governments are facing a structural revenue collapse, and that they need to resize public spending appropriately.

Unlike the aftermath of past recessions, odds are that revenues will take a long time to catch back up to their previous trend lines—if they ever do. Tax payments have fallen so far that it would require a rousing economic rally to restore them. This at a time when the Obama administration’s policies on taxes, spending and more seem designed to produce the opposite result. From 1930 to 2008, our national average annual real GDP growth rate was 3.49%. After crunching the numbers, my team has estimated that it would take GDP growth of at least twice the historical average to return state tax revenues to their previous long-term trend line by 2012.

I doubt even that would suffice to rescue most states. Instead, historical forecasting models need to be revised. One-third of state revenues (over half in seven states) come from sales taxes, but it’s hard to imagine them snapping all the way back up to where they were just a few years ago. Americans are now saving much more then they used to relative to how much they are spending. This sudden shift will mean that even in good economic times to come consumers will likely spend less and therefore pay less in sales taxes than they did during bubble years.

Incredibly, state spending has ballooned over the past decade, growing at a rate of 6 percent a year, far in excess of population growth or wage growth.

I have one small disagreement with Daniels, however.

The “progressive” states that built their enormous public burdens by soaking the wealthy will hit the wall first and hardest. California, which extracts more than half its income taxes from a fraction of 1% of its citizens, is extreme but hardly alone in its overreliance on a few, highly mobile taxpayers. Both individuals and businesses are fleeing soak-the-rich states already. Those who remain in high-tax states will be making few if any capital gains tax payments in the years to come. Even if the stock market comes roaring back to life, the best it could do is speed the deduction of recent losses.

Though think Daniels basic point is right, namely that California doesn’t have a business-friendly climate, I think that this has more to do with regulation than the tax burden on the rich per se. (Interestingly, Daniels proposed a surtax on high earners to close a budget shortfall early in his first term.) Despite high taxes, California’s rich aren’t the most footloose slice of the population. Last week’s issue of The Economist noted the following:

The Public Policy Institute of California (PPIC), a non-partisan think-tank in San Francisco, has examined domestic migration in and out of California, and found that the high personal income taxes that are allegedly driving out the rich cannot be to blame. The poorest Californians, those paying very little in taxes, are the most likely to leave the state: 1.73 households are leaving for every one that arrives. Among the richest, only 1.09 households are leaving for each arrival.

It is true that the top destinations for those leaving include Nevada, Texas and Washington, three states that have no personal income taxes. Oregon, however, is also popular and it has high income taxes. Proximity seems to be a bigger factor than tax rates, says the PPIC.

The rich can afford high taxes. Taxes are a far more potent threat to families that are trying to build wealth than those that already have it. The real problem with California’s economic policy is that it is making life miserable for California’s poor and lower-middle-class, and a lot of this happens not so much through the tax code as through perverse restrictions on job growth and development. In City Journal, Ed Glaeser brilliantly described how development restrictions in coastal California have been a disaster for the environment.

California’s abundant restrictions on new construction don’t do much to deter building across America as a whole. No matter what the Bay Area does, plenty of new households will come into being, and they will need new homes. By restricting local development, California regulators just make sure that construction occurs someplace else. That someplace else tends to be a lot less environmentally friendly than the California coast, blessed as it is with a superbly temperate climate. The net result of this process: land-use restrictions in California increase carbon emissions and raise the risks of global warming.

Glaeser doesn’t add the obvious point that these development restrictions also encourage less-affluent Californians to flee the state in search of cheaper housing. These pressures will presumably ease in the near term, but not enough.

A brief aside: Progressives focus on Proposition 13, the consequences of which have been negative in many respects, e.g., it has undermined local government by centralizing the raising of revenue, it has also undermined “horizontal equity,” i.e., the notion that similar people should pay similar tax rates, etc. But progressives tend to think that centralizing the raising of revenue is a good thing: it leads to a more egalitarian distribution of public goods, it leads to less Tiebout choice, which conservatives like and progressive generally loathe. Again, I don’t think Prop 13 proved to be a great thing in the end. But progressives don’t seem to understand its real flaws. Rather, they use it as a clumsy shorthand for broader anti-tax sentiment, not understanding that the revolt against the property tax began as a movement of the left and the right.

Mitch Daniels is badly needed on the national political scene as a voice of reason. 

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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