If tax rates don't matter...

by John Hood, John Locke Foundation and NC SPIN panelist, August 9, 2013.

After the North Carolina General Assembly enacted its tax-reform package last month, critics denied it would have a positive effect on the state’s economy. Among other arguments, they advanced the notion that tax rates don’t really influence the behavior of investors, entrepreneurs, workers, and consumers.

It’s not a very sensible notion. If tax rates don’t matter, why did so many families just shop for school supplies during North Carolina’s tax-free weekend? Why do special interests lobby so strenuously to secure and protect their favorite tax breaks? Why have past Democratic politicians enacted tax breaks and credits for such decisions as saving for college or investing in low-income housing?

You don’t have to agree with these tax policies to recognize that they are designed to influence behavior. A tax rate is a price. You incur that price if you make a decision that subjects more of your income to federal, state, or local taxation. Correspondingly, a tax cut reduces the price of earning wages, investing capital, or buying goods and services. To deny that taxes affect economic decisions is akin to denying that prices affect economic decisions. It is, in short, crackpot economics.

That's not to say that the tax rate is the only policy instrument that matters. You have to consider the spending side of the equation.

Government expenditures come in three flavors: protective (mainly law enforcement and courts), productive (mainly infrastructure and education), andredistributive (Medicaid, unemployment compensation, welfare, and other transfer payments). Under certain conditions, government spending on protective and productive services can boost economic growth. The same can’t be said forspending on redistributive programs, which advocates must justify on other grounds.

In theory, for example, police spending can reduce the need for private households and businesses to spend money on security precautions, damage repair, or replacement of stolen property. Also theoretically, education spending can reduce the cost to employers of finding and deploying highly productive workers, while transportation spending can reduce the cost to businesses of moving freight or the cost to employees of commuting to work.

However, these expenditures must be paid for, sooner or later, with taxes. Net economic benefits occur only when the value added by government spending outweighs the value subtracted by taxation. Because programs run by government monopolies tend to be inefficient and unresponsive to consumer demand, there is no consistent relationship between state expenditures and outcomes such as better-educated workers or well-designed highway systems. That’s whymaintaining high tax rates to fund these programs is more likely to harm the economy than help it.

There a broader point to consider, as well. Many factors influence state economic performance far more than state taxes or spending could ever do. They include technological innovation, international trade, shifts in consumer preferences, changes in family structure, availability of natural resources, climate, monetary policy, government regulation, and federal taxes and spending.

State governments, in other words, don’t have wide latitude in determining theabsolute health of their state economies. What they can do is choose the right mix of state fiscal and regulatory policies to influence the relative health of their economies — how employment, income growth, and other indicators compare against other states under similar economic, national, and international constraints.

The preponderance of empirical research on the matter offers this advice to state officials:

• Apply simple, broad-based taxes with low marginal rates to pay for core state services, while employing usage-based fees or taxes to fund enterprises such as highways and utilities. Most importantly, avoid tax policies that discourage private savings and investment, the indispensable seed corn for economic growth. Even the prospect of future taxes on capital formation can have serious economic consequences, as Minnesota Fed economist Ellen McGrattan demonstrates in a study published last year in the Quarterly Journal of Economics. Using innovative measurements of capital taxes and public expectations, she found that federal fiscal policy played a large role in perpetuating the Great Depression during the 1930s.

• Use competitive contracting, consumer choice, and rigorous performance evaluation to improve the quality of productive services such as education.

• Keep spending on redistributive programs to the minimum required to fund temporary assistance for those who can work and an efficient safety net for those too disabled to work. Never overfund consumption programs and then call it “investment.”

During the 2013 session, state lawmakers and the McCrory administration took this advice to heart. Their reform initiatives on taxes, regulations, education policy, highway funding, and Medicaid will improve North Carolina’s long-term economic health.