State Income Taxes and Economic Growth

Theoretical Issues

Economic theory provides an explanation for a negative relationship between taxes and economic growth. Taxes raise the cost or lower the return to the taxed activity. Income taxes create a disincentive to earning taxable income. Individuals and firms have an incentive to engage in activities that minimize their tax burden. As they substitute activities that are taxed at a lower rate for activities taxed at a higher rate, individuals and firms will engage in less productive activity, leading to lower rates of economic growth. In addition, government expenditures—how the taxes are spent—will also have an impact on economic growth. We assume that state residents know both the level of taxes and the level of government services, and that they are rational in searching for the highest level of government services consistent with the lowest possible tax price. The tax price is especially relevant for state and local governments because residents can vote with their feet. If residents perceive that the tax price is too high, relative to the government services offered, they would move to another jurisdiction. Businesses also assess the taxes they pay relative to the government services they receive. If government services are not worth the taxes businesses must pay, there is an incentive to relocate to another jurisdiction. The mobility of residents and businesses in response to higher tax rates is an important factor in constraining the power of state and local governments to impose higher taxes.

State Income Taxes and Economic Growth The tax price concept suggests that there should be a negative relationship between higher tax rates and state economic growth. However, there is a substantial debate regarding this theoretical proposition. Holcombe and Lacombe (2004) explore this debate with regard to the potential negative impact of state income taxes on state economic growth. Several theoretical arguments are used to support the inference of a negative relationship. When a state income tax is added to federal taxes, the marginal impact of the state income tax may be greater (Browning 1976). Furthermore, when two governments tax the same tax base the combined tax rate may be inefficiently high (Sobel 1997). For a given level of state spending, however, a broader tax base that includes income taxation may have a lower excess burden than a narrow tax base that excludes income taxation. Holcombe and Lacombe (2004) point out that even if there is a negative relationship, it may not be significant. If state taxes are small relative to federal taxes, and if federal policy creates uniformity among the states, tax policy may not significantly impact state economic growth. They argue that it is important to measure the magnitude of this relationship. Empirical Issues There are a number of empirical issues that arise in examining the impact of state tax rates on economic growth. The first of these is convergence. Convergence A major issue that must be addressed before the predicted negative relationship between taxes and economic growth can be tested is the issue of convergence in growth rates across states.3 Convergence implies a negative relationship between growth rates and the initial level of income per capita. Differences in growth rates may be due to the differences in initial levels of income per capita. A regression analysis of the relationship between taxes and economic growth would have to control for initial income to isolate convergence and tax effects on state growth rates,download