Carl Davis, Matthew Gardner, and Harley Heimovitz are with the Institute on Taxation and Economic Policy. ITEP is a nonprofit, nonpartisan research organization, based in Washington, that focuses on federal and state tax policy. ITEP's mission is to inform policymakers and the public of the effects of current and proposed tax policies on tax fairness, government budgets, and sound economic policy.
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In November 2011, Arthur Laffer's consulting firm (Arduin, Laffer & Moore Econometrics) prepared a study for the Oklahoma Council on Public Affairs (OCPA) that has been repeatedly cited in recent debates over cutting state personal income taxes.1 The study is titled "Eliminating the State Income Tax in Oklahoma: An Economic Assessment," and has had a particularly notable impact on debates in Kansas and Oklahoma. The governors of each of these states justified their efforts at income tax repeal in their State of the State speeches by citing Laffer's findings regarding the supposed economic benefits of repeal.2
But despite its high-profile spokespeople, the Laffer study is flawed to the point of being almost completely useless. This report examines two components of the Laffer study: its claim that states without personal income taxes are outperforming those with the highest top tax rates, and its regression analysis purporting to show that cutting state tax rates will bring about tremendous economic growth.
States Without Income Taxes Are Actually
Lagging 'High-Rate' States
The Laffer study's most frequently cited finding is that the economies in the nine states without broad-based personal income taxes are stronger than those in the nine states with the highest top marginal tax rates.3 But by some sensible measures, residents of "high rate" income tax states are actually experiencing economic conditions at least as good, if not better, than those living in states lacking a personal income tax.4
As Figure 1 (next page) shows, the nine "high rate" states identified by Laffer have actually seen more economic growth per capita over the last decade than the nine states that fail to levy a broad-based personal income tax. Moreover, while the median family's income, adjusted for inflation, has declined in most states over the last decade, those declines have been considerably smaller in "high rate" states than in those states lacking an income tax entirely. Finally, the average unemployment rate between 2001 and 2010 has been essentially identical across both types of states.
Three Measures of Economic Performance, 2001-2010
The appendix (p. 797) to this report includes state-specific findings for each of these three measures, and reveals that the economic problems in no-income tax states aren't limited to just Florida and Nevada, as some observers have recently claimed.5
- Six of nine no-tax states are doing worse than the average state when it comes to economic growth per capita: New Hampshire, Washington, Texas, Florida, Tennessee, and Nevada.
- Five of nine no-tax states are doing worse than average in terms of median income growth: Texas, South Dakota, Nevada, Tennessee, and Alaska.
- Six of nine no-tax states have higher than average annual unemployment rates: Florida, Texas, Tennessee, Washington, Nevada, and Alaska.
So how did Laffer reach such a different conclusion, and in the process generate a wave of claims that no-tax states are booming? The Laffer study focuses on a number of variables that are very closely related, including population growth, total employment growth, and total growth in economic output (GSP). But since a larger population brings with it more demand, it's only natural that states experiencing the fastest population growth would also experience more growth in the total number of jobs and total amount of economic output. Simply put, the Laffer analysis is hugely distorted by its failure to acknowledge the overriding importance of population changes to the variables it presents.
Equally important is the study's failure to acknowledge that population shifts are determined by a slew of factors unrelated to state tax structures, and its lack of any serious effort to prove otherwise. After all, if states' no-tax status is what's drawing in new residents, then Laffer's analysis may have some use. But according to the U.S. Census, eighteen of the top twenty states in terms of population growth between 2001 and 2010 are located in the south or western part of the country, and seven of these states are located in the so-called Sunbelt. Demographers have identified a large number of reasons for the population growth occurring in the south and west that are completely unrelated to these states' tax structures. Lower population density and more accessible suburbs are important factors, as are higher birth rates, immigration, and even warmer weather.
With this in mind, the growth of states lacking an income tax appears little more than coincidental, and should be assumed as such until credible evidence is presented to the contrary. Six of the nine states not levying a personal income tax are located in the south or western parts of the country (eight of nine if you count Alaska and South Dakota), and are therefore benefiting from the same regional trends also bolstering growth in states with comparatively high top income tax rates like Oregon, Idaho, and North Carolina. In this light, it should come as little surprise that the state without an income tax that experienced the lowest rate of population growth was New Hampshire -- the only non-income tax state located in the northeastern part of the country.
Also ignored in Laffer's analysis is the fact that states choosing not to levy an income tax often do so because they possess some unique economic advantage that allows them to generate tax revenue through non-traditional means. According to the Bureau of Economic Analysis, three of the top six states with the largest mining sectors, relative to their economies, also lack an income tax (Alaska, Wyoming, and Texas). Alaska and Wyoming also happen to be the two best performing states by Laffer's measure. Among the states with the highest top tax rates, by contrast, no state gets more than 1 percent of its economic output from mining, and most states get just 0.1 percent or less.
Unsurprisingly, serious state-based analysts in non-income tax states frequently point to natural resources as the cause of their economic success. The Wyoming Economic Analysis Division, for example, recently described the condition of their state's economy as such:
After a short, but severe recession, Wyoming's economy has turned around since the beginning of 2010, thanks to the robust rebound of the energy industries. The State's gradual recovery continued to be faster than the U.S. average. For the third quarter of 2011, Wyoming's recovery was still on track, and may have picked up speed.6
And the most recent Alaska Economic Performance Report explains that:
Alaska's economy fared extremely well during 2009 compared to other states. While most of the U.S. was significantly impacted by the collapse of the real estate market and job losses in the financial sector, Alaska's economy remained strong. Alaska is one of only four states in which gross state product increased during 2009. . . . Solid oil prices continued providing funds to the state's treasury while seafood, minerals, tourism, and timber continue to provide economic opportunity statewide.7
To put the importance of natural resources in perspective, it's also worth noting that North Dakota -- a state that levies an income tax and is endowed with significant natural resources -- is consistently at the top of the list of strongest economic performers. North Dakota ranks first in the nation under two of the three measures of economic success presented in this report: lowest average unemployment rate between 2001 and 2010, and strongest per capita GSP growth during that same period. In terms of the remaining measure, median income growth, North Dakota ranks second behind only West Virginia, another state that levies an income tax.
Regression Analysis Is Also Fundamentally Flawed
In addition to its flimsy anecdotal evidence regarding the performance of states without personal income taxes, the Laffer study also includes a regression analysis attempting to demonstrate the relationship between state income tax rates and economic growth. That analysis is used to predict that annual personal income growth by 2022 would more than double (from 2.39 to 5.65 percent) if the Oklahoma income tax were gradually repealed by that time. In the report's words, the analysis shows a "negative and highly significant" (a.k.a. inverse) relationship between state income tax rates and personal income growth.
While this result is no doubt attention-grabbing, the underlying regression used to produce it is deeply flawed. For starters, the measure of "tax rates" used in Laffer's regression for each year between 2001 and 2008 is the top marginal combined state and federal tax rate in each state. Since the goal of the regression is to show how state tax rates affect economic growth, it's hard to see why the study would muddy the waters by measuring the combined federal and state tax rate -- that is, until you see how that choice affects the results.
As noted, the Laffer regression finds a "negative and highly significant" relationship between the combined federal/state tax rate in a given state and economic growth over the 2001-2008 period -- but under our approximation of that regression, the relationship actually becomes positive and insignificant when the model is corrected to include only variation in state tax rates. Put another way, when the noise created by changes in federal tax rates is removed, it becomes obvious that differences in state tax rates are not driving the economic predictions made by Laffer.
The reasons for this are not complicated. The top federal tax rate was substantially higher in 2001 (at 39.1 percent) and 2002 (38.6 percent) than in the 2003-2008 period (when the top rate was 35 percent). This, of course, is the result of the Bush era tax cuts signed into law in 2001 and 2003. By including the plummeting federal tax rate in their regression, Laffer and his associates essentially assume a 4.1 percentage point cut in every state's top marginal tax rate between 2001 and 2003 even though no state's tax rate was reduced by anywhere near this amount during this period.
Furthermore, 2002 was by far the worst year for U.S. economic growth in the eight-year period in the analysis, and 2001 also saw low growth nationally. Following the deep post-9/11 trough, personal income predictably grew at a relatively fast rate, just as cuts in federal tax rates happened to be going into effect.
By creating a bogus measure (federal and state tax rates combined) and mapping it onto an exceptional moment in economic history, Laffer creates the illusion that cuts in state tax rates between 2001 and 2003 fueled economic growth later in the decade.
But an incorrect measure of tax rates is hardly the study's only flaw, as the regression ignores a wide variety of other factors that more plausibly affect economic growth. Even if one replaces combined federal and state tax rates with only state tax rates, as just described, the even more basic problem remains that the Laffer regression makes no effort to measure the impact of other factors, from coastline to climate to natural resources, that explain state economic growth. Any serious analysis of the relationship between state income tax features and state economic growth requires a far more detailed and careful econometric approach than is given in Laffer's regression -- or in our modestly improved regression mentioned above.
As an example, a July 2011 study by James Alm and Janet Rogers, titled "Do State Fiscal Policies Affect State Economic Growth?" tests the impact of more than 130 explanatory variables in attempting to explain state economic growth, including a variety of tax- and spending-related factors, but also including many geographic and demographic variables.8 Notably, the Alm and Rogers report does not include federal taxes among the many state tax variables used, and finds no significant impact of state income taxes on state economic growth.
The Laffer study is flawed to the point of being almost completely useless. Its anecdotal evidence regarding the economic performance of states without income taxes confuses coincidental population growth with tax-driven economic performance, and also fails to acknowledge the natural resource advantages enjoyed by a number of the most successful non-income tax states. Whether looking at income levels, unemployment rates, or economic output per person, states with "high rate" income taxes have economies that actually equal or surpass those in states lacking an income tax. Similarly, the Laffer study's other major component -- a regression analysis purporting to show that cutting state income tax rates will bring about enormous economic growth -- is also laughably flawed in its inaccurate measurement of tax rates and its failure to control for a huge number of factors important to state economic growth. Given its myriad problems, the Laffer study provides no reason for states to expect that reducing or repealing their income taxes will improve the performance of their economies.
State-Specific Data for No-Tax vs. 'High-Rate' States
Growth in Per Capita Real GSP, 2001-2010
Change in Real Median Household Income, 2001-2010
Figure 4. Average Annual Unemployment Rate, 2001-2010
1 OCPA and ALME, "Eliminating the State Income Tax in Oklahoma: An Economic Assessment," November 2011.
2 Kansas Governor Sam Brownback said that he wants to "get us ever closer to the pro-growth states with no state income taxes -- which are among the country's strongest economic performers," while Oklahoma Gov. Mary Fallin (R) specifically cited data from the Laffer analysis in attempting to make the case for income tax repeal.
3 States without a broad-based personal income tax include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. The states with the highest marginal personal income tax rates as of January 1, 2011, as identified by Laffer, include California, Hawaii, Maine, Maryland, New Jersey, New York, Ohio, Oregon, and Vermont.
4 The focus of this report is on states with the highest top marginal income tax rates as of January 2011 in order to be consistent with the relevant Laffer analysis, though we should note that this measure provides only a very partial snapshot of what are in reality much more complicated personal income tax codes.
5 "The Heartland Tax Rebellion," The Wall Street Journal, Feb. 8, 2012.
6 Wyoming Economic Analysis Division, "Economic Summary: 3Q2011," December 2011, p. 1.
7 Department of Commerce, Community, and Economic Development, et al., "2009 Alaska Economic Performance Report," February 2011, p. 1.
8 Alm, James, and Janet Rogers, "Do State Fiscal Policies Affect State Economic Growth?" 39 Public Finance Review 483-526 (2011).
END OF FOOTNOTES
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