If you are looking for case studies to show how tax policy and economic competitiveness matter for economic growth, look no further than the 50 states, or as Justice Louis Brandeis called them, "laboratories of democracy." The annual publication "Rich States, Poor States: ALEC-Laffer State Economic Competitiveness Index," which I coauthor, compares and contrasts the states that have made relative economic progress, with those that continue to struggle, while highlighting the policies that make a difference for economic opportunity and well-being.
As demonstrated over the eight editions of this publication, states rise and fall based in part on changes to public policy. For instance, a decade ago, who would have guessed that Michigan could witness an increase in private sector employment and significant gains in economic competitiveness? However, legislators worked with Gov. Rick Snyder (R) and made significant policy changes, like repealing the hated Michigan business tax and passing a right-to-work law, and by doing so, set the state on the path to recovery.
One of the great, understated facts of state policy is that states do not enact policy changes in a vacuum. When a state changes policy, for better or worse, it immediately affects the incentive structure for individuals and businesses alike -- and the change in incentives directly affects the state's overall competitiveness. Of course, many factors influence a state's economy and potential for economic growth, but policy decisions are an important piece of the puzzle, and one that lawmakers can control. Through statistical and anecdotal evidence, "Rich States, Poor States" makes a compelling case that pro-growth tax and fiscal policy is what really makes the difference for economic vitality in the states.
Crisis in State Spending Growth
Budget shortfalls plagued almost every state throughout and long after the 2008 recession. During the good times, states increased spending, created new spending programs, and made promises to state employees that are no longer sustainable.
Seven years after the Great Recession of 2008 and hundreds of billions in Keynesian "stimulus" later, the national outlook remains uneasy. As they say, bad federal news -- such as the $18 trillion national debt -- flows downhill. Further, even as the economic picture for some states has brightened, many states are facing budget problems and unfunded pension obligations as far as the eye can see.
The state budget crises following 2008 clearly were not caused by a shortfall of taxes. The Mercatus Center at George Mason University found from 2000 to 2009 alone, real state and local spending increased 90 percent faster than real private sector GDP. Unquestionably, these trends in state spending are unsustainable in the long term.
At the state level, there are no printing presses, and a vast majority of policymakers are required to balance their budgets, unlike the federal government. Therefore, taxes and spending remain two sides of the same fiscal coin. Most state policymakers cannot add a budget item without raising taxes or cutting spending elsewhere.
The solution needed for state budgets is simple. Lawmakers should approach the budget with priorities in mind, just like families and businesses do every month. Before increasing spending, some fundamental questions need to be asked:
- What is the role of government?
- What are the essential services governments must provide to fulfill their purpose?
- How will we know if the government is doing a good job?
- How much should all of this cost?
- When cuts must be made, how will they be properly prioritized?
In the end, the key to responsible budgeting involves exercising the ability to say "no" when necessary. Unless state leaders take the approach of prioritizing state spending, the years ahead will be dangerous for taxpayers.
Unfunded Pension Liabilities
Perhaps the most dangerous financial threat to states today is in the area of unfunded pension liabilities for government workers. To be sure, states face tremendously long odds to regain their economic footing after the economic downturn. Many states lost more than 20 percent of their entire asset portfolio during the market crash of 2008. Today, according to the nonpartisan State Budget Solutions, total unfunded pension liabilities equal nearly $5 trillion across the 50 states.
Unfortunately for pension reform advocates, states have kicked the can down the road for many years, refusing to make tough decisions and continuing to overpromise benefits. In many cases, powerful government employee unions have stopped meaningful reforms in their tracks. States that continue to carry unsustainable public pension obligations on their books create a major risk for taxpayers. Unless current pension plans are fixed, taxpayers will be on the hook for major tax increases in the future. Also, core public services could face devastating reductions due to the explosive growth of annual pension payments that crowd out other spending priorities.
One major challenge in pension policy is the lack of timely and accurate data. For far too long, elected officials have relied on unrealistic pension data based on faulty assumptions. While greatly outdated even at the time of release, government pension reports have misrepresented the actual financial obligations facing taxpayers. The lack of pension transparency has been caused, in large measure, by government accounting standards, which have been very "flexible" compared with private sector standards. States should adopt common-sense accounting standards, such as generally accepted accounting principles used by private sector firms. For instance, the true scope of unfunded liabilities is hidden from taxpayers and revolves around assumed rates of return for the investments made by pension funds. Most Americans have suffered some difficult investment losses in their 401(k) plans over the years. When states use an assumed rate of return of 8 percent or more to calculate their liabilities, as is the case in many states today, the crisis of pension liabilities is further hidden from public view.
The reform option most discussed by pension reform experts is transitioning away from the traditional, defined benefit plans into 401(k)-style, defined contribution plans for new government workers. Private sector employers moved in this direction years ago, and many acknowledge the defined benefit pension model is unaffordable for state taxpayers. A study by Robert Novy-Marx and Joshua Rauh, two pension reform experts, reports that -- absent reform -- the massive unfunded pension liabilities would require huge taxpayer contributions to bail out failing defined benefit plans. Their report notes that "the average immediate increase is $1,385 per household per year. In 12 states, the necessary immediate increase is more than $1,500 per household per year, and in five states it is at least $2,000 per household per year."
The good news, however, is that many states are recognizing fiscal reality and are looking at fundamental pension reform. Michigan, under the leadership of then-Gov. John Engler in the 1990s, and Utah's more recent reforms led by then-Sen. Dan Liljenquist, serve as models for pension reform. In 1997 Michigan enacted a reform that closed the state's defined benefit plan for new employees and set up 401(k)-style personal accounts. A recent actuarial analysis conducted for the Mackinac Center for Public Policy reported that the state has already saved nearly $4.3 billion, with the added benefit of workers having portable personal retirement assets.
In 2014 Oklahoma lawmakers also approved a pension reform plan to enroll most state workers hired on or after November 2015 into a 401(k)-style defined contribution pension plan. The Oklahoma plan effectively caps the unfunded liabilities associated with defined benefit plans and puts both state employees and the state's budget on a sustainable path for the future.
One of the greatest problems with defined benefit plans, outside of the numerous accounting difficulties outlined above, is the perverse incentive structure the plans provide for elected officials. It is astonishingly lucrative for elected officials to have the power to promise lavish future benefits upon government workers today, while not having to pay for them upfront. Therefore, the 401(k)-style reform may be the key to improving the political incentives for funding pensions, and in the process, solving this major crisis facing state taxpayers.
High-Tax States vs. Low-Tax States
Faced with these daunting fiscal circumstances, many states have taken the lead in identifying and implementing pro-growth economic policies and have mitigated the economic malaise. The research in "Rich States, Poor States" highlights how incentives matter for economic competitiveness, and how competitiveness drives income, population, and job growth in the states.
From Economics 101, we know that incentives matter. High taxes are a disincentive to economic activity and affect the economic opportunities available in all 50 states. All taxes affect incentives, but not all taxes are created equal. The research from "Rich States, Poor States" indicates personal and corporate income taxes are among the worst taxes for state growth. And according to a recent study by the OECD, taxes on capital and income are the most economically damaging, while taxes on consumption and property are less economically damaging.
Americans are voting with their feet, and very strongly against states with high taxes. Over the last decade, on net, more than 3.4 million Americans have moved out of one of the nine states with the highest personal income taxes: Kentucky, Maryland, Vermont, Minnesota, New Jersey, Oregon, Hawaii, New York, and California (where the average top marginal rate is an astonishing 10.39 percent). Conversely, more than 3.3 million Americans migrated to one of the nine states without a personal income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Put differently, every day on average -- weekends and holidays included -- 944 individuals left the high-income-tax states, nearly 40 an hour.
This mass exodus from high-tax states is certainly not a recent development. Every decade, states take population data from the census and redraw the lines for state legislative and congressional districts. For Washingtonians, this is when population gains and losses really matter. When you look at long-term population trends and how Americans continue to vote against the high-tax, big-government states, the consequences of poor policy are quite visible. For instance, it is hard to even fathom the fact that New York has lost 14 congressional seats since the census of 1960. However, one new development from the 2010 census was, for the first time in history, California did not gain a congressional seat. Meanwhile, Texas gained an incredible four new congressional seats.
The results are telling. The no-income-tax states outperform their high-tax counterparts across the board in gross state product growth, population growth, job growth, and, perhaps shockingly, even tax receipt growth. Over the past decade, the nine no-income-tax states, on average, saw 26.3 percent greater growth in economic output, 148.6 percent greater growth in population, and 81.7 percent faster revenue growth than the average of the nine states with the highest rates. While the highest-income-tax states experienced 4.58 percent growth in jobs, the no-income-tax states enjoyed double that rate of job growth at 9.61 percent.
Some wonder how the no-income-tax states could outperform their high-tax counterparts even with regard to revenue growth. However, this provides us with a useful lesson in supply-side economics and the Laffer curve. The no-income-tax states perform so well because they are setting pro-growth incentives, attracting new residents, and in the process, broadening their "base" of taxpayers. So as Texas gains enough new residents to fill its four new congressional districts, they don't pay an income tax, but they pay sales taxes, property taxes, and all the other taxes and fees levied by the state -- and the revenue pours in. Instead, the high-tax states are creating direct disincentives for investment and continue to hemorrhage taxpayers. Therefore, as they attempt to increase tax rates, investment flees and the state can rarely fully realize the revenue gains that are projected.
When talking about the damaging incentives put in place by income taxes, some quickly accuse tax reformers as just providing tax cuts for the rich. However, let us not forget that many small businesses pay these personal income taxes as subchapter S corporations, limited liability partnerships, and other passthrough entities. These small businesses make up more than 90 percent of all businesses, employ more than 50 percent of American workers, and pay more than 40 percent of all business taxes.
Some will also argue that high income taxes are necessary to ensure an undefined concept of tax "fairness." In reality, attempts to redistribute wealth through state tax codes fall flat on their faces nearly every time. Revenue officials in states like Maryland, New Jersey, and Oregon are frustrated as they have recently attempted to soak the "rich" but have fallen short with revenue collections as residents flee. There is no Berlin Wall preventing taxpayers from moving across state lines.
Some states have attempted to deny the link between taxes and growth publicly by keeping marginal tax rates high. However, to attract and keep businesses operating in their state, some states have taken up carving out special preferences in the tax code in an attempt to mitigate the drag on economic growth that high taxes represent. This tax cronyism is used by most states to some extent, but some far more than others. For instance, New York has handed out more than 50,000 grants to specific companies to keep or attract industry to one of the highest-taxed states in the union. Rather than pursue this carveout policy, states should look to reduce marginal tax rates as much as possible to create a level playing field in which businesses can compete for the patronage of customers.
People and businesses will continue to follow incentives and vote with their feet towards the states with the most competitive business climates -- a reality reflected best by the continued popularity of enacting tax relief in the states and the 2014 state-level election results. In our 2013 "Tax Cut Roundup" publication, we highlighted the 17 states that significantly reduced their tax burdens. In the 2014 election year, 14 states significantly reduced their tax burdens. This trend of states enacting tax relief measures should not come as a surprise given the breadth of evidence regarding how taxes negatively affect economic growth.
Another lesson on taxes from 2014 can be seen in the results from gubernatorial races around the country. Traditionally high-tax states have realized that continuing to grow government faster than the private sector and perpetually increasing taxes is unsustainable in the long term. Voters in Maryland, Illinois, and Massachusetts elected governors who campaigned on reducing or not increasing taxes. The incumbent governors in these states were notorious for enacting tax increases constantly and had to bear the consequences of the lackluster economy that their policies produced.
Because of our Founding Fathers' wisdom, Americans enjoy a 50-state free trade zone where individuals and businesses are able to conduct commerce and trade. States can, in part, affect their own destinies by the policies and incentives they choose to put in place. The actual performance of any state depends on many factors -- not just on what that specific state does. States do not enact policies in a vacuum.
When states like Arizona, Maine, and Oklahoma want to discuss options for eliminating their personal income taxes, it's no surprise that the debate spreads to Idaho, Nebraska, and Ohio. The beauty of the American experiment is that it allows states to choose which path they will follow. The choice is not a partisan one. As the great Ronald Reagan would say, the choice is not about Republican versus Democrat; the choice is between up or down for the future of our states.
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