State income taxes and economic growth.

• Author: Poulson, Barry W.

This article explores the impact of tax policy on economic growth in the states within the framework of an endogenous growth model. Regression analysis is used to estimate the impact of taxes on economic growth in the states from 1964 to 2004. The analysis reveals a significant negative impact of higher marginal tax rates on economic growth. The analysis underscores the importance of controlling for regressivity, convergence, and regional influences in isolating the effect of taxes on economic growth in the states.

Taxes and State Economic Growth

A number of studies have explored the impact of taxes on state economic growth. (1) Most, but not all, of these studies find evidence of a negative effect of taxes on various measures of state economic performance. A few studies have attempted to isolate the effect of state income taxes on economic growth. (2) Most of those studies find or no effects of average tax levels on income, but high marginal income tax rates appear to have a significant negative impact on income.

This article begins with the theoretical rationale for exploring the impact of taxes on state economic growth using an endogenous growth model. The next section explores empirical issues in the analysis of taxes on state economic growth. The final section reviews the empirical results. The evidence supports previous studies that find a significant negative impact of higher marginal tax rates on state economic growth. Further, the evidence shows that states with higher marginal income tax rates appear to be at a disadvantage in achieving higher rates of 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.

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.

Within the endogenous growth model framework, whether or not there is convergence in growth rates among the states is an empirical question. (4) Regression analysis is often used to test the relationship between steady state growth rates and initial income. (5) These regressions, referred to as "Barro regressions," test the convergence hypothesis. Recent regression studies for the states reveal a negative correlation between growth rates and initial income (see Besci 1996). (6) This evidence of convergence in growth rates is significant even when other exogenous factors that influence growth rates are introduced in the regression analysis.

The regression test for convergence has been criticized in the economies literature. In particular, critics argue that Barro regressions cannot determine whether the states are converging toward a single steady state growth rate or whether individual states are converging toward unique steady state growth rates--that is, conditional convergence.

What is important for our study is that this type of regression analysis is particularly well suited to exploring the impact of policy variables, such as tax policy, on growth rates in the states. In an early study of this issue Yu, Wallace, and Nardinelli (1991) found evidence that convergence is the most powerful explanation for differential growth rates in the states. Their regression analysis revealed that convergence effects dominate tax policy and other variables in determining state economic growth. More recent studies, however, have found that even when convergence effects are accounted for, tax policy significantly 'affects state economic growth (Besci 1996, Crain and Lee 1999, Crain 2003). These studies control for the effect of convergence on economic growth in the states in order to isolate the effect of taxes. The assumption is that when states begin with lower levels of income per capita they will experience higher rates of economic growth. In the absence of barriers to the mobility of factors of production, income per capita in lower income states will tend to converge with that of higher income states. To control for the effects of convergence, a variable for the initial level of real per capita personal income (RPCP) is incorporated in the regression analysis used in this article.

Regional Factors

As Holcombe and Lacombe (2004) point out, a problem with all cross-section studies of the effect of taxes on state economic growth is that it is difficult to control for geographically related differences among states. To address that issue, they use a border county technique.

The hypothesis of regional influences on economic growth in the United States extends back to the early work of Turner (1920) on the role of the frontier in economic growth. Richard Easterlin (1960) provided an empirical foundation for regional influences on the growth of individual states. Implicit in Easterlin's analysis is an exogenous growth model with long-run convergence of income per capita in the states.

Easterlin traced the historical patterns of economic growth in individual states. He found evidence that frontier states with higher levels of income per capita attracted labor and capital from older states with lower levels of income per capita. The frontier states experienced more rapid rates of economic growth, until their income per capita converged toward the national average. This pattern of convergence was repeated as each new frontier region opened up and the population expanded westward.

One could argue that this "frontier thesis" may explain growth patterns of states in the...