Tag Archives: tax rates

Does the New Markets Tax Credit Program work?

Location-based programs that provide tax credits to firms and investors that locate in particular areas are popular among politicians of both parties. Democrats tend to support them because they are meant to revitalize poorer or rural areas. In a recent speech about the economy, presumed Democratic nominee Hillary Clinton spoke favorably about two of them: the New Markets Tax Credit Program and Empowerment Zones.

Some Republicans also support such programs, which they view as being a pro-business way to help low-income communities. However, House Speaker Paul Ryan’s recent tax reform blueprint generally disapproves of tax credit programs.

Due to the volume of location-based programs and their relatively narrow objectives, many taxpayers are unfamiliar with their differences or unaware that they even exist. This is to be expected since most people are never directly affected by one. In this post I explain one that Hillary Clinton recently spoke about, the New Markets Tax Credit (NMTC) program.

The NMTC program was created in 2000 as part of the Community Renewal Tax Relief Act. It is managed by the Community Development Financial Institutions Fund, which is a division of the U.S. Treasury Department.

The NMTC program provides both new and established businesses with a tax credit that can be used to offset the costs of new capital investment or hiring new workers. The goal is to increase investment in low income communities (LIC) in order to improve the economic outcomes of residents.

Even though the program was started in 2000, no funds were issued to investors until 2003 (although some funds were allocated to the program in 2001 and 2002). Since 2001 over $43 billion has been allocated to the program. The figure below shows the allocations by year, amount issued to investors, and the total amount allocated from 2001 – 2014 (orange bar, uses right axis).

NMTC allocations

Figure 1

Practically all of the allocated funds from 2001 to 2012 have been issued to investors. A little over $250 million remains from 2013 and $1.3 billion from 2014. As the figure makes clear, this program controls a non-trivial amount of money.

The types of projects funded by the NMTC program can be seen in the figure below. The data for this figure comes from a 2013 Urban Institute report.

NMTC projects funded

Figure 2

So what have taxpayers gotten for their money? The program’s ‘fact sheet’ asserts that since 2003 the program has

“…created or retained an estimated 197,585 jobs. It has also supported the construction of 32.4 million square feet of manufacturing space, 74.8 million square feet of office space, and 57.5 million square feet of retail space.”

Like many government program administrators, those running the NMTC program seem to confuse outputs with outcomes. Presumably the goal of the NMTC program is not to build office space, which is a trivial achievement, but to improve the lives of the people living in low income communities. In fact, the program’s fact sheet also states that

“Investments made through the NMTC Program are used to finance businesses, breathing new life into neglected, underserved low-income communities.”

What really matters is whether the program has succeeded at “breathing new life” into LICs. To answer this more complicated question one needs to examine the actual economic outcomes in areas receiving the credits in order to determine whether they have improved relative to areas that haven’t received the credits. Such an exercise is not the same thing as simply reporting the amount of new office space.

That being said, even the simpler task of measuring new office space or counting new jobs is harder than it first appears. It’s important for program evaluators and the taxpayers who fund the program to be aware of the reasons that either result could be speciously assigned to the tax credit.

First, the office space or jobs might have been added regardless of the tax credit. Firms choose locations for a variety of reasons and it’s possible that a particular firm would locate in a particular low income community regardless of the availability of a tax credit. This could happen for economic reasons—the firm is attracted by the low price of space or the location is near an important supplier—or the location has sentimental value e.g. the firm owner is from the neighborhood.

A second reason is that the firms that locate or expand in the community might do so at the expense of other firms that would have located there absent the tax credit. For example, suppose the tax credit attracts a hotel owner who due to the credit finds it worthwhile to build a hotel in the neighborhood, and that this prevents a retail store owner from locating on the same plot of land, even though she would have done so without a credit.

The tax credit may also mistakenly appear to be beneficial if all it does is reallocate investment from one community to another. Not all communities are eligible for these tax credits. If a firm was going to locate in a neighboring community that wasn’t eligible but then switched to the eligible community upon finding out about the tax credit then no new investment was created in the city, it was simply shifted around. In this scenario one community benefits at the expense of another due to the availability of the tax credit.

A new study examines the NMTC program in order to determine whether it has resulted in new employment or new businesses in eligible communities. It uses census tract data from 2002 – 2006. In order to qualify for NMTCs, a census tract’s median family income must be 80% or less of its state’s median family income or the poverty rate of the tract must be over 20%. (There are two other population criteria that were added in 2004, but according to the study 98% qualify due to the income or poverty criterion.)

The authors use the median income ratio of 0.8 to separate census tracts into a qualifying and non-qualifying group, and then compare tracts that are close to and on either side of the 0.8 cutoff. The economic outcomes they examine are employment at new firms, number of new firms, and new employment at existing firms.

They find that there was less new employment at new firms in NMTC eligible tracts in the transportation and wholesale industries but more new employment in the retail industry. Figure 2 shows that retail received a relatively large portion of the tax credits. This result shows that the tax credits helped new retail firms add workers relative to firms in transportation and manufacturing in eligible census tracts.

The authors note that the magnitude of the effects are small—a 0.2% increase in new retail employment and a 0.12% and 0.41% decrease in new transportation and wholesale employment respectively. Thus the program had a limited impact during the 2002 – 2006 period according to this measure, despite the fact that nearly $8 billion was granted to investors from 2002 – 2005.

The authors find a similar result when examining new firms: Retail firms located in the NMTC eligible tracts while services and wholesale firms did not. Together these two results are evidence that the NMTC does not benefit firms in all industries equally since it causes firms in different industries to locate in different tracts. The latter result also supports the idea that firms that benefit most from the tax credit crowd out other types of firms, similar to the earlier hotel and retail store example.

Finally, the authors examined new employment at existing firms. This result is more favorable to the program—an 8.8% increase in new employment at existing manufacturing firms and a 10.4% increase at retail firms. Thus NMTCs appear to have been primarily used to expand existing operations.

But while there is evidence that the tax credit slightly increased employment, the authors note that due to the limitations of their data they are unable to conclude whether the gains in new employment or firms was due to a re-allocation of economic activity from non-eligible to eligible census tracts or to actual new economic activity that only occurred because of the program. Thus even the small effects identified by the authors cannot be conclusively considered net new economic activity generated by the NMTC program. Instead, the NMTC program may have just moved economic activity from one community to another.

The mixed results of this recent study combined with the inability to conclusively assign them to the NMTC program cast doubt on the programs overall effectiveness. Additionally, the size of the effects are quite small. Thus even if the effects are positive once crowding out and reallocation are taken into account, the benefits still may fall short of the $43.5 billion cost of the program (which doesn’t include the program’s administrative costs).

An alternative to location-based tax credit programs is to lower tax rates on businesses and investment across the board. This would remove the distortions that are inherent in location-based programs that favor some areas and businesses over others. It would also reduce the uncertainty that surrounds the renewal and management of the programs. Attempts to help specific places are often unsuccessful and give residents of such places false hope that community revitalization is right around the corner.

Tax credits, despite their good intentions, often fail to deliver the promised benefits. The alternative—low, stable tax rates that apply to all firms—helps create a business climate that is conducive to long-term planning and investment, which leads to better economic outcomes.

Does Tax Increment Financing (TIF) generate economic development?

Tax increment financing, or TIF, is a method of financing economic development projects first used in California in 1952. Since then, 48 other states have enacted TIF legislation with Arizona being the lone holdout. It was originally conceived as a method for combating urban blight, but over time it has become the go-to tool for local politicians pushing economic development in general. For example, Baltimore is considering using TIF to raise $535 million to help Under Armor founder Kevin Plank develop Port Covington.

So how does TIF work? Though the particulars can vary by state, the basic mechanism is usually similar. First, an area is designated as a TIF district. TIF districts are mostly industrial or commercial areas rather than residential areas since the goal is to encourage economic development.

Usually, in an effort to ensure that TIF is used appropriately, the municipal government that designates the area as a TIF has to assert that economic development would not take place absent the TIF designation and subsequent investment. This is known as the ‘but-for’ test, since the argument is that development would not occur but for the TIF. Though the ‘but-for’ test is still applied, some argue that it is largely pro forma.

Once an area has been designated as a TIF district, the property values in the area are assessed in order to create a baseline value. The current property tax rate is applied to the baseline assessed value to determine the amount of revenue that is used for the provision of local government goods and services (roads, police, fire, water etc.). This value will then be frozen for a set period of time (e.g. up to 30 years in North Carolina), and any increase in assessed property values that occurs after this time and the subsequent revenue generated will be used to pay for the economic development project(s) in the TIF district.

The key idea is that municipalities can borrow against the projected property value increases in order to pay for current economic development projects. A simple numerical example will help clarify how TIF works.

In the table below there are five years. In year 1 the assessed value of the property in the TIF district is $20 million and it is determined that it takes $1 million per year to provide the government goods and services needed in the area (road maintenance, sewage lines, police/fire protection, etc.). A tax rate of 5% is applied to the $20 million of assessed value to raise the necessary $1 million (Tax revenue column).

TIF example table

The municipality issues bonds totaling $1 million to invest in an economic development project in the TIF district. As an example, let’s say the project is renovating an old business park in order to make it more attractive to 21st century startups. The plan is that improving the business park will make the area more desirable and increase the property values in the TIF district. As the assessed value increases the extra tax revenue raised by applying the 5% rate to the incremental value of the property will be used to pay off the bonds (incremental revenue column).

Meanwhile, the $1 million required for providing the government goods and services will remain intact, since only the incremental increase in assessed value is used to pay for the business park improvements. Hence the term Tax Increment Financing.

As shown in the table, if the assessed value of the property increases by $2 million per year for 4 years the municipality will recoup the $1 million required to amortize the bond (I’m omitting interest to keep it simple). Each $1 million dollars of increased value increase tax revenue by $50,000 without increasing the tax rate, which is what allows the municipality to pay for the economic development without raising property tax rates. For many city officials this is an attractive feature since property owners usually don’t like tax rate increases.

City officials may also prefer TIF to the issuance of general obligation bonds since the latter often require voter approval while TIF does not. This is the case in North Carolina. TIF supporters claim that this gives city officials more flexibility in dealing with the particular needs of development projects. However, it also allows influential individuals to push TIF through for projects that a majority of voters may not support.

While TIF can be used for traditional government goods like roads, sewer systems, water systems, and public transportation, it can also be used for private goods like business parks and sports facilities. The former arguably provide direct benefits to all firms in the TIF district since better roads, streetscapes and water systems can be used by any firm in the area. The latter projects, though they may provide indirect benefits to nearby firms in the form of more attractive surroundings and increased property values, mostly benefit the owners of entity receiving the development funding. Like other development incentives, TIF can be used to subsidize private businesses with taxpayer dollars.

Projects that use TIF are often described as ‘self-financing’ since the project itself is supposedly what creates the higher property values that pay for it. Additionally, TIF is often sold to voters as a way to create jobs or spur additional private investment in blighted areas. But there is no guarantee that the development project will lead to increased private sector investment, more jobs or higher property values. Researchers at the UNC School of Government explain the risks of TIF in a 2008 Economic Bulletin:

“Tax increment financing is not a silver bullet solution to development problems. There is no guarantee that the initial public investment will spur sufficient private investment, over time, that creates enough increment to pay back the bonds. Moreover, even if the investment succeeds on paper, it may do so by “capturing” growth that would have occurred even without the investment. Successful TIF districts can place an additional strain on existing public resources like schools and parks, whose funding is frozen at base valuation levels while growth in the district increases demand for their services.”

The researchers also note that it’s often larger corporations that municipalities are trying to attract with TIF dollars, and any subsidies via TIF that the municipality provides to the larger firm gives it an advantage over its already-established, local competitors. This is even more unfair when the local competitor is a small, mom-and-pop business that already faces a difficult challenge due to economies of scale.

There is also little evidence that TIF regularly provides the job or private sector investment that its supporters promise. Chicago is one of the largest users of TIF for economic development and its program has been one of the most widely studied. Research on Chicago’s TIF program found that “Overall, TIF failed to produce the promise of jobs, business development or real estate activity at the neighborhood level beyond what would have occurred without TIF.”

If economic development projects that rely on TIF do not generate additional development above and beyond what would have occurred anyway, then the additional tax revenue due to the higher assessed values is used to pay for an economic development project that didn’t really add anything. Without TIF, that revenue could have been used for providing other government goods and services such as infrastructure or better police and fire protection. Once TIF is used, the additional revenue must be used to pay for the economic development project: it cannot be spent on other services that residents might prefer.

Another study, also looking at the Chicago metro area, found that cities that adopt TIF experience slower property value growth than those that do not. The authors suggest that this is due to a reallocation of resources to TIF districts from other areas of the city. The result is that the TIF districts grow at the expense of the municipality as a whole. This is an example of the TIF working on paper, but only because it is pilfering growth that would have occurred in other areas of the city.

Local politicians often like tax increment financing because it is relatively flexible and enables them to be entrepreneurial in some sense: local officials as venture capitalists. It’s also an easier sell than a tax rate increase or general obligation bonds that require a voter referendum.

But politicians tend to make bad venture capitalists for several reasons. First, it’s usually not their area of expertise and it’s hard: even the professionals occasionally lose money. Second, as Milton Friedman pointed out, people tend to be more careless when spending other people’s money. Local officials aren’t investing their own money in these projects, and when people invest or spend other people’s money they tend to emphasize the positive outcomes and downplay the negative ones since they aren’t directly affected. Third, pecuniary factors don’t always drive the decision. Different politicians like different industries and businesses – green energy, biotech, advanced manufacturing, etc. – for various reasons and their subjective, non-pecuniary preferences may cause them to ignore the underlying financials of a project and support a bad investment.

If TIF is going to be used it should be used on things like public infrastructure – roads, sewer/water lines, sidewalks – rather than specific private businesses. This makes it harder to get distracted by non-pecuniary factors and does a better – though not perfect – job of directly helping development in general rather than a specific company or private developer. But taxpayers should be aware of the dangers of TIF and politicians and developers should not tout it as a panacea for jump-starting an area’s economy.

The Economics of Regulation Part 3: How to Estimate the Effect of Regulatory Accumulation on the Economy? Exploring Endogenous Growth and Other Models

This post is the third part in a three part series spurred by a recent study by economists John Dawson and John Seater that estimates that the accumulation of federal regulation has slowed economic growth in the US by about 2% annually.  The first part discussed generally how Dawson and Seater’s study and other investigations into the consequences of regulation are important because they highlight the cumulative drag of our regulatory system. The second part went into detail on some of the ways that economists measure regulation, highlighting the strengths and weaknesses of each.  This post – the final one in the series – looks at how those measures of regulation are used to estimate the consequences of regulatory policy.  As always, economists do it with models.  In the case of Dawson and Seater, they appeal to a well-established family of endogenous growth models built upon the foundational principle of creative destruction, in the tradition of Joseph Schumpeter.

So, what is an endogenous growth model?

First, a brief discussion of models:  In a social or hard science, the ideal model is one that is useful (applicable to the real world using observable inputs to predict outcomes of interest), testable (predictions can be tested with observed outcomes), flexible (able to adapt to a wide variety of input data), and tractable (not too cumbersome to work with).  Suppose a map predicts that following a certain route will lead to a certain location.  When you follow that route in the real world, if you do not actually end up at the predicted location, you will probably stop using that map.  Same thing with models: if a model does a good job at predicting real world outcomes, then it sticks around until someone invents one that does an even better job.  If it doesn’t predict things well, then it usually gets abandoned quickly.

Economists have been obsessed with modeling the growth of national economies at least since Nobel prize winner Simon Kuznets began exploring how to measure GDP in the 1930s.  Growth models generally refer to models that try to represent how the scale of an economy, using metrics such as GDP, grows over time.  For a long time, economists relied on neoclassical growth models, which primarily use capital accumulation, population growth, technology, and productivity as the main explanatory factors in predicting the economic growth of a country. One of the first and most famous of such economic growth models is the Solow model, which has a one-to-one (simple) mapping from increasing levels of the accumulated stock of capital to increasing levels of GDP.  In the Solow model, GDP does not increase at the same rate as capital accumulation due to the diminishing marginal returns to capital.  Even though the Solow model was a breakthrough in describing the growth of GDP from capital stock accumulation, most factors in this growth process (and, generally speaking, in the growth processes of other models in the neoclassical family of growth models) are generated by economic decisions that are outside of the model. As a result, these factors are dubbed exogenous, as opposed to endogenous factors which are generated inside of the model as a result of the economic decisions made by the actors being modeled.

Much of the research into growth modeling over the subsequent decades following Solow’s breakthrough has been dedicated to trying to “endogenize” those exogenous forces (i.e. move them inside the model). For instance, a major accomplishment was endogenizing the savings rate – how much of household income was saved and invested in expanding firms’ capital stocks. Even with this endogenous savings rate, as well as exogenous growth in the population providing labor for production, the accumulating capital stocks in these neoclassical growth models could not explain all of the growth in GDP. The difference, called the Solow Residual, was interpreted as the growth in productivity due to technological development and was like manna from heaven for the actors in the economy – exogenously growing over time regardless of the decisions made by the actors in the model.

But it should be fairly obvious that decisions we make today can affect our future productivity through technological development, and not just through the accumulation of capital stocks or population growth. Technological development is not free. It is the result of someone’s decision to invest in developing technologies. Because technological development is the endogenous result of an economic decision, it can be affected by any factors that distort the incentives involved in such investment decisions (e.g., taxes and regulations). 

This is the primary improvement of endogenous growth theory over neoclassical growth models.  Endogenous growth models take into account the idea that innovative firms invest in both capital and technology, which has the aggregate effect of moving out the entire production possibilities curve.  Further, policies such as increasing regulatory restrictions or changing tax rates will affect the incentives and abilities of people in the economy to innovate and produce.  The Dawson and Seater study relies on a model originally developed by Pietro Peretto to examine the effects of taxes on economic growth.  Dawson and Seater adapt the model to include regulation as another endogenous variable, although they do not formally model the exact mechanism by which regulation affects investment choices in the same way as taxes.  Nonetheless, it’s perfectly feasible that regulation does affect investment, and, to a degree, it is simply an empirical question of how much.

So, now that you at least know that Dawson and Seater selected an accepted and feasible model—a model that, like a good map, makes reliable predictions about real world outcomes—you’re surely asking how that model provided empirical evidence of regulation’s effect on economic growth.  The answer depends on what empirical means.  Consider a much better established model: gravity.  A simple model of gravity states that an object in a vacuum near the Earth’s surface will accelerate towards the Earth at 9.81 meters per second squared. On other planets, that number may be higher or lower, depending on the planet’s massiveness and the object’s distance from the center of the planet.  In this analogy, consider taxes the equivalent of mass – we know from previous endogenous growth models that taxes have a fairly known effect on the economy, just like we know that mass has a known effect on the rate of acceleration from gravitational forces.  Dawson and Seater have effectively said that regulations must have a similar effect on the economy as taxes.  Maybe the coefficient isn’t 9.81, but the generalized model will allow them to estimate what that coefficient is – so long as they can measure the “mass” equivalent of regulation and control for “distance.”  They had to rely on the model, in fact, to produce the counterfactual, or to use a term from science experiments, a control group.  If you know that mass affects acceleration at some given constant, then you can figure out what acceleration is for a different level of mass without actually observing it.  Similarly, if you know that regulations affect economic growth in some established pattern, then you can deduce what economic growth would be without regulations.  Dawson and Seater appealed to an endogenous growth model (courtesy of Perreto) to simulate a counterfactual economy that maintained regulation levels seen in the year 1949.  By the year 2005, that counterfactual economy had become considerably larger than the actual economy – the one in which we’ve seen regulation increase to include over 1,000,000 restrictions.

New York’s Population Challenge

Last week at City Journal, Aaron Renn explored the New York region’s loss of domestic residents since 2000. He demonstrates that one of the world’s economic powerhouses is falling victim to the trend of domestic outmigration that New York state is seeing. Between 2000 and 2010, the New YOrk region lost 2 million domestic residents and they took with them billions of dollars of income. In Freedom in the 50 States, Will Ruger and Jason Sorens rank New York as the country’s least-free state based on its regulatory and tax regimes. They point to its tax burden — the highest in the nation —  and indebtedness as a factors contributing to the state losing 9-percent of its domestic population on net since 2000. Renn also posits that high tax rates are a leading cause for residents leaving New York City, many of them moving to Sun Belt states.

While the New York City region is only maintaining a positive population growth rate through births and international immigration, it’s far from the case that no one is willing to suffer its high tax rates in exchange for the city’s economic dynamism and cultural amenities. Rather the city’s exorbitant rental rates demonstrate that millions of people are willing to pay a premium to live in the region in spite of city and state policies that hamper economic development.  The vacancy rate for apartments is below 2-percent, well under many estimates for the natural vacancy rate. While lower taxes at the state and municipal levels in the New York region would reduce the flow of domestic outmigration at the margin, they would also increase competition for the city’s coveted apartments.

Are New York City’s amenities so desirable that its policymakers don’t need to worry about losing more residents to other states than they’re gaining? Its own not-so-distant history indicates that even the Big Apple is susceptible to the ravages of population loss. From 1950 to 1980, the city’s population fell from 7.9 million to 7 million, with most of that loss occurring in the 1970s. This time period corresponded with sharp increases in crime and the city’s famous default. These are predictable consequences of urban population decline, particularly in indebted cities where a decrease in tax base equates with inability to meet obligations to creditors .

While pursuing policy reforms designed to boost the state’s competitive standing to attract businesses and residents is a key piece of ensuring the city does not fall prey to population exodus, perhaps most importantly, city policymakers should examine their land use restrictions that limit would-be residents from moving to the city. Over the past decade, New York’s housing stock has grown only 5.3% in the face of the highest rental rates in the country for much of this time period. Historic preservation, density restrictions, and an onerous review process prevent the city’s housing stock from growing to meet demand.

Renn points out that most of New York’s domestic inmigration comes from midwestern cities and college towns across the country. Presumably many of these new residents are early in their careers and are on the margin of being able to afford New York rents. If New York housing were more attainable, more American young people would select the city as the starting place for their careers and it would attract more of the foreign immigrants essential to maintaining the city’s diversity and innovation. Ed Glaeser explains that those states that are successfully attracting more residents, like Texas and Georgia, are also those in which developers are able to build more housing with fewer restrictions. By allowing more housing in New York City and the surrounding areas, policymakers would both protect their tax base and help to maintain the city as a center of innovation and economic growth. In their effort to retain citizens — and particularly high-income retirees — New York City and New York state policymakers will need to revisit their punishing tax schemes. But at least as importantly they should focus on allowing those residents who would like to move to the city for economic and cultural opportunities to be able to afford to do so.

 

 

 

 

What would real reform in Virginia look like?

A couple of months ago, I blogged about Virginia Governor Bob McDonnell and the gifts he and his family have received from businessman Jonnie Williams, Jr. The comments were eventually picked up by journalist Katie Watson, first in a column and then in an interview with the local CBS affiliate. Eventually the Richmond Times Dispatch invited me to turn the blog into an OpEd and this last Sunday Bart Hinkle of the Dispatch elaborated on the point in an excellent post. I suspect many readers will agree that Hinkle made the point far more eloquently than I:

Many have wondered why McDonnell, otherwise a paragon of rectitude, would take such swag. But nobody has asked why Williams would give it — because the answer is obvious. Star Scientific has not made a profit in a decade. But it might, if the governor were to place the weight of the state on the economic scales.…Virginia’s governor has a lot of quo to give whether or not he takes a fistful of quid.

Image by hin255

Image by hin255

 

In my view, Virginians need to think as constructively as possible about the sorts of reforms that would prevent scandals like this from happening in the future. Unfortunately, my guess is that the political response will focus—to use Hinkle’s words—on the quid and not on the quo. I believe this would be a huge missed opportunity.

In Virginia, gifts to public officials valued at $50 or more are permitted but must be disclosed, while gifts of any value to family members of public officials are permitted and do not need to be disclosed at all. Just about every article I’ve read on the matter emphasizes this point and I’d guess that a number of legislators are busy drawing up bills to change these laws as I type. For his part, the governor himself has indicated an interest in changing the ethics laws, though he’s offered no specifics.

It’s understandable that this is peoples’ first instinct: If business owners are giving money to elected officials and their family members in return for special treatment from government, it seems only natural that there ought to be a law forbidding such gifts to elected officials and their families. I’m not opposed to such laws per se. But it would be a mistake to think that they are going to solve the problem.

Water flows downhill. And as long as elected officials are expected to dole out lucrative privileges to particular firms, particular firms will want to play in the political sandbox.

Even if Virginia adopted a complete ban on all gifts of any size to elected officials and their family members, I predict firms and their leaders would still donate to political action committees, they’d endorse candidates, they’d sponsor third-party political advertisements, they’d organize get-out-the-vote efforts, and they’d host fundraisers and campaign events. In an endless game of whack-a-mole, reformers could no doubt try to curtail these efforts too (with the First Amendment a likely casualty). But so long as businesses face such lucrative incentives to play politics, the reformers will always be one step behind.

A better—more permanent, and more direct—reform would strike at the heart of the quid-pro-quo problem. It would limit the government’s ability to favor particular firms in the first place. This would require the elimination of all targeted tax exemptions and credits. The state could then use the extra money obtained from closing loopholes to lower its corporate and individual tax rates. The state would also need to eliminate all programs that make grants or loans to particular firms (you can see a listing of such programs here).

In one fell swoop, these types of reforms would instantly remove the incentive for firms to seek the favor of politicians. These reforms would also improve the economic climate of Virginia. Without government assistance, industries would be more competitive, lowering their prices and improving the quality of their products. Firms would pay more attention to trends in customer desires rather than political trends. This would help ensure that labor and capital would be allocated on the basis of genuine costs and benefits rather than political costs and benefits. And millions of dollars that are now wasted in seeking government-granted privilege could be put to more valuable uses.

This does not mean that the state would be powerless to entice firms to relocate here. Governors, legislators, and mayors across the state could and should work to make sure that Virginia’s tax and regulatory regimes are the least burdensome in the nation. Elected officials (and their spouses) could and should tout the state’s superior business climate.

And one of their talking points would be the fact that all businesses in Virginia get the same fair shake, whether they donate to politicians or not.

Are High Taxes on Smokeless Tobacco Encouraging People to Smoke?

President Obama’s recent budget proposal to pay for pre-school programs by increasing cigarette taxes highlights the confusion both on federal and state levels over taxing tobacco products. A recent Mercatus working paper questions the efficiency and utility of sin taxes in general. But even more fundamentally, tobacco tax policy may fail in its primary goal, which is to reduce the health risks of consuming tobacco.

Since the goal of tobacco taxes is to reduce tobacco’s harms by discouraging its use, the tax rates on various tobacco products should be commensurate with their health risks. If smoking carries four times higher cancer risks than using smokeless tobacco, then the tax rates on cigarettes should be four times higher than taxes on, for example, smokeless tobacco. Yet if cigarettes are taxed at a lower rate than this ratio, the policy may in fact encourage tobacco users to smoke as opposed to using less harmful smokeless tobacco.

A health policy that does not encourage riskier tobacco products should set the ratio of smokeless tobacco and cigarette taxes similar to their health risk ratios. According to a recent review of medical studies, snus (a common type of smokeless tobacco) users face considerably lower oral cancer, gastric cancer and cardiovascular disease risks compared to smokers (see Table 1). In addition, other studies found that, unlike smoking, snus does not lead to lung cancer (the table shows the lung cancer risk for nonsmokers compared to smokers). Importantly, snus users do not expose those around them to second hand smoking, further limiting its negative health impacts. Based on the relative health risks, snus taxes should be considerably lower than cigarette taxes.

Table 1. Comparative Health Risks

Health Risk Risk Ratio (Snus users vs. Smokers)
Oral Cancer 0.43
Gastric Cancer 0.60
Cardiovascular Diseases 0.55
Lung Cancer 0.14

So how do states fare? Table 2 shows the tax rates for cigarettes and smokeless tobacco for select states, which are calculated based on the data are from Tobacco Free Kids campaign (in the source, the tax rates are per ounce of snus and per pack of cigarettes). To make sure that we compare apples to apples, I account for the varying nicotine content in these products. According to a recent study, consuming one gram of snus delivers nicotine content equal to smoking a cigarette. That works out to about a can of snus (typically 1.2 oz) replacing approximately 35 cigarettes (almost two packs). So I convert state taxes to show rates per equivalent nicotine amounts. For simplicity, I focus only on the states that tax smokeless tobacco by ounce. Other states tax smokeless tobacco based on either wholesale or manufacturing prices rather than retail, making calculations trickier.

The relative cancer and cardiovascular disease risks of snus are lower than the risks of smoking, ranging between 0.14 and 0.6 (see Table 1). States with a high snus to cigarette tax ratio are essentially pushing tobacco users towards smoking, which carries higher health risks (coded red in the table). States with a moderate tax ratio are somewhat neutral (coded yellow). Their tax ratio is commensurate with relative health risks for some but not all risk sources. Finally, states with a low tax ratio generally encourage tobacco consumers to use a safer product (coded green).

Table 2. State Tobacco Taxes for Equivalent Nicotine Content

State Snus Tax (gram) Cigarette Tax (cigarette) Tax Ratio (Snus/Cigarette)
Arizona $0.01 $0.10 7.88%
Connecticut $0.04 $0.17 20.75%
Delaware $0.02 $0.08 23.81%
District of Columbia $0.03 $0.13 21.16%
Illinois $0.01 $0.10 10.69%
Iowa $0.04 $0.07 61.73%
Maine $0.07 $0.10 71.25%
Montana $0.03 $0.09 35.27%
Nebraska $0.02 $0.03 48.50%
New Jersey $0.03 $0.14 19.60%
New York $0.07 $0.22 32.44%
North Dakota $0.02 $0.02 96.20%
Oregon $0.06 $0.06 106.42%
Rhode Island $0.04 $0.17 20.39%
Texas $0.04 $0.07 59.54%
Vermont $0.07 $0.13 50.35%
Washington $0.09 $0.15 58.91%
Wyoming $0.02 $0.03 70.55%

Note: snus and cigarette taxes are rounded to nearest cent. The tax ratio is based on actual tax values.

The picture that emerges from the table is that of a confused health policy pursued by the states. Only two states in the list set the snus and cigarette tax rates at the level that does not steer consumer towards riskier tobacco products. Most states set the tax rates at levels that are commensurate with some risks but not the others. Specifically, most states do not account for the fact that snus does not cause lung cancer, which is one of the greatest risks of smoking. Finally, a few states may be steering tobacco users towards cigarettes by setting snus taxes too high (or cigarette taxes too low).

I am not claiming that smokeless tobacco is harmless or that states should promote smokeless tobacco as a substitute for cigarettes. As the National Cancer Institute points out, smokeless tobacco is not a safe alternative to smoking. It still carries increased health risks, including certain types of cancer and cardiovascular diseases. But current policy on tobacco taxes may result in the unintended consequence of pushing tobacco users away from less risky forms of tobacco towards riskier ones.

A time when politicians tried to coax ‘the opposition’ to their view

Rostenkowski,danOn May 28, 1986, Ronald Reagan delivered an Oval Office speech calling for tax reform: a revenue-neutral plan to reduce marginal tax rates and close scores of loopholes that privileged particular firms, industries, and individuals. The Great Communicator lived up to his reputation, delivering a flawless speech that somehow managed to evoke lofty images (“Two centuries later, a second American revolution for hope and opportunity is gathering force again”) and yet grounded these images in relatable prose (“No other issue will have more lasting impact on the well-being of your families and your future.”)

Democratic House Speaker Tip O’Neill asked Ways and Means Chairman Dan Rostenkowski to deliver the Democratic response. The choice was controversial. Over the previous five years, the Democrats had flopped in just about every one of their responses to the president. Rostenkowski, famous for his mumbled delivery and mixed metaphors, seemed unlikely to do any better. Here is what the congressman said:

Good evening, I’m Dan Rostenkowski from Chicago. Let me read you something that pretty well explains what tax reform is all about, and what Democrats are all about.

[Reading from a book] “The continued escape of privileged groups from taxation violates the fundamental democratic principle of fair treatment for all and undermines public confidence in the tax system.” That was Harry Truman’s message to Congress thirty-five years ago.

Trying to tax people fairly: That’s been the historic Democratic commitment. Our roots lie with working families all over the country, like the Polish neighborhood I grew up in on the northwest side of Chicago. Most of the people in my neighborhood worked hard in breweries, steel mills, packing houses; proud families who lived on their salaries. My parents and grandparents didn’t like to pay taxes. Who does? But like most Americans they were willing to pay their fair share as the price for a free country where everyone could make their own breaks.

Every year politicians promise to make the tax code fair and simple, but every year we seem to slip further behind. Now most of us pay taxes with bitterness and frustration. Working families file their tax forms with the nagging feeling that they’re the biggest suckers and chumps in the world. Their taxes are withheld at work, while the elite have enormous freedom to move their income from one tax shelter to another. That bitterness is about to boil over. And it’s time it did.

But this time there’s a difference in the push for tax reform. This time, it’s a Republican president who’s bucking his party’s tradition as protectors of big business and the wealthy. His words and feelings go back to Roosevelt and Truman and Kennedy. But the commitment comes from Ronald Reagan and that’s so important and so welcome.

Because, if the president’s plan is everything he says it is, he’ll have a great deal of Democratic support. That’s the real difference this time. A Republican president has joined the Democrats in Congress to try to redeem this long-standing commitment to a tax system that’s simple and fair. If we work together with good faith and determination, this time the people may win. This time I really think we can get tax reform.

Then, he asked the audience to send letters of support:

Even if you can’t spell Rostenkowski, put down what they used to call my father and grandfather—Rosty. Just address it to R-0-S-T-Y, Washington, D.C. The post office will get it to me. Better yet, write your representative and your senator. And stand up for fairness and lower taxes.

This account comes from Jeffrey Birnbaum and Alan Murray’s classic history of the 1986 tax reform, Showdown at Gucci Gulch. They write:

When the speech was over, and the microphones were turned off, the camera crew did something Rothstein [Rostenkowski’s media consultant] had not seen before: they broke into applause. “That was my first clue we hit it over the fence,” Rothstein says.

The second clue was an ecstatic call from the White House. The third was the incredible response from the American people who deluged Washington with more than seventy-five thousand supportive letters addressed to “Rosty.”

I’m not one for nostalgia. I think many humans have a tendency to look at history through sepia-colored glasses that idealize our own political and cultural past.

But it is hard to read Rostenkowski’s speech without seeing the glaring contrast with today’s political rhetoric. The speech is still partisan in a way: He makes it seem as if Democrats had always wanted a simpler and fairer code and he congratulates Reagan for coming around to their view. This is, of course, ahistorical as both parties were at fault for a tax code riddled with loopholes. But the whole thrust of the speech seems designed to make the other side feel safe about moving towards Rostenkowski’s position.

As an economist, I’m accustomed to thinking about human interaction as exchange: when two people meet, there is almost always an opportunity for mutually beneficial exchange (though transactions costs mean that many of these opportunities are unrealized). And the more different these people are in their tastes and in their productive abilities, the greater the opportunity for exchange.

It is interesting that more politicians don’t see their task as one of getting “the other side” to feel comfortable about abandoning its position and moving toward the middle. Instead, politicians seem to increasingly address themselves to their own base. Unfortunately, what draws the base in often pushes the other side away.

In a follow-up post, I’ll address some possible explanations for this.

The battle of the taxes

In my last post, I discussed several exciting tax reforms that are gaining support in a handful of states. In an effort to improve the competitiveness and economic growth of these states, the plans would lower or eliminate individual and corporate income taxes and replace these revenues with funds raised by streamlined sales taxes. Since I covered this topic, legislators in two more states, Missouri and New Mexico, have demonstrated interest in adopting this type of overhaul of their state tax systems.

At the same time, policymakers in other states across the country are likewise taking advantage of their majority status by pushing their preferred tax plans through state legislatures and state referendums. These plans provide a sharp contrast with those proposed by those states that I discussed in my last post; rather than prioritizing lowering income tax burdens, leaders in these states hope to improve their fiscal outlooks by increasing income taxes.

Here’s what some of these states have in the works:

  • Massachusetts: Gov. Deval L. Patrick surprised his constituents last month during his State of the State address by calling for a 1 percentage point increase in state income tax rates while simultaneously slashing state sales taxes from 6.25% to 4.5%. Patrick defended these tax changes on the grounds of increasing investments in transportation, infrastructure, and education while improving state competitiveness. Additionally, the governor called for a doubling of personal exemptions to soften the blow of the income tax increases on low-income residents.
  • Minnesota: Gov. Mark Dayton presented a grab bag of tax reform proposals when he revealed his two-year budget plan for the state of Minnesota two weeks ago. In an effort to move his state away from a reliance on property taxes to generate revenue, Dayton has proposed to raise income taxes on the top 2% of earners within the state. At the same time, he hopes to reduce property tax burdens, lower the state sales tax from 6.875% to 5.5%, and cut the corporate tax rate by 14%.
  • Maryland: Last May, Maryland Gov. Martin O’Malley called a special legislative session to balance their state budget to avoid scheduled cuts of $500 million in state spending on education and state personnel. Rather than accepting a “cuts-only” approach to balancing state finances, O’Malley strongly pushed for income tax hikes on Marylanders that earned more than $100,000 a year and created a new top rate of 5.75% on income over $250,000 a year. These tax hikes were signed into law after the session convened last year and took effect that June.
  • California: At the urging of Gov. Jerry Brown, California voters decided to raise income taxes on their wealthiest residents and increase their state sales tax from 7.25% to 7.5% by voting in favor of Proposition 30 last November. In a bid to put an end to years of deficit spending and finally balance the state budget, Brown went to bat for the creation of four new income tax brackets for high-income earners in California. There is some doubt that these measures will actually generate the revenues that the governor is anticipating due to an exodus of taxpayers fleeing the new 13.3% income tax and uncertain prospects for economic growth within the state. 

It is interesting that these governors have defended their proposals using some of the same rhetoric that governors and legislators in other states used to defend their plans to lower income tax rates. All of these policymakers believe that their proposals will increase competitiveness, improve economic growth, and create jobs for their states. Can both sides be right at the same time?

Economic intuition suggests that policymakers should create a tax system that imposes the lowest burdens on the engines of economic growth. It makes sense, then, for states to avoid taxing individual and corporate income so that these groups have more money to save and invest. Additionally  increasing marginal tax rates on income and investments limits the returns to these activities and causes people to work and invest less. Saving and investment, not consumption, are the drivers of economic growth. Empirical studies have demonstrated that raising marginal income tax rates have damaging effects on economic growth. Policymakers in Massachusetts, Minnesota, Maryland, and California may have erred in their decisions to shift taxation towards income and away from consumption. The economies of these states may see lower rates of growth as a result.

In my last post, I mused that the successes of states that have lowered or eliminated their state income taxes may prompt other states to adopt similar reforms. If the states that have taken the opposite approach by raising income taxes see slowed economic growth as a result, they will hopefully serve as a cautionary tale to other states that might be considering these proposals.

To Raise Taxes or to Close Loopholes?

Imagine for a moment that you are interested in lowering your nation’s debt-to-GDP ratio. Let’s assume you are determined to ignore the experience of other nations and you are dead-set on lowering your debt-to-GDP ratio by raising revenue rather than by cutting spending.

This leaves you with two choices:

Choice A: increase tax rates.

Choice B: leave rates where they are but close loopholes.

President Obama’s erstwhile deficit commission, Simpson-Bowles, favored Choice B. And I think it is fair to say that most economists do as well. Why? Put simply, a rate increase has deleterious demand and supply-side effects, whereas a loophole closing only has deleterious demand-side effects. If you raise rates, people are incentivized to spend less and work less (or hide more of their income from the IRS). But if you close loopholes, people are incentivized to spend less while their incentive to work is unchanged.  What’s more, when you close loopholes, you tend to remove other distortions in the economy (think: mortgage interest deduction) and you diminish the incidence of government-favoritism.

There are at least three strikes against the fiscal cliff deal struck this week:

  1. It ignored the evidence that tax increases are more economically harmful than spending cuts.
  2. It opted to raise revenue through rate increases rather than loophole closings.
  3. It actually expanded corporate tax loopholes!

On the last point, don’t miss Vero’s pieces here and here, Tim Carney’s pieces here and here, Matt Stoller’s piece here, and Brad Plumer’s piece here.

The Study of American Capitalism

(Note to readers: Three talks in three states over the last week have made me a terrible blogger. Thankfully, Eileen and Emily have stepped up where I have stepped down.)

Mercatus has now organized its work around government-granted privilege and crony capitalism under a new project called the Study of American Capitalism. We are thrilled that Celia Sandel has joined the Mercatus team to manage the project. If you are a scholar working or thinking about working in this field, please reach out to Celia. We’d love to hear from you.

Speaking of which, we’ve already released a number of excellent papers on the topic. And now, in no particular order:

In Crony Capitalism: By-Product of Big Government, Professor Randal Holcombe of Florida State University explores the links between government power and cronyism, writing:

The more government is involved in an economy, the more the profitability of business will depend on government policy. Even those entrepreneurs who would prefer to avoid cronyism are pushed into it, because they must become politically active to maintain their profitability. When the government looms large in economic affairs, businesses push for government policies that can help them, and try to avoid suffering harm as a result of government policies that can work against them. If one’s competitors are engaging in cronyism, avoiding cronyism means that one’s competitors will gain government-bestowed advantages.

In Government Cronyism and the Erosion of Public Trust, Professor John Garen of the University of Kentucky examines the relationship between cronyism and eroding trust in government. He writes:

Survey data show a large decline in trust in government, much of which has occurred while government grew rapidly. Evidence indicates that government growth has been associated with rent-seeking and cronyism, leading to a withdrawal of trust. Thus, cronyism—bad government— can undermine even the appropriate functions of government.

Professors Daniel Smith and Daniel Sutter of Troy University gauge public perceptions of the problem in Gauging the Perception of Cronyism in the US:

Cronyism can have real and significant costs, yet it is challenging to measure objectively. In fact, just the perception of cronyism can inhibit business formation, distort the allocation of entrepreneurial talent, and undermine support for free market capitalism. Refined measures of perceptions of cronyism among both business leaders and the public could help advance our understanding of cronyism and its effects on our economic system.

Last, but by no means least, my graduate-school colleague Professor Jeremy Horpedahl of Buena Vista University has teamed up with my current student, Brandon Pizzola, to explore the privileges that lurk in our tax code in A Trillion Little Subsidies:

Total tax expenditures in the United States are currently around $1 trillion, with over 80 percent accruing to individuals and the remainder to corporations. We review each of the ten largest tax expenditures for individuals and corporations, focusing on the following distortions of economic activity: spending on goods and services, capital allocation, the distribution of income, and lobbying and rent-seeking. The benefits of tax expenditures accrue disproportionately to higher-income earners, since they are more likely to itemize deductions and can afford to hire accountants to minimize their tax burden. Eliminating tax expenditures would increase economic growth and allow for lower tax rates, further increasing growth.

(Many) more to come!