Tag Archives: tax rates

Illinoisans Are Becoming More Realistic About Dealing with the Budget Crisis

Although Illinois has become the quintessential example of a state with a broken budget process, a recent poll by the Paul Simon Public Policy Institute provides evidence suggesting that there may be some positive change occurring among Illinois voters.

Since 2008, the Simon Institute has conducted an annual survey of 1,000 voters in Illinois in order to examine how the general public thinks the state should deal with its budget problems. Specifically, the Simon institute has asked Illinois voters if they think the state’s budget deficit should be handled by: 1) bringing in more revenue, 2) cutting waste and inefficiency in government, or 3) a combination of budget cuts and revenue increases.

A majority of Illinoisans (57.7%) still believe that cutting waste and inefficiency will solve the state’s budget problems.  Unfortunately, this is a non-serious way to cut – targeting inefficacy and waste is easy since there are no real constituencies for either. This is why it’s important to dig deeper and ask people about specific cuts.

Proposals for program cuts in the Institute’s poll include, among others, cutting spending on education, public safety, programs for poor people, and pension benefits for state workers. Not surprisingly, a majority of Illinoisans oppose cuts to each of these programs.

However, there has been a substantial increase in the number of people that favor cuts in Illinois’s pension system. In 2008, 24.1 percent of voters favored cutting spending on pension benefits for state workers. This number has increased by more than 20 percentage points over the past three years, to 45.5 percent.

There has also been a growing acceptance for various means of increasing revenues. This year’s results show that:

 in 2011, for the first time, majorities approve of two of the revenue-raising measures in the poll: expanding legalized gambling (56.8%) and expanding the sales tax to cover services as well as goods (50.1%).

This is good news. It suggests that Illinoisans are becoming more realistic about dealing with the state’s budget crisis. Specifically, it suggests that Illinoisans are beginning to embrace the principle of generality in taxation – broadening the base will allow the state to potentially lower its tax rates.  Additionally, a majority (74.1%) of Illinoisans oppose an increase in the state’s sales tax rate  – highlighting the fact that voters are not just in favor of more taxes, but a broader tax base.

Ultimately, the results from this year’s Simon Institute poll indicate that Illinoisans are not only beginning to understand the severity of their state’s budget crisis but are also starting to accept some pragmatic avenues of reform. Politicians and policy makers in Illinois must act on this opportunity and focus on passing structural reform.

New Tax Foundation Study on Unemployment Insurance across the States

On Monday, the Tax Foundation released a new study by Joe Henchman on Unemployment Insurance policies in the 50 states. The study highlights that while the federal-state program is supposed to be counter-cyclical, in reality states do not use periods of high growth to prepare their unemployment trust funds for recessions. At the beginning of 2008, most states were prepared to pay less than one year’s worth of high unemployment benefits, leading to quick insolvency for many states’ funds in recession.

In order to provide benefits, states have had to borrow from the federal government. Henchman explains:

Beginning on September 30, 2011, states must pay approximately $1.3 billion in interest on those outstanding balances; in many cases, businesses and employees in those states will also face increases in federal unemployment insurance tax rates as a result of those federal loan balances. These new interest obligations and tax increases, if they ultimately occur, come at a time when private sector hiring is already at a low level and states are under significant fiscal pressure. These unemployment insurance fiscal policies may exacerbate negative job growth and tax trends, instead of operating countercyclically as the program was intended.

The study also provides analysis of the different taxes and benefits across the states. The compilation of the variation of tax rates, duration of benefits, funding gaps, and other policy factors makes this paper an excellent jumping off point to look at state level reforms based on states that have performed relatively well in this program compared to the neighbors.

In a more ambitious policy proposal, Henchman recommends Individual Unemployment Benefit Accounts as an option for reform. These accounts, which Chile adopted in 2002, provide a measure of income stability during periods of unemployment. Unlike state-administered UI programs, though, private accounts do not carry the perverse incentives that may dissuade people from finding work while they are receiving these benefits because money which goes unused during unemployment can be accessed upon retirement. In 2010 Eileen Norcross and I did a brief analysis of the incentives that the current UI program provides and came to the same general policy recommendation.

 

A Minimum Tax: An Admission of Failure

Over a decade ago, Democratic Senator Bill Bradley opined:

A minimum tax is an admission of failure. It demonstrates not only that the system is broke, but also that Congress doesn’t have the guts to fix it.*

How does a minimum tax come about? In my view, there are six steps:

Step 1: Congress and the president decide on a tax base (income, consumption, both, etc.) and then set tax rates. It should stop right here, but it doesn’t.

Step 2: Congress and the president decide to encourage certain behavior by changing the terms of Step 1. For example, to encourage home borrowship ownership, they allow people to deduct mortgage interest payments from their taxable income. Or to encourage energy efficiency, they allow people to claim credits to offset the cost of certain government-ordained products. Or to encourage fecundity (I guess), they allow people to claim credits for having more kids.

Step 3: Congress and the president repeat Step 2 over 200 times.

Step 4: Congress and the president decry the loopholes in the code that allow some individuals and firms to escape taxation altogether (sometimes while calling for more tax credits!).

Step 5: Congress and the president throw up their hands, admit that they will never actually eliminate the loopholes and lower rates. Instead, they invent a whole new tax code, morph it on top of the current tax code and call it a “minimum tax.”

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*Quoted in Harvey S. Rosen, Public Finance, 6th Edition, (New York: McGraw-Hill, 2002), p. 358.

California’s shrinking property tax revenues

Proposition 13, the 1978 law that caps property taxes in California at 1 percent of a home’s value and, “forbids major tax increases unless a home is sold or rebuilt,” has left counties with a revenue problem. While falling home values usually lead local governments in other states to increase property tax rates, California counties can only watch as property tax revenues fall with the housing market.

According to the Wall Street Journal, Stanislaus County’s assessed property tax values fell 21 percent over the past four years and 4.7 percent this year. This year’s property tax collection of $447 million is 11.6 percent lower than two years ago. The debate over whether Proposition 13 has worked as intended – protecting the elderly and those on fixed incomes from rapidly rising property tax increases or whether it has led to fiscal distortion and centralization continues.

Governor Christie’s pared down budget

The Star Ledger reports that Governor Christie, “took an axe” to the state’s budget and “slashed $900 million in a budget he blasted as ‘unconstitutional.'” Cuts were made to state aid to municipalities, college tuition aid, Medicaid and aid to suburban schools leaving $640 million in surplus. He also vetoed bills to tax millionaires for more school funding aid.

In an analysis of New Jersey‘s fiscal problems we found that these areas are some of the primary weaknesses in New Jersey’s budget. The school aid formula, guarded by the court since 1976, effectively prevents the legislature and Governor from making appropriations decisions. This result of the court’s involvement in school funding has been a fiscal and educational disaster for the state. Since the 1970s many changes in tax rates have been to the income tax in order to fund schools and provide aid to municipalities. Over thirty years later and there are few to no improvements in urban school districts. The price for New Jerseyans is one of the most progressive income taxes in the nation and a property tax crisis.

As for Aid to Distressed Cities this program highlights another long-running problem in New Jersey’s fiscal landscape. Several of its cities rely on state aid in lieu of property tax revenues because they have not recovered from long-running economic problems. The problem with state aid is that it masks the cost of spending to local residents,  subsidizing local inefficiencies and the continuance of failed approaches to local economic development.

Inefficiencies and poor performance are rampant in areas that have relied heavily on aid, notably the education system. What is needed is the kind of reform being discussed by some leaders in the state – both Republican and Democrat. Cities like Camden need to be able to try new approaches to schools. A new pragmatism among Democratic city leaders in other parts of the country shows a willingness to confront fiscal reality and ask: how much of our budget is being consumed by unsustainable benefits packages and how much is left over to  run the city? Atlanta, Georgia, Montgomery County, Maryland are two such recent examples.

What is Economic Freedom and What Can it Say About Prosperity?

My post in the NYT’s Room for Debate blog elicited a good number of comments and questions. So today I thought I might elaborate on the most-important of these questions: What exactly is economic freedom and what do we know about the way it affects prosperity?

First, its impact. The economists Chris Doucouliagos and Mehmet Ali Ulubqasoglu recently reviewed 45 studies examining the freedom-growth relationship. They concluded:

[R]egardless of the sample of countries, the measure of economic freedom and the level of aggregation, there is a solid finding of a direct positive association between economic freedom and economic growth.

Studies also find that economic freedom tends to be associated with a whole host of other factors that humans tend to value such as:

  • Higher income levels: Faria and Montesinos (2009) Dawson (1998), De Haan and Siermann (1998), De Haan and Sturm (2000), Cole (2003), Gwartney et al. (2004) and Weede (2006);
  • Lower poverty levels: Norton (2003);
  • Less volatility in the business cycle: Dawson (2010);
  • Better environmental outcomes: Norton (1998), ch. 2);

even:

  • Fewer homicides: Stringham and Levendis (2010); and 
  • Greater levels of reported happiness: Ovaska and Takashima (2006)

But what is economic freedom?

The concept is quite old, dating back to well-before Adam Smith. For his part, he called it “a system of natural liberty” and gave us a view of what he meant by it when he wrote:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.

This, however, is still pretty vague.

So in the last quarter-century, a number of economists have focused on defining and—importantly—measuring economic freedom. There are now a number indices of economic freedom at both the national and sub-national levels. Among academics, the most-widely cited of these is the Economic Freedom of the World index, the latest of which is authored by Professors James Gwartney, Joshua Hall, and Robert Lawson. This index grew out of a series of conferences initiated by (Nobel Laureate) Milton Friedman and the Fraser Institute’s Michael Walker in the mid-1980s to early 1990s. Other attendees included economic luminaries such as “Lord Peter Bauer, Gary Becker, Douglass North, Armen Alchian, Arnold Harberger, Alvin Rabushka, Walter Block, Gordon Tullock, and Sir Alan Walters” (a number of whom have either won Nobel prizes in own their right or are likely to in the years that come). Out of these conferences, a consensus began to emerge that the four cornerstones of economic freedom were:

  • Personal choice,
  • Voluntary exchange coordinated by markets,
  • Freedom to enter and compete in markets, and
  • Protection of persons and their property from aggression by others.

From these conceptual cornerstones, the authors of the index began to gather data with an eye toward objectively measuring the degree to which the laws of different nations permit (or don’t) the exercise of economic freedom. Their index includes factors such as government consumption spending as a share of total consumption, top marginal income tax rates, the degree of judicial independence, growth in the money supply, taxes on international trade, and regulation of private sector credit (among 17 other components). The index now covers more than 140 countries, with data on many going back to 1970. And now there are literally hundreds of peer-reviewed articles that are based on this index or one of many others like it.

Since the publication of this index, a number of others have gotten in on the game. There are now indices that measure freedom at the sub-national level, the most-recent of which is Sorens and Ruger’s Freedom in the 50 States, published by Mercatus (the next addition of which is coming out soon). 

As I have recently noted, these state level indices suggest that economic freedom is a powerful predictor of prosperity.

So that, in a nutshell, is economic freedom.

Economically Free States see 30 Percent Faster Job Growth

In my last post, I mentioned a couple of business climate indices. There is a new paper by Jed Kolko, David Neumark, and Marisol Cuellar Mejia which examines these types of indices in depth. They find that states with high rankings in economic freedom indices tend to have faster job growth, greater wage growth, and greater growth in gross state product.

There are a lot of indexes out there that attempt to rank states in terms of their business climates and the results of their rankings often conflict. As the authors write:

[A]cross all 50 states, every state but one ranks in the top 20 in at least one index, and every state ranks in the bottom half in at least one index.

However, it turns out that when you dig deeper, the indices can be grouped into two general categories and there is actually a lot of consistency within these categories.

Economic Freedom Indices:

The first category examines what the authors call “taxes and costs” and what I might call economic freedom. It includes factors such as the cost of doing business, the size of government, tax rates and tax burden, regulation, litigation, and welfare and transfer payments. The following five indices tend to capture these types of factors:

The economic freedom component of the Freedom in the 50 States Index by Sorens and Ruger would almost certainly fall into this category too, but since the authors focused on indices that have been around for several years, they do not include it.

Productivity and Quality of Life:

The second group of indices tends to measure what the authors call “productivity or quality of life.” These indices include measures of quality of life; equity; employment, earnings and job quality; business incubation; human capital; infrastructure; and technology, knowledge jobs, and digital economy. It appears to me that a number of the indices in this group focus on outcomes (are there a lot of “knowledge jobs in the state”?) while others in this group focus on policy inputs aimed at improving the quality of life (has the government invested in business incubation and human capital?). The indices that tend to fall into this category include:

  • The State New Economy Index by the Progressive Policy Institute, the Information, Technology and Innovation Foundation, and the Kauffman Foundation,
  • The Development Report Card for the States—Performance by the Corporation for Enterprise Development,
  • The Development Report Card for the States—Development Capacity, also by the Corporation for Enterprise Development,
  • The Development Report Card for the States—Business Vitality, also by the Corporation for Enterprise Development, and
  • The State Competitiveness Index by the Beacon Hill Institute.

The distinction isn’t always clear cut and I’d note that the Beacon Hill State Competitiveness Index, for one, also seems to capture a lot of economic freedom-type factors. The authors categorize an eleventh index, the Fiscal Policy Report Card on the Nation’s Governors by the Cato Institute, as falling somewhere between these two broad groups.

The authors examined the degree to which these indices predicted job growth, wages, and Gross State Product (controlling for other factors that might influence economic growth, including weather and historical industry mix). They found that the quality of life indices generally do a poor job of predicting these positive economic outcomes. In contrast, the economic freedom (aka “low taxes and few regulatory costs”) indices are strong predictors of job growth, wages, and GSP. In particular, the authors found “the corporate income tax structure and base matter for wage and GSP growth, though not necessarily for employment growth.” furthermore, the relationship, “does not appear to be driven by the top marginal tax rate, but rather by other factors such as the simplicity of corporate taxation…” They also found that greater welfare and transfer payment spending was associated with slower economic growth (they have reason to dismiss most concerns about reverse causality; but I’ll leave that to the reader to investigate).

The two indices with the best record for predicting economic progress were the Economic Freedom of North America index by Fraser (“the strongest and most robust evidence”) and the State Business Tax Climate by the Tax Foundation. Looking at the Fraser index, they found that moving a state from the 40th to the 10th place in terms of economic freedom “would increase the rate of growth of employment by 0.317 percentage point.” Given that the mean employment growth rate is 1.15 percent, this amounts to about 30 percent faster employment growth.

Lastly, the authors found that “footloose” industries such as manufacturing that are less-tied to the geography of the state tend to be more responsive to the policies captured by these indices.

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Update: I have fixed a broken link to the article.  Thanks to alert readers! 

State and Local Economic Development Programs

Fairfax County’s Economic Development Authority has opened a new office in Los Angeles. Their aim is to lure Californians who are fed up with the Golden State’s web of taxes and regulations. 

It is true, of course, that California’s business climate is abysmal. According to Sorens and Ruger, California is number 44 in terms of fiscal freedom (with 50 being the least-free), and 46 in terms of regulatory freedom. Other indices come to the same conclusion. Kail Padgitt of the Tax Foundation, for example, evaluated states based on their business tax climate and California came in at #49.

Virginia, by contrast, does decently well in both reports. By Sorens and Ruger’s measure, the state is the 13th most-economically-free in the nation and by Padgitt’s, its business tax climate is the 12th-best.

Given the important link between taxes and economic prosperity—see studies by Agostini and Tulayasathien (2003); Mark, McGuire, and Papke (2000); Harden and Hoyt (2003); and Gupta and Hofmann (2003) or reviews by Helen Ladd (1998) or Padgitt (2010)—it might seem only natural for Virginia to highlight its relatively low-tax environment. 

The irony, however, is that taxpayer-funded projects like an economic development office located 2,285 miles away from the county make it more-difficult for Fairfax to maintain its competitive tax rates. More expensive than the office itself are the handful of subsidies and tax expenditures that the state and the county offer to businesses that relocate or that meet special criteria (these subsidies include the option for the state to dole out “discretionary, deal-closing” benefits).

Proponents of economic development programs will no doubt contend that these expenses pay for themselves. But the economic literature is far from conclusive on that score.

Some studies find that targeted incentives lead to employment growth in the industries they target.

But others find evidence to suggest that these results are exaggerated. Examining 366 Ohio firms, for example, Gabe and Kraybill (2002) found that incentives have large effects on announced employment growth but modest or even negative effects on actual employment growth.

According to a recent Wall Street Journal article, some states and localities have begun to notice this discrepancy. John Garcia, the economic development director in my hometown of Albuquerque recently announced that the city was trying to collect nearly half a million dollars in property tax abatements that were given to a call center that relocated and then closed shortly thereafter.

But the real question is not whether these types of incentives are a good deal for the firms that receive them (one would think they would be!), but rather are they a good deal for the state at-large?

In a case study examining Virginia giveaways, Alwang, Peterson, and Mills (2001) draw attention to the fact that “most economic development events involve winners and losers.” For example, other firms may have to pay higher costs for purchased inputs. They found that the benefits doled out to one firm cost others more than $1 million, annually.  

Sweet deals can also crowd-out legitimate government expenditures on true public goods. Burstein and Rolnick (1996), write:

[W]hen competition takes the form of preferential treatment for specific businesses, it misallocates private resources and causes state and local governments to provide too few public goods.

Furthermore, cost-benefit analyses of economic development deals rarely account for the so-called rent-seeking losses that such deals inevitably invite: firms will sink millions of dollars into societally useless activities—lobbying and ingratiating themselves to the politicians—in an effort to win these privileges. The money they spend on smart and expensive lobbyists, lawyers, and accountants would be better spent developing new products and services that actually provide value to customers. These losses are hard to measure but that does not mean that they don’t exist.

In my view, states and localities should aggressively compete with one another over businesses. And part of that competition should involve figuring out ways to provide public goods at the lowest possible tax and regulatory cost. But this cost should be low for everyone, not just for the politically-connect firms.

HT to my colleague, Dan Rothschild, for directing me to the news about Fairfax County.

Comparing cell phones and cigarettes

One of the ways in which hard-up states are seeking to increase revenues is by increasing taxes on cell phones and other mobile communications devices, which when combined with federal taxes, can now total almost a quarter of a user’s monthly bills. (Indeed, only in three states is this total tax rate less than ten percent.)

Today an article on BNA suggests that on the federal level, lawmakers may have had enough. The Wireless Tax Fairness Act, which was introduced but never voted on in two previous Congresses, would prohibit  new “discriminatory” fees and taxes on cellular products. One of the bill’s sponsors, Rep. Zoe Lofgren of California, is quoted as saying “Some localities are taxing cell phones like sin taxes. I don’t think using a cell phone is like smoking, but that’s the tax rate.”

This stikes me as exactly right. A little background on basic public finance is in order. The purpose of taxes is to raise money for necessary governmental functions. To that end, economists frequently prescribe that rates be low and broad in order to minimize the impact on consumers’ behavior — so-called tax neutrality. This is because taxation should be about raising revenue, not changing behavior.

Some economists tweak this prescription through the Ramsey Rule, which holds (in a nutshell) that the more influenced by tax rates consumers are (demand elasticity) the less something should be taxed (and vice versa).

Sin taxes are the opposite; they’re about reducing a behavior that policy makers judge to be morally offensive (like many people view smoking).

Relatedly, Pigouvian taxes seek to bring the costs to society (the social cost) in line with the costs born by a buyer. (For instance, some people advocate higher alcohol taxes on the theory that drinkers impose costs on others, though this argument is fraught with difficulties.)

Cell phone taxes above regular sales taxes levied by states and localities do not fit any of the four rationales provided here. On the one hand, taxing them at over twenty percent of a user’s bill is hardly neutral. Nor does it likely fit the Ramsey Rule prescription; consumers respond to cell phone taxes by buying less of it or by avoiding taxes by pretending to move. (Just look around you at how consumer takeup and use of cell phones has changed as prices have fallen over the last decade.) Cell phones are not sinful or offensive. And there’s no serious case to be made that the social cost of cell phones exceeds the cost born by users. In short, by any principle of public finance, high cell phone taxes are a bad bad bad idea.

Cell phones are, most people’s revealed preferences show, a great thing. There’s simply no case under the principles of tax neutrality, the Ramsey Rule, sin taxes, or Pigouvian taxes to tax cell phones at these high rates. Policy makers would be well advised to cut rather than hike these rates going forward.

The Wrong Line in the Sand

There are many in policy circles these days who believe that newly-empowered House Republicans – especially those that were elected with Tea Party backing – ought to draw a line in the sand on raising the debt ceiling. This is the wrong line in the sand. Excessive debt is indeed bad. But it is a symptom of the disease, not the disease itself. To treat the real disease, I believe we need to get serious about addressing the spending problem.  

What is Wrong With Debt?

It used to be that Republicans focused almost-exclusively on taxes instead of on their root cause: spending. This, of course, biased policy in favor of huge deficits. When deficits are large but manageable, they drive up interest rates and crowd-out private investment. And when deficits are large and unmanageable, they can up-end a country’s entire economy.

Economists Carmen Reinhart and Kenneth Rogoff examined the implications of debt in 44 countries over a 200 year period. They found that in economically-advanced countries, when debt-to-GDP ratios moved from around 30 percent of GDP to 90 percent or more, economic growth rates tended to halve. Now the US isn’t a typical country and investors may be willing to let our government get away with debt-to-GDP ratios that are higher than 90 percent.

But certainly they are not going to let us get away with debt-to-GDP ratios of 200+ percent (which is what the CBO projects for 2035), let alone 300+ percent (2047) or 800 percent (2078).

At some point, the federal government will have accumulated too much debt for investors to feel comfortable lending at current rates. At that point, they will demand higher interest rates which will undermine economic growth.

In a best-case scenario, we will join the list of countries that have seen excessive debt severely hamper their economic growth rates. In a worst-case-scenario, the increased interest-cost will further add to the government tab, consuming the whole budget and causing the whole edifice to collapse under its own weight.   

What is Wrong with Taxes?

Now you might think we ought to draw a line in the sand and not borrow anymore. The problem is that if we refuse to raise the debt limit, it might cause the government to default on its existing debt, hastening the day when investors will lose confidence in the full faith and credit of the government.

An even more-likely scenario is that a refusal to raise the debt limit will trigger a massive tax increase. Some critics, of course, have blithely suggested that a tax increase is just what we need. The problem here is that taxes can also inflict great economic harm. Economists Christina and David Romer examined over 60 years of U.S. data to understand the impact of taxes on GDP. They carefully disentangled the tax-effect from other effects, and concluded that a tax increase of 1 percent of GDP lowers real GDP by almost 3 percent.

The CBO projects that if we were to meet our current long-term spending promises without more borrowing, all taxes would need to roughly double. If the Romers’ estimate is anywhere near accurate, a doubling of all tax rates would trigger one of the worst economic contractions in US history.  

So what should we do? I’d say the first thing we need to do is focus on spending. Its two symptoms — excessive debt and excessive taxation — are both economically damaging. Only by focusing on the disease can we avoid both symptoms.

Spending is where the line should be drawn.