New Study Shows Sound Tax Policy is Associated with Economic Growth

July 03, 2014

A new study from the National Bureau of Economic Research assesses several different state business climate indexes, investigating their relationship to economic growth and inequality. The authors look at 10 different business climate indexes spreading across a wide range of priorities from the Progressive Policy Institute’s State New Economy Index to the Fraser Institute’s Economic Freedom Index. Our State Business Tax Climate Index was also included. The study found that indexes that assess “productivity and quality of life” (often associated with higher government spending)  are poor predictors of economic growth, changes in inequality, and poverty rates, while indexes that assess taxes and other policy-created business costs predict faster growth, but also faster rising inequality.

However, while those were the study’s general findings, its specific findings with regards to our Index were more positive. The State Business Tax Climate Index has a strong association with greater economic prosperity, but is not associated with any worsening poverty or inequality. This paper provides conclusions consistent with the idea that good tax policy can support economic growth, and that tax policy is a poor tool for social aims like addressing income inequality.

Taxes and Inequality

The authors note that these results can be challenging to interpret. It is not the case that better scores on indexes that penalize government size and higher taxes (“tax-and-cost” indexes) create higher inequality as opposed to better scores on indexes measuring equity, quality of life, and human capital predict lower inequality. No index measured was able to identify policies or variables leading to lower inequality, because inequality rose almost everywhere, no matter what state policies were adopted. As the authors write, “"Touting a state’s high ranking on the productivity/quality-of-life indexes to argue that such a state might, for example, be spared from some of the rising inequality the United States has experienced is not warranted, but instead requires more explicit evidence on specific policies."

More notably for our State Business Tax Climate Index, not all tax-and-cost indexes are created equal. Tax-and-cost indexes generally did predict faster-rising inequality: but only if they included government spending variables. Our index, which includes only tax variables, and other indexes mostly composed of tax variables, did not have a significant association with inequality. The paper states clearly why some indexes better predict rising inequality than others: "Thus, our takeaway from this analysis is that less generous welfare is likely what is driving the relationship between a higher ranking on the EFI tax-and-cost index and faster growth of inequality, which seems a quite reasonable interpretation."

This study provides no significant evidence for the idea that more growth-friendly tax policies lead to faster rising inequality. Insofar as fiscal policy impacts inequality, it does so much more through the spending side of government than the taxing side.

Taxes, Growth, and Poverty

Consistent with the academic research on the topic, this study confirms the strong association between better tax policies and economic prosperity. Our Index was one of the strongest predictors of employment growth among the indexes studied. On the other hand, for some productivity/quality of life indexes, higher scores are actually associated with worse economic outcomes. This is consistent with our previous arguments, that good tax policy can play a vital role in supporting economic growth.

Meanwhile, no index meaningfully predicted poverty rates (though better Index scores did have a weak association with lower poverty rates). This is important because it reveals how states reduced the growth rate of inequality. States with better tax-and-cost index scores had faster rising inequality but no difference in poverty rates. So while more redistributive policies may reduce inequality, this study offers no evidence that they get people out of poverty.

In sum, this study shows that most policy-connected differences in inequality seem to be associated with differences in spending, not taxes. Even what inequality differences do exist seem to be driven more by the differences in middle- and high-earners than by different poverty rates. There is little evidence that broad tax bases and low tax rates make inequality worse, and none at all that they make poverty worse, while there is good evidence that such sound tax policies support economic growth. Various spending policies may impact inequality, and policymakers may think that is an important consideration. But even for those policymakers who are the most concerned about inequality, this study suggests that tax policy isn’t the best way to address those concerns.

Read more about our State Business Tax Climate Index.

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