Mercatus Center Study Identifies Link Between Low State Taxes and Economic Prosperity

July 15, 2014

A new paper from the Mercatus Center assessing the relationship between state taxes and economic activity has found that higher, more progressive state income taxes tend to be associated with slower economic growth, lower average incomes, less business formation, and worse migration flows. The sheer breadth of the study, assessing numerous different potential determinants of state economic outcomes and a relatively large number of those outcomes, makes it a useful contribution to the debate on state tax policy.

Does this paper prove that sound tax policy will create economic growth?

In general, better tax policy is closely associated with better economic outcomes, but that association can be nuanced. This paper confirms that lower average total tax rates had a significant correlation with faster growth in economic output across multiple different statistical methods. On the other hand, whether or not a state had a personal income tax, or whether its taxes were highly progressive, did not impact growth. Somewhat confusingly, however, the presence and progressivity of personal income taxes did affect the level of average income. This may seem difficult to reconcile, but in fact it’s fairly straightforward: this study provides evidence that total tax burdens impact rates of growth, but not average income levels. But structural features, this study indicates, may tend to impact the level of economic activity more than the rate of growth.

Only a very broad measure of taxes and a small number of structural features are assessed, so further detailed research would be needed to confirm these relationships, but they do suggest how, through various channels, both tax burdens and tax structures matter for economic outcomes.

On other measures economic activity, taxes had still other effects. The rate of formation of new businesses was not impacted by average tax rates or the presence of an income tax, but was impacted by the progressivity of income taxes. Migration patterns were likewise unaffected by average tax rates, but were affected by progressivity.

What else does this paper find impacts economic growth?

Along with taxes, other variables impact growth as well. Major federal government investments can help prop up state-level growth, as anyone living in the Washington, DC area is well aware (though this may not be a sustainable strategy for the whole nation). The presence of a young workforce, valuable farmland and natural resources, and high rates of public and private investment is also associated with better economic outcomes.

Non-tax variables also impact migration, and those impacts are similar to what previous studies have found. Higher spending on education tends to attract migrants, while higher spending on health and welfare tends to drive people away from a state. The most powerful determinants of migration are employment-related variables, as many people move for jobs.

In all, this new paper serves to reinforce what most reasonable people intuitively recognize: taxes impact economic decisions in significant ways, but exactly how may vary somewhat by what tax and what economic outcome we assess. Taxes, while significant, are not the only factor involved, and in some cases their impact can be small compared to larger economic forces. Yet even so, taxes are a significant variable policymakers can directly control, and thereby serve as a useful tool to support economic growth.

Read more on taxes and growth here.

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