Nebraska Department of Revenue Finds Tax Cuts Good for the State’s Economy

November 13, 2013

The Nebraska Department of Revenue recently released a study suggesting that, in 2010, a $100 million income tax reduction would have created 1,788 new jobs, while a $100 million sales tax reduction would have created 2,615 new jobs. This finding comes on the eve of talks of tax reform in the state, a subject that we have weighed in on with our own comprehensive study of the state’s tax code.

But given that the economic literature overwhelmingly shows the positive effects of income tax cuts and shows that consumption taxes are less economically damaging than income taxes, these results are a little peculiar—they seem to show that sales tax cuts are better. Digging into the meat of the Nebraska report, here are some explanations I found for why their simulation gives different results than most economic literature would lead us to expect:

1. The report identifies investment as fully determined by the real rate of return on investment for investors outside of Nebraska. So income tax changes that alter Nebraskan savings have no effect on investment, and very limited effect on investment by non-Nebraskans. This assumption makes sense for making a mathematical model of one state, but doesn’t strictly hold for the real economy: if every state decided its state-level savings rate didn’t matter for investment, and so taxed income more, investment overall would fall sharply.

2. The report, as best I can tell, views income taxes are being fully borne by households. It doesn’t address that income taxes have large effects on after-tax business earnings for pass-throughs, which constitute a huge share of Nebraska businesses. Thus they miss a second conduit, aside from Nebraskan savings, through which income taxes affect investment, and thus growth. Again, this is a pretty fair assumption for modeling, because figuring out how to model pass-throughs would be very complex, and Nebraska’s DoR is using a standardized model they use for many studies. But while it’s a fair assumption for making a computer model, it ignores key features of Nebraska’s real economy.

3. The report assumes that net migration won’t be meaningfully affected by taxes. This probably isn’t a huge effect, but it does still matter.

As a rule of thumb, these types of econometrics models are extremely useful for saying if a policy will help or hurt, broadly speaking. They’re also good tools for saying which specific industries will be helped or hurt, or what the distributional consequences of a tax change will be. But using these models to make projections about future effects of policies, and putting much faith in the precise numbers, would be a mistake. Small changes in a simulation’s assumptions can lead to big changes in those final numbers: and when the amounts we’re talking about are only about 1,000 jobs (a small fraction of Nebraska’s workforce), we have to be extra careful in claiming too much about the different policies.

The crucial takeaway from this report is that a $100 million cut in 2010 would have increased investment and disposable income by much more than $100 million. Disposable income would have risen by either $181 million or $122 million, and investment by $123 million or $65 million. Those are huge effects: for every dollar cut in taxes, Nebraskans could have had between $1.23 and $1.81 in extra income. We’re certainly hopeful that, next year, Nebraskans will get to enjoy the benefits of such a pro-growth tax reform.

More on Nebraska.

NOTE: The model being used is what is called a “Computerized General Equilibrium,” or CGE, model. These models take extremely detailed data from a base year (in this case 2010) and run it through a mathematical model of the economy. They then adjust that model for, in this case, if taxes had been different. So a CGE model, put precisely, never predicts what will happen if a policy is implemented: it claims to show what would have happened if a policy had been implemented in the past. CGEs are not projections, they are simulations. All the same, CGEs are commonly misused to make claims about future effects of not-yet-implemented policies.

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