March 1, 2002

States That Use Tax Hikes to Close Budget Gaps Could Open Employment Gaps

Thanks in large measure to the Bush tax cuts passed last spring and the economic stimulus bill passed just a couple months ago, Americans are enjoying the largest drop in their tax burden in two decades. This year, Tax Freedom Day arrived on April 27, two days earlier than last year and a full four days earlier than 2000, when Tax Freedom Day arrived on May 1 — the latest day ever.

But for millions of taxpayers in more than three dozen states, the gift Washington has given taxpayers may soon be taken away by their own state legislatures. Because of the weakened economy, these state lawmakers are considering a wide array of tax hikes — rather than spending cuts — in order to close budget gaps.

While lawmakers are naturally concerned about the impact of spending cuts on “essential” services, they should be even more concerned about the effects of tax hikes — not only on the performance of their own state’s economy, but on the overall economy. Numerous economic studies have demonstrated that states can damage their own economies with high taxes. But we should also not ignore the potential negative impact on the national economy resulting from the cumulative effect of dozens of state tax hikes all in the same year.

The basic lesson of tax policy is as old as Adam Smith: in most every instance, the more a good or service is taxed, the less of it is supplied and demanded. So if lawmakers try to raise more revenue through higher payroll taxes, chances are there will be lower employment. Likewise, an increase in the sales tax will lead to fewer sales, and an increase in taxes on businesses will lead to fewer businesses to employ workers.

But few state lawmakers appear to have learned this simple lesson. Maryland lawmakers, for example, recently increased the state’s tobacco tax by 50 percent, to $1.00 per-pack from 66 cents per-pack. Based on what we know from the large number of economic studies of tobacco taxes, the results of Maryland’s effort is predictable. First, the burden of these new taxes will fall directly on lower-income individuals because over one-third of tobacco tax revenue is collected from people who earn less than $20,000.

Second, the state will see a rise in the illicit smuggling of cigarettes by criminals and a rise in the number of everyday consumers who will cross into neighboring states with lower tobacco taxes to purchase their cigarettes (Virginia’s tax is 2.5 cents per-pack). The result: Maryland will collect far less revenue than their politicians are now predicting even though the same amount of cigarettes will be consumed in the state.

Other states are considering similar hikes in taxes on beer and spirits. Economic studies consistently show that the result of such tax increases are the same as tax hikes on tobacco — increased smuggling, cross-border purchases, a greater tax burden on the poor, and, ultimately, fewer tax collections than predicted.

Given how easily capital and certain firms — such as software designers — can move these days, lawmakers should be very cautious about harming their business climate. Lawmakers in Indiana, for example, are considering an increase in the state’s corporate income tax from 7.9 percent to 8.5 percent. Were this to pass the legislature, it would make the state’s corporate income tax the highest in the Great Lakes region and place Indiana at a competitive disadvantage in both new business starts and existing business re-location decisions.

Income tax hikes are also looming for taxpayers in many states. Some Indiana lawmakers, for example, have proposed a 0.2 percentage point increase in the individual income tax, while lawmakers in many other states are trying to legislate postponements or repeal of recently passed tax cuts. While some of these increases may appear small, economic studies show that any increase in personal income taxes will mean slower growth in personal income, employment, and small business creation.

Several states are considering keeping their estate and gift taxes even as the federal “death tax” is phased out. Needless to say, these states risk losing their wealthy residents to states without a death tax.

Many states are also considering “decoupling” their state tax rules from the changes passed recently in the federal tax code. For example, lawmakers in Illinois are on the verge of decoupling the state from the new accelerated business depreciation component of the 2002 stimulus package. The federal provision is designed to boost the economy by encouraging businesses to invest in new plant and equipment. It allows them to write off 30 percent of the cost of new equipment purchases within the first year. Given the potential benefit to a state’s economy, it is hard to imagine a more self-destructive measure than to disallow this federal expensing provision at the state level.

While many states will succeed in closing their budget deficits through a variety of tax increases, the victory will be Pyrrhic. The economic evidence is very clear that these tax increases will hurt their economies, lower incomes, and slow business creation as economic activity moves to low-tax locations. This seems like a high price to pay to avoid making tough choices on state spending.

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