Testimony Before the Nebraska Legislature Finance Committee on Income Tax Reform

February 6, 2013

Strong Consensus is that Taxing Consumption Instead of Investment Promotes Savings and Long-Run Economic Growth

Taxes are taxes, right? I’ve heard the argument: If government is going to spend the same amount whether or not the tax system is reformed, then why bother?

The type of taxes does matter because different taxes have different economic effects. If a tax has a lot of administrative costs for the government, if it has a lot of compliance costs for taxpayers, if it discourages investment and risk-taking and capital formation, then it will be more harmful to prosperity and job creation than another tax that is less harmful.

That’s actually what we did at the federal level in 1986: we swapped a income tax system that had very high rates – up to 70% – with lots of tax-free shelters and loopholes and special-interest exemptions, and replaced it with a broader, flatter system. Rather than some people paying zero and some people paying 70, we evened it out so everyone pays about the same. Now, all those special interest provisions have been seeping back into the code, so it’s time for another housecleaning, but that’s another matter.

The Organization for Economic Co-operation and Development (OECD), which is a research organization set up by governments in industrialized world, actually has a hierarchy of which taxes most impact economic growth. They’ve determined that the corporate income tax is the most harmful for economic growth, followed by the individual income tax. Consumption taxes like the sales tax, and property taxes were found less harmful to economic growth. The reason, by the way, is how these taxes interact with highly mobile capital and less variable consumption and less mobile land. High taxes on capital greatly affects capital, while high taxes on consumption or land affect those things less.

This finding – that taxing consumption instead of capital leads to more economic growth – is the academic consensus as well. We have produced a recent literature review of 26 academic studies published in prestigious journals, of which 23 found a negative effect of higher taxes on economic growth, and of those that distinguish between types of taxes, they find that individual income taxes do more harm than consumption taxes like sales taxes. For example, Mullen & Williams (1994) looked at state tax changes from 1969 to 1986 and found that higher marginal tax rates reduce gross state product growth, even after for adjusting for the overall state tax burden. Prescott (2004) found that Europe’s highly progressive income taxes led workers to work fewer hours and not seeking additional career-advancing opportunities. Chernick (1997) found that progressive state income taxes negatively affects GDP growth, and so on.

Even the left-of-center Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, acknowledges this fact. They write: “In practice, consumption is inherently easier to measure than income, and the dynamic efficiency gains from encouraging savings and investment could be large.” Now admittedly, they are reluctant to advocate moving fully to consumption taxes out of fairness concerns. Regressivity. But it is important to understand that there is broad academic and public finance consensus that shifting from consumption to income taxes leads to greater economic growth. How that growth balances against fairness concerns is a valid question, but it is false to deny the taxes-growth link.

Now I don’t want to overstate this case. You may get some people who say dropping the income tax a few points will cause millions of people to move to Nebraska. And there will be some people who claim that Nebraska could raise taxes as high as they want and no one will move out of state. The real answer lies in the middle. Taxes definitely change behavior. That’s why a bunch of New Yorkers live in Florida for half the year plus one day, it’s why the ATF is interdicting shipments of cigarettes being illegally transported from low-tax states to high-tax states, it’s why we see a spike in asset sales right before any capital gains tax increase. That said, individuals and businesses choose where to locate for a whole host of reasons: regulations, education, family connections, infrastructure, the weather, etc. The difference between taxes and those things is that the Legislature can change a tax system – for better or worse – almost instantaneously. Education reforms can take up to a generation to manifest themselves in economic growth, infrastructure has a long lead time, and there’s not much the Legislature can do about Nebraska weather. But a different tax system can change everything.

Indeed, something bold is needed. We’re coming out of this economic downturn, knock on wood. Entrepreneurs, investors, ideas people, creative people, ambitious people – thanks to modern transportation and communications, they can live just about anywhere in the world. “Why Nebraska?” is the question that you’ll need to answer for these people. It’s not the only answer, but no income tax is a pretty good answer.

Progressivity vs. Regressivity

A few words on progressivity and regressivity. The good people at ITEP and Citizens for Tax Justice have their updated study out, ranking the states on regressivity. They conclude that every state’s tax system is regressive, even California and Vermont. That’s a weakness of their methodology – however progressive you make your tax system, it’s still not progressive enough. We have other methodology critiques but I won’t bore you with them here.

The reason their study gets traction is because fairness is important. Fairness is subjective and fairness is tough to measure, but tax systems need to be perceived as fair by the taxpayers subject to them.

To be meaningful, though, you have to do more than ITEP’s comparing the effective tax rate of bottom income quintile with the top quintile and so on. Three things to keep in mind.

First, taxes is just half the equation. The real help that state and local governments give to those who need help is on the spending side. If you just look at taxes, you’re going to miss TANF, you’re going to miss SNAP, you’re going to miss Section 8, you’re going to miss pre-K, you’re going to miss job training, and a bunch of other things that often make a bigger difference at promoting equity and helping people out than how many different income tax brackets you have.

Second, the tax system is a blunt, problematic, and I would argue ineffective tool for achieving societal fairness. Take the sales tax exemption for groceries, which everyone loves and no one wants on the table. One reason everyone likes it is because it gives makes a necessity of life—food—tax-free for those struggling to get by. But the blunt tax exemption doesn’t just apply to the working mom picking up food for the kids. It also applies to the rich guy buying his arugula and caviar. Many states have hefty corporate income taxes, but a corporation can be owned by millions of middle class Americans with 401(k)s as much as it can be owned by a couple fat cat New Yorkers. The tax system is meant to raise revenue. It’s not a good tool for reshaping society.

Third, remember that a lot of these stats, including ones that I’m providing you, are snapshots. A lot of the poor are people in their twenties just starting out and retirees with no income but lots of assets. Half of millionaires – half of the people who report $1 million or more of income on their tax return – are a millionaire for just one year. Only 6% of millionaires stayed a millionaire for all nine years between 1999 and 2007. I sometimes tell the story of President Harry Truman. When he left office in 1953, he had nothing, as he had spent his whole life in public office, first in the Army, then as a county administrator, then Senator, then Vice-President and President. He did what most presidents do routinely nowadays – he wrote his memoirs, a one-time project to earn a bunch of money to keep him and his wife comfortable for the rest of their lives. But when he sold those memoirs to the publisher, he did it at a time when the top income tax rate was 90 percent. He kept almost nothing from the book. In fact, we as a country passed the presidential pension law because it was very likely he would have ended up on relief otherwise. By the way, Herbert Hoover was the only other living ex-president at the time, and he took the pension too, not because he needed it but because he didn’t want Truman to be embarrassed at being the only one. Hoover often gets a bum rap so I wanted to mention that noble moment of his.

Anyways, that whole story should remind you of the perils of soak the rich tax policies.

Proper Taxation of Business-to-Business Transactions

The Governor should be commended for his overall vision and goals for Nebraska’s tax system. I will admit, however, that the sales tax broadening he lays out is not what I would have come up with. Taxing business-to-business transactions, although it’s a mistake nearly every state makes, leads to double taxation. We actually recently recommended in North Carolina and Louisiana that they exempt business-to-business transactions and instead expand the sales tax to services. Today, in many states, the clothing store, the convenience store, every retailer has to collect sales tax on everything they sell, every transaction. But lawyers, accountants, real estate agents – all of their sales are completely tax-free. Ending this unfair disparity between those who sell goods and those who sell services, which is actually just a holdover from how sales taxes were designed in the 1930s – would lead to a more equitable and stable sales tax system and generate a lot of revenue to reduce sales or income tax rates. If that is an avenue that is of interest to the Governor or the Legislature, we are certainly eager to help.

This suggestion and criticism, I must note, does not reduce my enthusiasm for the overarching goal: a simpler, more sensible tax system for Nebraska that will mean more jobs and economic growth.

The “Three Legged Stool” Argument Has No Basis

A spurious you may hear that you should be aware of is the “three legged stool” argument. Now there are plenty of decent and sensible reasons to oppose an income tax repeal but this is not one of them. The argument goes something like you need every major tax because that way you have a diversity of revenue options. Much like a stool needs three strong equal legs, a state revenue system needs three separate revenue sources.

There is no academic evidence supporting this urban legend. In fact, the state with the most stable revenue over the last ten years was South Dakota: a state that doesn’t even have corporate and individual income taxes, and gets nearly half its revenue from the sales tax. One of the most volatile was California: a state that has every major tax. Believe me – it’s my home state – if there’s a tax out there, California’s got it.

In reality, if you want a stable tax system – stable for government and for taxpayers – what matters is that you have a well-structured tax system with broad bases and low rates. Having three revenue sources achieves nothing if each of them is badly designed, with high rates and narrow bases, as in California. By the way, we looked at volatility by type of tax, and once again: corporate income and individual income taxes were the most volatile, sales taxes about in the middle, and property taxes least volatile. Income taxes magnify the economy – they boom in good times and bust badly in bad times. Every public finance expert will agree on this, although they will disagree on what to do about it.

For my part, reducing or repealing your income tax and relying more heavily on a broad-based sales tax will likely reduce year-over-year volatility. It would be more stable. So bear that in mind when someone starts talking about the supposed three-legged stool.

Thank you.

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