Bacon's Rebellion

James A. Bacon

Taxes, Government and Prosperity

Virginia can't tax its way to prosperity, but starving critical assets like roads and schools won't create wealth either. The solution: Demand productivity and innovation from state and municipal government.

Back in 2004 when Virginians were debating the merits of higher taxes, a prominent politician coaxed chuckles from a business-friendly crowd at an event I attended when someone asked, wouldn't higher taxes hurt Virginia's economic growth?

Low taxes were OK, he retorted -- if you wanted to be like Mississippi.

Badda bing!

There were two assumptions embedded in that quip. First, that Mississippi had significantly lower than average taxes. Second, that the state's unenviable economic performance was no endorsement of low taxes.

It's often illuminating to refer to the facts. Back in 2004, according to Tax Foundation data, the Magnolia state ranked 31st among the 50 states in terms of state and local tax burden per capita -- five notches higher than Virginia. Virginia would hardly look to Mississippi as an example of a low-tax state.

Mississippi was indeed the poorest state in the country, but it wasn't as poor as it once was. In 1970, its per capita income was a pitiful 64 percent of the national average. By 2005, it had clawed its way up to 73 percent of the national average -- overcoming the legacy of Jim Crow segregation, an ill-educated workforce and a century of under-investment in knowledge-creating institutions. Mississippi's lower-than-average tax burden, higher than Virginia's though it was in 2000, was one of its few competitive advantages and arguably accounted for much of its slow but steady progress toward national norms.

I don't mean to dwell on Mississippi. The point of the story is this: A lot of what Virginia's political elites think they know about taxes and regional economic growth is driven by ideology and partisanship, and a lot of it is just plain wrong. The complex reality doesn't support the position of either those who think taxes are no big deal, or those who would oppose taxes blindly without offering alternatives for accomplishing core missions of state and municipal government.

Allow me to submit two propositions:

• All other things being equal, lower taxes create a business climate more favorable to growth and prosperity than higher taxes.

• But all things are rarely equal. The economic performance of states and regions is strongly influenced by their local industry mix -- regional economies rise and fall along with their leading industries -- as well as the level of public investment in productivity-enhancing, wealth-creating assets like schools, universities, research centers, transportation systems and other infrastructure.

As I hope to demonstrate, taxes and public investment both matter. The central challenge for Virginia government is to keep taxes as low as possible while also delivering core public services needed to sustain prosperity and a high standard of living.

Many of those who editorialize about state-local government posit a one-to-one trade-off between taxes and services: In the absence of borrowing, cuts in taxes can be paid for only by cuts in services. That notion, I maintain, is intellectually bankrupt and a sure-fire recipe for stagnation. Virginia cannot afford such a blinkered approach to governance.

Instead, Virginia should follow a third path: working diligently to make government more efficient... in effect, to do more with less. We need to replace a governmental culture of "good enough" with the zealous pursuit of productivity and innovation. That's what successful private companies do, even if it requires painful change, and it's what the enterprise known as the Commonwealth of Virginia must do as well.

Economists have debated the impact of state/local taxes on economic performance for years. You can hop onto the Internet and find any number of studies to fit your preconceived notions. Here's my quick-and-dirty analysis.

In the chart below, I've ranked the states by 2000 tax burden, as calculated by the Tax Foundation.

As I argued earlier in the "Economy 4.0" series, per capita income is the single best metric for economic prosperity. Accordingly, using Bureau of Economic Analysis figures, I have expressed each state's per capita income as a ratio of the national average in 2000 and 2005. (A score of 100 equals the national average. A score of 95 indicates per capita income five percent lower than the national average; 102 indicates two percent above average.)

Then I calculated the percentage-point gain or loss in relative standing over that five-year period. Virginia, for instance, rose from 104 to 109, meaning that its income gained five percentage points relative to the national average.

Next, I broke down the 50 states by quintiles and calculated the average tax burden and average income gains for each quintile, as seen below.(1)

Overall, it is clear to see, lower tax burdens are associated with higher rates of relative income growth.

It's not difficult to explain why this might be the case. Lower business taxes improve the return on capital that businesses invest. While taxes may be only one factor among many influencing the investment decisions of large corporations whose playing field is the entire globe, they are particularly significant for small and midsized businesses that reinvest profits to fuel their enterprise's growth.

Lower personal taxes also create a hospitable climate for foot-loose members of the creative class who have the means to live anywhere they want. As Richard Florida has famously argued, the "creatives" are drawn to communities marked by openness, diversity and tolerance. But an examination of internal migration patterns in the U.S. also shows a consistent flow of well-off citizens from high-tax states to low-tax states. It appears that many members of the creative class like to keep the money they earn rather than have it taxed away.

However, there are plenty of exceptions to the low-tax rule: The middle quintile(2) of states was the worst performer of all between 2000 and 2005 (see the chart below), showing no gains compared to the national average at all. Thus, it is equally clear that taxes are not the only factor that contribute to income growth.

What are some of those other factors? One is industry mix. If you dredge through the details of the per capita income data over the years, you'll see that many smaller states move up and down with changes in the price of energy and agricultural commodities that play a large role in their economies. Similarly, the decline of certain industries can drag a state down, as automobiles have done to Michigan, while the rise of other industries, such as information technology in Virginia, has propelled per capita income growth.

Another factor may be the large-scale immigration (legal or otherwise) of poor, unskilled Latin Americans into the border states. Undoubtedly that was a factor behind the under-performance of California and Texas between 2000 and 2005. However, one shouldn't make too much of this phenomenon: Arizona and New Mexico, which also share the border with Mexico, showed relative income gains over the same period.

Finally, as some economists have noted, higher levels of state spending (and the taxes to