Misunderstanding the Link between Taxes and Economic Development

Tax Foundation graphic reproduced in the Atlantic Cities blog.
Tax Foundation graphic reproduced in the Atlantic Cities blog.

by James A. Bacon

In his latest post at the Atlantic Cities blog, Richard Florida asserts that a “lower state income tax does not spur economic development.” In support of his proposition, he argues that states with higher tax burdens are more affluent; they have higher concentrations of talent and workers in the so-called “creative” occupations. Writes Florida:

States with tax [income tax] burdens that range from $1,205 to $1,864 per person average $10,000 more in income than states with zero state income taxes — $81,594 versus $69,612. The same pattern is true of wages — states with high collections average $50,610 in wages versus $43,638 for states with low collections.

That’s pretty much his whole argument, although he does cite a two-year-old study from Nevada finding that states with Republican governors are associated with somewhat lower rates of growth and another study that criticizes “business climate” indexes as designed with political ends in mind.

There’s really no excuse for such superficial analysis. Yes, it’s true that high taxes and high incomes are correlated. But which way does the causality run? Do high taxes lead to high incomes, or do high incomes lead to high taxes? I would argue that the high incomes came first and the high taxes followed.

The evidence will show that some high-income states can trace much of their good fortune to historical factors, such as their 19th-century and early 20th-century leadership in the industrial revolution that created the vast wealth that seeded key institutions (universities, especially) necessary for the transition to the late-20th century transition to the knowledge economy. Thus, to pick an obvious example, Massachusetts prospers today because it is home to Harvard, MIT and a host of other highly ranked universities with billion-dollar endowments — not because of the splendiferous benefits conferred by its high taxes. Other states retain pockets of prosperity because they are home to world-class industry clusters that emerged decades ago and that seemingly no amount of mal-governance can dislodge. Think California, Silicon Valley and Hollywood.

What small-government conservatives argue is that lower-tax regimes stimulate more economic growth than high-tax regimes. Lower taxes may have little effect on an entrepreneur’s proclivity to launch a new business, but they do allow entrepreneurs to retain more of their earnings, which they can reinvest in growth. (With the wealth of online tax calculators and estimators available, it’s much easier for businesses to get a better idea of their tax situation in order to grow in one state or another.)

The evidence is indisputable that high-tax states, on average, experience less job creation and significant out-migration to low-tax states. It’s pretty intuitive that people don’t move from New York to, say, Florida, North Carolina or Georgia for the better restaurants and high-brow culture. They move in search of superior job opportunities and lower cost of living. As a result, over a time span measured in decades, the income and wealth gap between Southern states and Northern states has narrowed considerably, even more so if you adjust for the differences in cost of living.

Where the debate gets interesting is when you ask the question, do higher taxes allow some states and local governments to support a higher level of infrastructure, amenity and service that people value more than the taxes they’re paying? Essentially, that is the argument that Florida makes. Insofar as states and regions use higher taxes to pay for better public schools and higher education, there may be some truth to that counter-argument. But when higher taxes go to pork-barrel spending, outrageous retirement packages for public employees and a more generous safety net for the poor, the argument falls apart.

To summarize, taxes are only one variable among many affecting economic growth and they explain only a modest fraction of the variability in growth rates between states. While lower taxes are (to my mind) clearly preferable to higher taxes, it would be unwise to overstate the case and tout them as an economic-development panacea. On the other hand, it is foolish, as Florida has done, to insist they have no significance.

For what it’s worth, Virginia’s income tax burden is 8th highest in the country, according to Tax Foundation data. Maybe that explains why economic growth here is relatively sluggish given the otherwise favorable business climate we have.

Share this article


(comments below)


(comments below)


10 responses to “Misunderstanding the Link between Taxes and Economic Development”

  1. DJRippert Avatar

    The most interesting thing about this article is the high tax status of Virginia. Even Maryland has a lower tax burden. Are you kidding me?

    The clowns in the Imperial Clown Show in Richmond are hysterical. The conservatives spend their days throwing their shoulders out of joint patting themselves on the back over Virginia being a low tax state. The liberals cry buckets of tears over the many government programs that are underfunded because Virginians don’t pay enough in taxes.

    Meanwhile, we have the 8th highest income tax in the US.

    All of which brings us to Ken Cuccinelli’s latest ad. He is filmed in a hardware store saying that he wants to lower taxes by eliminating tax loopholes. That’s a winning idea. Nothing would make me happier than seeing the Clown Show separate from the insider cabal that runs this state.

  2. larryg Avatar

    well.. you have to look at ALL the taxes in a state, Income, Sales , Real estate, property, etc…

    some states fund education more at the state level than others and that’s a big chunk of taxes whatever level it is collected at.

    but I question the lower tax idea because it assumes that taxes are going into some economic black hole – and that’s simply not true.

    Take Massachusetts and Northern Virginia, for example, both high tax areas and what is the money spent on? Education. So if NoVa cut it’s taxes and reduced it’s investment in education, would it prosper better economically?

    Let’s ask DJ that question.. what say you DJ?

    Massachusetts also taxes high and spends high on education and is ranked 7th in the world while the rest of the US ranks 25th.

    I’m betting that NoVa ranks up there with Mass, many points higher than RoVa.

    so that money goes to good use (depending on your point of view) but it also goes right back into the economy.

    so.. people in NoVa instead of spending more of their money on Volvos and backyard pools spend it on education – but in both cases the money goes back into the economy.

    would people, as Conservatives say, “spend it more wisely than local govt would (on education)”.

    That’s likely where MIT came from…. higher taxes spent on higher Ed….

  3. NoVA pays for public schools twice. We send huge amounts of personal income tax revenues to Richmond, and get a fraction back. And then we pay high real estate taxes to operate our own public schools.

    I fully support paying taxes to ensure public schools throughout the state can offer a good education to their students. I would qualify that obligation with a minimum effort requirement, so that rural schools cannot cut real estate taxes when they get more money from Richmond. Second, I think the school divisions in urban/suburban/exurban areas should have their higher cost of living accounted for in the system.

    What drives me the craziest are the morons from NoVA who relentlessly push for more state tax dollars for education without understanding how the system operates. Yes, fight hard to send more dollars to Richmond in exchange for pennies and nickels. Some of them are so foolish that they could easily write editorials for the WaPo.

    1. DJRippert Avatar

      Education is a big part of the sucking sound of money flowing out of NoVa. But there are other areas as well. In 2011 Fairfax County had 11 murders on a base of 1.1M residents. The US homicide rate in 2011 was 4.8 per 100,000 people or about 53 for a population the size of Fairfax County’s. Virginia’s murder rate in 2011 was 3.7 per 100,000. However, if you remove both Fairfax County’s population and murder count Virginia goes up to 4.2 per 100,000. Last year Henrico County had 12 murders with a population less than one third that of Fairfax County’s.

      How much extra do we pay for law enforcement, jails and prisons than we use?

  4. larryg Avatar

    TMT – isn’t there a required local effort for schools?

    have you seen this:

  5. Richard Avatar

    It’s as ridiculous to link high taxes with economic development as it is to link low taxes with economic development.

    High taxes may be the result of inefficient government. Low taxes may be a symptom of a state’s “race to the bottom.”

    If taxes are used to make life better for the people who live and work there, they’re worthwhile and will make the state more attractive to individuals (including the “job creators”) and businesses. If a state has a lousy school system, inferior universities, a bad legal system, and bad roads, it doesn’t matter how low the state’s tax rate is.

  6. larryg Avatar

    the low or no tax premise is that people would spend their money more wisely than govt would.

    so, for instance, when govt sends people a bill for water/sewer, the premise is that if you let people decide how to spend that money, they’d find a better thing to spend it on.

    or if we did not have taxes for schools – that people would find better, less costly but better private schools to send their kids to.

    they get more circumspect when it comes to taxes for roads. They usually end up saying that govt wastes money and we could have more/better roads if govt was not so wasteful but mention letting the private sector build roads and charge for them and that is even more unpopular.

    people buy pornography, booze, cars with bad repair records, super-fat fast food, airline trips to recreational theme parks, but they won’t buy health insurance or save enough money for retirement but they’ll send money to religious ministries and online/TV scams.

    Not all people do these things obviously but the economy consists of a great deal of not-very-smart spending that is not wise nor frugal nor truly productive in an economic sense.

  7. larryg Avatar

    and with NoVa – no matter the issue with school funding – they choose to pay much higher taxes to provide – literally – world class educations to their citizens.

    they choose to do this. They’d do it no matter the SOQ composite index issue.

    what would NoVa be if it were a “low tax” , low-tax schools region?

    so you’d cut taxes in NoVa, cut funding to schools so it looked more like RoVa and the extra money in people’s pockets would go into the non-govt economy ….and do what?

    what would be the better economic path from that lower tax scenario?

    seriously. let’s hear a rationale for NoVa for lower taxes…

  8. DJRippert Avatar

    ” … and the extra money in people’s pockets would go into the non-govt economy ….and do what?”.

    Yes, all money that people keep vs giving to the government is wasted. Your subscription to the Obama4Life foundation is assured.

  9. larryg Avatar

    Actually it has virtually nothing to do with Obama and everything to do with the idea that cutting taxes starves money from the govt who does not spend it in productive ways and lets people decide what to spend it on – which is virtually always more productive and useful than what the govt would spend it on.

    Put that idea at the Fairfax County level and agree that lowering property taxes and cutting the Fairfax County school system would be better for it’s citizens.

    true? Obama’s fault again?


    for some reason – the idea of cutting taxes – at the local level – seems like a totally different concept than cutting taxes at the National level, eh?

    I just thought that if this idea really had solid majority support – it would certainly start at the local level and bubble up to the State and National level rather than the other way around.

Leave a Reply