Collaborative Research: The Impact of State and Local Taxes on Growth Using Improved Tax Measures

W E Upjohn Institute For Employment Research, Kalamazoo MI

Investigators

Abstract

This research will provide important new evidence on a long-standing controversy in academic and public policy circles: whether tax incentives are a cost-effective means of stimulating state economic growth. Previous research has relied on statistical analysis to determine the effect of state and local taxes on state economic growth, controlling for other factors that influence growth. This project will utilize a superior measure of the crucial explanatory variable?state and local taxes on business?and test the sensitivity of the results to the kind of tax measure used. Most previous estimates of business taxes' influence on growth have employed a broad, average tax measure such as state taxes as a percent of state personal income. Yet, economic theory suggests that marginal costs, not average costs, are what matters for profit-maximizing investment behavior. This project develops and uses a marginal tax rate -- the additional taxes resulting from new business investment in a state -- derived from a representative firm model that incorporates apportionment formulas, state and local tax incentives, and other features of the state and local tax system. Marginal tax rates are in fact very poorly related to the kinds of average tax rates typically employed in previous studies. This casts doubt on the accuracy of prior estimates of the size of the tax effect on growth in cross-state evaluations of economic development policy. To investigate the possible bias, the researchers will estimate multiple growth equations for 20 U.S. states using alternative tax measures and a variety of functional forms. Something of a consensus has developed among academic researchers over the past 15 years that the sensitivity of economic growth to business taxes is small (although some academics take issue with this conclusion). This in turn implies that tax incentives do not stimulate sufficient growth to offset the public revenue losses from the incentives. Incentives are good policy, then, only if the public benefits exceed the tax losses. Public economic development officials, on the other hand, continue to believe that incentives not only create jobs but augment revenue. This project helps to refocus scholarly debate on replicable findings about the impact of state and local business taxes on economic growth. Because the marginal business tax measures in this project differ considerably from the commonly used measures, this research will shed important light on this debate.