About the American Legislative Exchange CouncilTax Myths Debunked has been published by the American LegislativeExchange C...
3Table of Contents		 Executive Summary				 Review of Reform Proposals: Primary Findings				 A Public Finance Mythology Rev...
4 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDThe U.S. economy has recently suffe...
5reform: Repealing property taxes and replacingthe revenues with a revised sales tax.” Texas PublicPolicy Foundation.Laffe...
6 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDdiscussion with references to the l...
7I. IntroductionMore than five years after the recession began in2007, the U.S. economy continues to be plaguedby weak eco...
8 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDII. Background: The State Fiscal Po...
9Mac and others into the doomed policyof “democratization of credit” and hous-ing access.The “hands off” policy that Germa...
10 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDIII. Promoting State Economic Grow...
11IV. Myth vs. Reality: Setting the Record StraightUnfortunately, the fiscal policy debate will becomemore strident as the...
12 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDdrinking even more.2By the Austria...
13•	 More recently, in a wide-ranging review of reces-sion history, Alesina et al. (2002) determined thatspending cuts are...
14 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDMyth#2Lower tax rates are bad for ...
15Do Revenues Really Rise when Tax Rates areIncreased?It is important to evaluate the implicit premise of pro-gressive tax...
16 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDFigure 7 suggests that total state...
17State-Level StudiesResearch at the state level is consistent with these find-ings. States compete with each other for bu...
18 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDMyth#4Austerity in the form of spe...
19opportunity of the recession to make structural changesto reign in the size of the state public sector. In fact, ac-cord...
20 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDthat deregulation, free trade and ...
21It is unlikely that those who wish to find fault with theoutcomes of our economy will be satisfied by correctionof the p...
22 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKED•	 The lowest quintile workers hav...
23A thorough reading of Orszag and Stiglitz (2001) reveals,however, that even they recognize this advice is counter-produc...
24 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDtoday’s interest rates. Strictly f...
25V. The Conundrum for StatesFor states, raising taxes on the wealthy is particularlychallenging. States like Oregon and M...
26 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDVI. Recent Research Supporting Fre...
27(ITEP) and its sister organization, Citizens for Tax Justice(CTJ), have seemingly led the policy attack on Laffer andALE...
28 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDVII. What do the Critics have to O...
29Third, Fisher’s findings that the ALEC–Laffer state rank-ings bear no relationship to state economic health iscontrary t...
30 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDThe findings are completely contra...
31It is noteworthy that the revenue relationship to taxrates is not established directly by the original LafferCurve itsel...
32 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDLaffer and Moore Econometrics stud...
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Tax Myths Debunked

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Across the country, states are seeking new ways to become more economically competitive and better ways to grow. Unfortunately, economic prosperity can be elusive, as some policy prescriptions that are supposed to help miss the mark. All too often, myths about taxes and budgets are prevalent in public policy debates and misinformation abounds. It is important to set the record straight with the facts regarding which policies allow a state to prosper and which policies can trap a state in economic malaise.

In Tax Myths Debunked, renowned economists Dr. Randall Pozdena, former vice president of research at the San Francisco Federal Reserve Bank, and Dr. Eric Fruits refute the Left’s popularly repeated myths about taxes and spending. Using both theoretical and empirical evidence, Tax Myths Debunked confirms what is clearly proven in Rich States, Poor States: The key to economic prosperity at the state level is in free-market, pro-growth tax and fiscal policy.

For more information, please visit www.alec.org

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Tax Myths Debunked

  1. 1. About the American Legislative Exchange CouncilTax Myths Debunked has been published by the American LegislativeExchange Council (ALEC) as part of its mission to discuss, develop, anddisseminate public policies, which expand free markets, promote eco-nomic growth, limit the size of government, and preserve individualliberty. ALEC is the nation’s largest non-partisan, voluntary member-ship organization of state legislators, with more than 2,000 membersacross the nation. ALEC is governed by a Board of Directors of state leg-islators. ALEC is classified by the Internal Revenue Service as a 501(c)(3) nonprofit, public policy and educational organization. Individuals,philanthropic foundations, businesses, and associations are eligible tosupport ALEC’s work through tax-deductible gifts.About ALEC’s Center for State Fiscal ReformALEC’s Center for State Fiscal Reform strives to educate our legislativemembers as well as our center-right allies throughout the states whoshare a commitment to our principles and shared goals. We also striveto educate our legislative members on how to achieve greater eco-nomic prosperity by outlining which policies work and which ones fail.This is done by personalized research, policy briefings in the states,and by releasing nonpartisan policy publications for distribution suchas Rich States, Poor States and the State Budget Reform Toolkit.Acknowledgements and DisclaimersThe authors wish to thank the American Legislative Exchange Council(ALEC) and the Center for State Fiscal Reform for their kind supportof this research. We would also like to thank Ron Scheberle, MichaelBowman, Jonathan Williams, Kati Siconolfi, Andrew Bender, Fara Klein,Ben Wilterdink, Adam Wise, and the professional staff at ALEC for theirvaluable assistance with this project. The opinions cited herein arethose of the authors and should not be attributed to those cited inthis docu­ment or any other organizations with which the authors areaffiliated.TAX MYTHS DEBUNKED© 2013 American Legislative Exchange CouncilAll rights reserved. Except as permitted under the United States Copy-right Act of 1976, no part of this publication may be reproduced ordistributed in any form or by any means, or stored in a database or re-trieval system without the prior permission of the publisher. The copy-right to this work is jointly held by ALEC and the authors. This studymay not be duplicated or distributed in any form without the permis-sion of the copyright holders and proper attribution.About the AuthorsEric Fruits, Ph.D., is president of Economics International Corp., anOregon-based consulting firm specializing in economics, finance andstatistics. He is also an adjunct professor at Portland State Universityand Pacific Northwest College of Art. Fruits has been engaged by pri-vate and public sector clients, including state and local governments,to evaluate the economic and fiscal impacts of business activities andgovernment policies. His economic analyses have been widely citedand have been published in The Economist, The Wall Street Journal andUSA Today. Fruits has been invited to provide analysis to the Oregonlegislature regarding the state’s tax and spending policies. His testimo-ny regarding the economics of Oregon public employee pension re-forms was heard by a special session of the Oregon Supreme Court. Hisstatistical analyses have been published in top-tier economics journals,and his testimony regarding statistical analysis has been accepted byinternational criminal courts.Contact Information:Eric Fruits, Ph.D., Economics International Corp.,Portland, OR 97213Phone: 503.928.6635E-mail: info@econinternational.comRandall Pozdena Ph.D., is president of QuantEcon Inc., an Ore-gon-based consultancy. He received his B.A. in economics, with honors,from Dartmouth College and his Ph.D. in economics from the Universi-ty of California, Berkeley. Former positions held by the author includeprofessor of economics and finance, senior economist at the StanfordResearch Institute (SRI International) and research vice president ofthe Federal Reserve Bank of San Francisco. He also served on numer-ous public, non-profit and private boards and investment committees.He is a member of the CFA Institute and a member and former officerof the Portland Society of Financial Analysts. He has written more than50 refereed articles and books and has been cited in The Wall StreetJournal, USA Today and numerous other national and regional publica-tions. He has served for more than a decade on the Oregon Governor’sCouncil of Economic Advisors.Contact information:Randall J. Pozdena, Ph.D., QuantEcon Inc.,P.O. Box 280, Manzanita, OR 97130Phone: 503.368.4604E-Fax: 866.307.2466E-mail: pozdena@quantecon.com
  2. 2. 3Table of Contents Executive Summary Review of Reform Proposals: Primary Findings A Public Finance Mythology ReviewI. IntroductionII. Background: The State Fiscal Policy ChallengeIII. Promoting State Economic Growth: Free-Market vs. Status Quo PoliciesIV. Myth vs. Reality: Setting the Record StraightMyth #1: Increased government spending stimulates the economy during recessions National and Cross-Country Studies State-Level StudiesMyth #2: Lower tax rates are bad for the economy in a recession Do Revenues Really Rise when Tax Rates are Increased?Myth #3: Raising tax rates will not harm economic growth National and Cross-Country Studies State-Level StudiesMyth #4: Austerity in the form of spending cuts will harm growth and employment Evidence that Austerity Can Stimulate Growth Is Europe Really Practicing Austerity?Myth #5: Real household income has not grown in the past 20 yearsMyth #6: The distribution of income is increasingly inequitableMyth #7: Raising tax rates on the rich will not harm the economy Does it Generate Enough Revenue? Where are we on the Laffer Curve?V. The Conundrum for StatesVI. Recent Research Supporting Free Market Approaches Rich States, Poor States The Progressives’ CritiquesVII. What do the Critics have to Offer? Dubious Analysis Oklahoma: Lower Income Taxes Fuel Faster Economic Growth Data and Methodology used by Arduin, Laffer and Moore Econometrics Why the Progressives’ Critique should be Ignored Tennessee Death Taxation: Elimination would Stimulate Economy Data and Methodology used by Laffer and Winegarden The Progressives’ Flawed Critique Dubious and Failed Policies ConclusionReferences and BibliographyEndnotes4457810111112131415161617181819192122232425262626282830303132333334353644
  3. 3. 4 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDThe U.S. economy has recently suffered its deep-est and most prolonged recession since the GreatDepression. The fundamental causes of the recessionand the slow recovery are the result of two decades ofpoorly conceived housing credit and other policies andthe adoption of long-ago discarded Keynesian policies.The latter policies have failed to rejuvenate the economyand have left behind a massive accumulation of nationaldebt. This accumulation has significantly constrained thepolicy options of the Federal Reserve, Congress and stateand local governments.State fiscal policy reform therefore needs to include pol-icies that will support economic growth and break withthe long tradition of high levels of taxation, governmentspending and intervention at the state level. The statesmust do this alone because the federal government willbe in no position to provide financial assistance.In this setting, defenders of the status quo and advocatesfor the so-called “progressive” reforms of higher taxesand greater government involvement have sought to dis-credit legitimate and research-based state fiscal policyreforms. The purpose of this paper is to set the recordstraight regarding recent pro-growth reform proposals,as well as illustrate the theoretical and empirical mythol-ogy that is used to discredit reform efforts.After first providing an introduction and background tothe current challenges that states face in reforming taxand spending strategies, the study provides an analysisof reform proposals that will reduce tax system impedi-ments to economic growth.Several scholarly articles and papers are referencedthroughout this report, and detailed citations are avail-able in the report’s bibliography.Review of Reform Proposals: Primary FindingsThe report’s primary findings are as follows:Well-respected economics authorities have ad-vanced tax reform proposals that offer the prospectof helping states grow their way out of their weakeconomies and the legacy of fiscal excess. Theseproposals are referred to herein as “free-market”proposals because their intent is to remove imped-iments to real recovery of the private economy.This is necessary not only to advance the economicwell-being of the states’ residents, but also to pro-vide an economy with enough vigor to support keypublic activities and services. The analyses reviewedinclude:Laffer, A. B., Moore and Jonathan Williams, RichStates, Poor States: ALEC-Laffer State EconomicCompetitiveness Index, (2012) for AmericanLegislative Exchange Council, 5th edition.Arduin, Laffer and Moore Econometrics (2011).“Eliminating the State Income Tax in Oklahoma: AnEconomic Assessment,” Oklahoma Council of PublicAffairs.Arduin, Laffer and Moore Econometrics (2009).“Enhancing Texas’ economic growth through taxExecutive Summary
  4. 4. 5reform: Repealing property taxes and replacingthe revenues with a revised sales tax.” Texas PublicPolicy Foundation.Laffer, A. B. and Winegarden, W. H. (2012). “The eco-nomic consequences of Tennessee’s gift and estatetax.” The Laffer Center for Supply-Side Economicsand Beacon Center of Tennessee.We found these proposals to be well-founded inwidely accepted theory and empirical work. Whereappropriate and available, we have brought our ownor others’ research to bear on theoretical or mea-surement issues raised by critics of these works.In all cases, we concluded that the opinions, anal-yses and measurements offered in these works tobe valuable resources for state policymakers facingtough fiscal choices.We reviewed “progressive” critiques of the afore-mentioned works to the extent they were suitablefor review. In general:Broad and inaccurate statements about the stateof the literature are made, but, in general, thecritiques make sparse or no reference to the ex-tensive literature that exists in the public financefield.The critiques, coming primarily from affiliatedprogressive organizations and networks, cameacross as “sound-byte” public relations cam-paigns.There is virtually no part of the record of the crit-ics that can be construed as having contributedin a meaningful way to the theory, measurementand analysis of the tax reform debate. Yet, theyhave been distributed widely as if they are re-search products.The authors of the critiques do not displayeconomics expertise or modern analyticalskills in the documents, Web sites or pro-mulgating organizations. They appear to la-bor under mythological or, at best, ambig-uous appreciation of what the professionalliterature has to say about the issues relevant tothe work of Laffer et al. or their critiques of thoseworks.The Laffer-ALEC Rich States, Poor States rankingof states’ pro-market policies have been subjectto a particularly disingenuous critique by PeterFisher, an economist on the Iowa Policy Project.We find that Fisher’s findings–though widely dis-tributed as authoritative–in fact are the result ofamateurish and incorrect analysis and misinter-pretation of data. When analyzed properly, theLaffer-ALEC rankings are proven to be stronglypredictive of states’ relative economic health.A Public Finance Mythology ReviewGiven the state of the critics’ misunderstanding of theanalyses crucial to the tax reform debate, this paper at-tempts to address that broader issue. We offer a briefreview of what we consider the key myths that circulateas accepted truth in the debate about tax reform.Our goal is not to deny that legitimate debate remains,but rather to demonstrate the strength of the evi-dence available on certain key issues. We present this“Our goal is not to deny thatlegitimate debate remains, butrather to demonstrate the strengthof the evidence available oncertain key issues.”
  5. 5. 6 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDdiscussion with references to the literature and our ownprior or current research. We address seven stronglyheld propositions that we believe are mostly mythologi-cal or, at a minimum, are open to serious debate.In this discussion, we present theory and evidence thatstrongly disputes this supposition. In fact, there is a sol-id theoretical and empirical basis for concluding thatincreased government spending and “printing press” li-quidity will delay economic recovery.This addresses the oft-heard charge that lowering taxrates slows economic growth because it necessitatesreduction in public spending. In our view, the evidenceand the literature support the notion that lower tax ratesare associated with more rapid growth—both duringnormal periods and during recovery from a recessionarycondition.In this discussion, we review the large body of evidencethat higher tax rates depress income and output.Empirical data supports the notion that a heavily indebt-ed economy exhibits slow growth. “Austerity programs”are focused on reducing the burden of public spendingon the economy so that the debt burden can be reducedas rapidly as possible. These abrupt measures are seen(incorrectly, in our view) as necessarily harmful. In fact,a growing amount of literature supports the notion thatproperly configured austerity programs can be expan-sionary.Reliance on incomplete statistics of various incomemethods and the number and type of actual taxpayersconceals significant real growth in incomes. Althoughthe recession has slowed this growth, it is clear thatthe economy itself is capable of providing broad-basedgrowth in real income, even under adverse policy con-ditions.To distract the public from the problems that public poli-cy has created for the economy, the “fairness” of incomedistribution has become a major feature of progressivetax reform. In this discussion, we present the measure-ment tools progressives use to exaggerate the extentand direction of income distribution, along with the phil-osophical and economic efficiency arguments that weighagainst policy to alter the distribution of income.Regardless of whether the distribution of income is “tooconcentrated” or not, it is a separate issue as to wheth-er it is good policy to more aggressively tax high incomeearners. We conclude that the U.S. tax system is alreadytoo progressive and discuss the implications of impairingthe incomes, savings and investment behavior of higherincome individuals.Myth#1Increased government spendingstimulates the economy duringrecessions.Myth#2Lower tax rates are bad for theeconomy in a recession.Myth#3Raising tax rates will not harmeconomic growth.Myth#4Austerity in the form of spendingcuts will harm growth andemployment.Myth#5Real household income has notgrown in the past 20 years.Myth#6The distribution of income isincreasingly inequitable.Myth#7Raising tax rates on the rich willnot harm the economy.
  6. 6. 7I. IntroductionMore than five years after the recession began in2007, the U.S. economy continues to be plaguedby weak economic growth. Keynesian deficit spendingremedies have not only failed to stimulate economicgrowth, but also have left the country with a huge over-hang of debt. This debt, in total, now exceeds the en-tire annual gross domestic product (GDP) of the nation.At this debt-to-GDP ratio, economic growth slows, andwe risk an extended period of unparalleled economicmalaise. Weakening conditions in the European Unionand China further reduce the likelihood of significantrecovery.This situation poses a particularly challenging problemfor the 50 states. They cannot realistically expect toreceive any significant increase in aid from the federalgovernment. Many state economies remain weak, whileeconomic conditions and demographics put greater ser-vice responsibility in their hands.Put simply, states must engineer their own economicand fiscal recovery policies. Against this background,prominent economists are counseling the states to moveaway from high tax policies that discourage growth andinstead consider policies that stimulate business, invest-ment and job growth.So-called progressives have sought to discredit thesereform efforts and advocate for increases in tax ratesand spending. Despite the fact that these regimens arethe genesis of today’s fiscal problems, the political leftcontinues to advance policies that expand a state’s role,while punishing those who are the sources of most pro-duction, investment and job creation.A key tactic of progressive policymakers is to attack thereform efforts and analyses of economists who advanceincreased focus on invigorating the private sector. Thepurpose of this publication is to identify the dangerousfallacies that are promulgated by progressive advocatesfor return to high tax rate policies and greater relianceon government sector activity and control. In our view,the progressive agenda risks exposing the United Statesto the same calamitous declines revealed by Europe’s ro-mance with social-democratic policy.We begin with a brief review of the missteps that havesapped the strength of the U.S. economy. We then turnto a review of the proposals that have been advanced bymarket-oriented economists and the war that has beendeclared on these ideas by progressive policy advocates.As we demonstrate in our findings, opposition to mar-ket-friendly reform is clearly a web of misrepresentationand out-of-date economic thinking.“The purpose of this publicationis to identify the dangerousfallacies that are promulgated byprogressive advocates for return tohigh tax rate policies and greaterreliance on government sectoractivity and control.”
  7. 7. 8 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDII. Background: The State Fiscal Policy ChallengeEconomic conditions deteriorated for both the na-tion and for most states with the onset of the 2007-2008 recession. The resulting job and income loss creat-ed fiscal problems for states as revenues declined fasterthan changes in public services and costs. The Obamaadministration and its liberal allies in Congress forgot thedismal performance of Keynesian-type deficit spendingas a stimulus of growth in the 1960s and 1970s and em-barked on an aggressive deficit spending policy anyway.Specifically, in the weeks before President BarackObama’s inauguration, his economic team began pushinga stimulus program that eventually became the AmericanRecovery and Reinvestment Act of 2009. The heads of theeconomics team—Berkeley economist Christina Romerand social welfare specialist Jared Bernstein—usedKeynesian multipliers toproject the impact of theproposed stimulus pro-gram’s economic growth.Many states followed thestimulus route as wellby issuing bonds, raisingtaxes and/or exhaustingcontingency funds toboost state spending.The Obama administra-tion’s projections werewidely off the mark. Thepresident’s economistspredicted that by thefourth quarter of 2010the stimulus would have led to employment of 137.5million. Instead, actual employment was 7.3 million low-er than the administration’s projections, and unemploy-ment rates reached 10 percent. They projected that 2012unemployment would be only 5.75 percent. Instead, un-employment is hovering around 8 percent, with much ofthat “improvement” coming from individuals leaving thelabor force unable to find employment.1As Figure 1 makes clear, we would have been better off–by the administration’s own modeling–to not embracethis (and many other) market-interventionist policiesand, instead, let the market work and redress the privatesector credit and housing market distortions that werecreated by the last, great intervention by the Departmentof Housing and Urban Development, Fanny Mae, FreddieFigure 1: The High Cost in Lost Jobs of Obama’s Keynesian “Recovery Plan”
  8. 8. 9Mac and others into the doomed policyof “democratization of credit” and hous-ing access.The “hands off” policy that GermanChancellor Ludwig Erhardt pursuedso successfully after the World War IIdevastation of Germany yielded whatis known as an “economic miracle” ofrapid recovery under conditions muchworse than we faced in 2008. Instead,we borrowed heavily to create suppos-edly “shovel-ready jobs” and delud-ed ourselves that “smart” spending bygovernment can bring the private econ-omy back to life without offsetting reac-tions by the private sector. The sorry leg-acy of that hubris is:• Gross federal debt increased by approximately $1trillion.• The federal debt-to-GDP-ratio rose to 100 percent.• The giant U.S. economy entered the same club as theunraveling, profligate social democracies of Europe.This leaves a durable legacy of fiscal challenges. In partic-ular, a sufficiently high debt-to-GDP ratio creates the riskof entering a death spiral of slower growth and increas-ing difficulty to meet interest payments and principal ofthe outstanding debt. Specifically, when the ratio of out-standing debt–to-GDP exceeds 70 percent, it becomesdifficult to grow fast enough for the economy to workits way out of the debt. Indeed, if interest rates on theoutstanding debt exceed the rate of economic growth, itbecomes impossible to grow one’s way out of the prob-lem, as illustrated in Figure 2.For state governments, this means:• For the foreseeable future, the federal government will be in no position to provide significant financialsupport to the states.• States must find their own solutions to economic and fiscal stimulus and support compatible reformsat the federal level.Indeed, it is likely that the federal government will cut back on current levels of state program support and/or subvert additional federal responsibilities to states. The states thus face the challenge of maintainingbudgetary balance using their own tools.Figure 2: High Debt-to-GDP Ratios Slow Future Growth Prospects0 to 50Ratio of Outstanding Debt to GDP (%), 44 Developed Countries, 2010Source: R. Pozdena, QuantEcon, Inc. © 2010AnnualRealGDPGrowthRateinPercent(2010)50403020100-10-2051 to 75 76 to 100101 to 200+MaximumMinimumAverage
  9. 9. 10 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDIII. Promoting State Economic Growth: Free-Marketvs. Status Quo PoliciesStates must increasingly devise their own methods ofbalancing service demands and revenue realities. Atthe same time, they are faced with a range of competingpolicy tools. In choosing the correct tool, state policy-makers must recognize several inescapable facts:• Economic growth—especially employment growth—is the key metric by which the electorate gradesits policymakers. Elected leaders must evaluate rev-enue raising schemes and spending programs withan eye toward how the policies would stimulate orstifle economic growth.• Fiscally speaking, it’s much easier to balance a bud-get with reduced spending than with increased rev-enues.• Private sector spending and investment has a muchgreater impact on economic growth than public-sec-tor spending.• Public sector spending forces out private sectorspending and investment.The debate is between free-market economists andthose who would preserve or enlarge the role of gov-ernment as a growth strategy. At one end of the rangeare those who advocate free-market approaches. Freemarket economists demonstrate that greater economicfreedom fosters economic growth and that governmentintervention stifles that growth. Policies that liberate theprivate sector from onerous taxes and regulations willspur economic growth. Greater economic growth simul-taneously will reduce the demand for costly governmentservices and increase government revenue.At the other end of the range are those who advocatefor a large and growing role for government and thepublic sector. This approach is born out of a belief thatthe free market is fundamentally flawed and subject tonumerous market failures. The implicit belief system ofsuch advocates is that regulations can mitigate marketfailures without any economic cost. This belief systemsupports the notion that public enterprise can replaceprivate firms and that taxes serve the dual progressiverole of raising revenue to support the public enterpriseswhile redistributing wealth to those who are deemed todeserve it more, whether earned or not.To avoid pejorative labels, we will simply refer to thesetwo positions as the free-market and status quo/pro-gressive positions, respectively.“The debate is between free-marketeconomists and those who wouldpreserve or enlarge the role ofgovernment as a growth strategy.”
  10. 10. 11IV. Myth vs. Reality: Setting the Record StraightUnfortunately, the fiscal policy debate will becomemore strident as the United States navigates the“fiscal cliff” and states find themselves facing the falloutof what may be another global recession.The political rhetoric is already crystallizing aroundbroader issues than have been raised by recent tax re-form proposals in Oklahoma, Texas and Tennessee,which are analyzed at length later in this publication.ALEC’s annual Rich States, Poor States publication hasgenerated many policy debates across the states. RichStates, Poor States ranks the 50 states based on fifteenpolicy indicators that theory suggests should influencethe economic health and growth of the states.The political rhetoric speaks to a set of broad assump-tions and reform notions, including:• Increased government spending stimulates theeconomy during recessions.• Lower tax rates are bad for the economy.• Austerity programs impair economic output andemployment.• Income is becoming less “fairly” distributed.• Higher tax rates on the rich will not harm the econ-omy.When examined closely, progressive arguments againstfiscal reform are not supported by the evidence. In thissection, we address the central factual premises of theprogressive arguments for higher taxes and larger gov-ernment.Myth#1Increased government spendingstimulates the economy duringrecessions.In the popular media, it is widely accepted that reduc-ing the current size of the public sector in a recessionwould be harmful to the economy. This myth is driven bythe incorrect belief that public spending is equivalent toprivate spending, provides stimulus and stability in a re-cession and has no offsetting adverse effects on savingsand investments. Therefore, many incorrectly argue thatif government sector spending or wages are reduced,this translates into a Keynesian reduction in aggregatedemand, diminishing the size of the economy.This myth, unfortunately, has deep roots in economicliterature. The notion of deficit spending as an offset toweak private demand was advanced by John MaynardKeynes in the 1930s. Keynesian-type fiscal policy wascredited (we now know, incorrectly) with the ultimaterecovery from the Great Depression. Worse yet, it pre-vailed over the Austrian view that counseled for privatesaving and “no-use-of-the-printing-press” (deficit spend-ing) to stimulate recovery.The Austrian School dismissed the notion that deficitspending could stimulate the economy and saw it as il-logical as a policy of trying to overcome a hangover by
  11. 11. 12 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDdrinking even more.2By the Austrian logic,taking resources from the private sector in arecession for public spending further depress-es the economy and stifles its recovery.Also, greater public spending today meanshigher taxes at some point down the line. Theresult is that the private sector reduces its ac-tivity in anticipation of having to bear futureburdens of taxation or has less to save and in-vest due to current taxation. Tax policies thatdiscourage investment and spending result inbusinesses and households looking elsewhereto locate or expand and can contribute todelayed investment and hiring. Such effectstend to persist over time. Most studies con-firm that greater government spending duringrecession is associated with slower economicgrowth:National and Cross-Country StudiesA large and long-standing body of literature finds that in-creased or higher government spending tends to reduceeconomic growth rather than increase it. This negativerelationship between prior levels of high spending andgrowth is apparent in the data from developed nations(See Figure 3).• Some 45 years ago, Baumol (1967) warned thatshifting resources from high productivity-growthprivate sectors to low-productivity sectors—for ex-ample, government services--will cause the growthrate of overall output to decline.• Barro (1991) argued that government consumptionhasnodirecteffectonprivateproductivity.Instead,hefinds that increased government consumption lowerssaving and growth through the distorting effects oftaxation or government-expenditure programs.• Hseih, E. and K. Lai (1994), using data from the G-7countries, found no evidence that increased govern-ment spending increases the rate of growth of percapita GDP. Barro (1996), for example, concludedthat most government spending does not enhanceproductivity. Indeed, the ratio of government con-sumption expenditure to economic output has anegative association with growth and investment.• Alesina, A. et al. (1999), using a cross-country anal-ysis of Organization for Economic Co-operation andDevelopment (OECD) studies found that reducingthe share of public spending in the economy wouldincrease economic growth by increasing investment.Specifically, they find that a 1 percent decrease inthe share of public spending in GDP leads to an im-mediate increase in the investment/GDP ratio by .16percentage points. Also, a cut in public sector costsof 1 percent of GDP leads to an immediate increasein the investment/GDP ratio by .51 percentagepoints, by 1.83 percentage points after two yearsand 2.77 percentage points after five years.• Mueller (2003) documented dozens of articlesthat empirically demonstrate that decision-makingand operational efficiency are much poorer in thepublic sector than in the private sector. Hence, thediversion of activity from the private sector to thepublic sector is inherently at high risk of beingcounter-productive.Figure 3: National GDP Growth is Lower when Prior GovernmentSpending Growth is Rapid-5% -3% -1% 1% 3% 5% 7% 9%10%5%0%-5%-10%-15%Percent Change in Government Spending as Share of GDP, 2001-2006PercentChangeinRealGDP2007-2011
  12. 12. 13• More recently, in a wide-ranging review of reces-sion history, Alesina et al. (2002) determined thatspending cuts are the most stimulative of econom-ic growth in a recession. This comports with theHayekian notion that the private sector needs togather increased resources to re-activate invest-ment after a “bust.”In addition to these formal analyses of major spendingstimulus programs, there is a wealth of informal obser-vations of more modest efforts. These, too, are consis-tent with the notion that stimulus spending is often azero-sum game (or worse) without any positive effect onmarket recovery momentum:• In 2008, the Bush administration authorized a one-time tax rebate. “Economists from the BrookingsInstitution estimated that each dollar of revenueloss from the rebates would increase real GDP bymore than a dollar if households consumed at least50 cents of each rebate dollar.” According to MartinFeldstein, who was initially an advocate of a smalltest program, consumers spent only one dollar outof every five received by the rebates, effectivelycausing a decline in GDP.3• The Obama administration’s 2009 Car AllowanceRebate System—the so-called “cash for clunkers”automobile stimulus program–simplycannibalized later car purchases throughits offer of a $4,000 rebate, accordingto Edmonds.com auto analysts.4Of the690,000 vehicles that were purchasedunder the program, at most, 125,000would not have been sold under existingmarket conditions anyway. That meansthat the program cost taxpayers a sub-sidy of $24,000 per car and raised carprices 10.3 percent just to move the pur-chase ahead slightly in time. In essence,the program was a tax with negativebenefits.• The First-Time Homebuyers Tax CreditProgram leads to a similar conclusion.The program offered an $8,000 tax cred-it to first-time homebuyers in 2009 or the first halfof 2010. It was expected that the demand for homeswould plummet after the expiration of the tax cred-it. Indeed, home sales fell by almost 40 percent inthe months after the program expired and homeprices at the end of 2011 were more than 7 percentlower than they had been at the peak reached withthe tax credit.5State-Level StudiesStudies comparing the growth rates of various stateswith different levels of public sector spending also failto identify consistent evidence that demonstrates howpublic spending increases a state’s rate of economicgrowth. This is particularly the case when the spendingis on transfer payments, but it is ambiguous even whenspending is on more productive items, such as educa-tion, health and infrastructure.Figure 4 shows that states that have a history of highrates of total government spending growth (per dollarof Gross State Product [GSP]) subsequently display muchlower rates of GDP growth. This is suggestive of a caus-al relationship between fiscal profligacy and subsequentslow growth.6Figure 4: State GSP Growth is Slower when Prior GovernmentSpending Growth is RapidPercentGrowthinGSP2007-2011-25% -20% -15% -10% -5% 0% 5% 10% 15% 20%Percent Increase in Public Spending as Share of GSP, 2000-200630%25%20%15%10%5%0%-5%-10%
  13. 13. 14 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDMyth#2Lower tax rates are bad for theeconomy in a recession.Progressive advocates of higher tax rates are fond of as-serting that “tax cuts do not pay for themselves,” and taxcuts during a recession compound the problem of weakaggregate demand by making it more difficult to financepublic spending.7Depending on the shape of the LafferCurve (Figure 5), whether one takes a long run vs. shortrun view, this is possible. Before taking that discussionfurther, however, it is important to ask why it is import-ant for tax cuts to pay for themselves. Shouldn’t policy-makers ultimately be more interested in maximizing totalprivate income?• Economist Feldstein makes this point cogently:“Why look for the rate that maximizes revenue? Asthe tax rate rises, the ‘deadweight loss’ (real loss tothe economy) rises so as the rate gets close to max-imizing revenue the loss to the economy exceedsthe gain in revenue. ... [W]ould I really want to giveup say $1 billion of GDP in order to reduce the defi-cit by $100 million? No. National income is a goalin itself. That is what drives consumption and ourstandard of living.”8Brad de Long, an advocate ofhigher marginal tax rates agrees: “Marty and Bruceare, of course, correct: you don’t want to be at thepeak of the curve: you want to be way down on theleft side.”9[Emphasis added.]Let us accept, for the sakeof argument, that the em-pirical evidence argues for aLaffer Curve revenue max-imizing point at combinedtotal of all tax rates of 70percent of income as arguedby Saez and de Long. Thisyields the right-leaning LafferCurve depicted in Figure5.10If the Laffer Curve is, in-deed, shaped this way andthe tax rate is a flat tax rate,then one can calculate theassociated gross income (and after-tax income) thatis associated with this Laffer Curve. Figure 5 pres-ents the Laffer Curve and also the gross income andafter-tax income curves that are consistent with it.This simplified example illustrates an importantpoint: Advocates of high tax rates cannot have itboth ways. If they levy high tax rates and are suc-cessful in gaining higher revenues, then they arecondemning the economy to be smaller. Indeed,at the hypothetical Saez/deLong rate of 70 per-cent and the arithmetic of Figure 5, we find:• Gross private income is maximized at a tax rate ofonly 50 percent.• After-tax private income is maximized at a lowerrate, still of only 33 percent.• At the tax rate (70 percent) that is assumed to max-imize revenue, after-tax income is only 43 percentof what it would be at a 33 percent rate, and grossincome is only 84 percent of what it would be at arate of 50 percent.In other words, shifting resources to the gov-ernment sector does not dynamically improvethe income performance of the economy; it de-grades it.Figure 5: The Laffer Curve: It is not only Revenue that Matters$35,000$30,000$25,000$20,000$15,000$10,000$5,000$-0% 5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%Laffer Revenue CurveGross IncomeAfter-Tax IncomeTax Rate as Percent of Gross RevenuePerCapitaRevenueorIncome
  14. 14. 15Do Revenues Really Rise when Tax Rates areIncreased?It is important to evaluate the implicit premise of pro-gressive tax policy advocates––namely, that higher taxrates and/or progressivity generate more revenue overa useful timeframe. A long-standing empiri-cal challenge to this view is the fact that for60 years, despite wide swings in federal taxrate levels and structures, the share of GDPcollected by the federal government in taxreceipts has been relatively stable (Hauser’sLaw).11Indeed, the federal government hasnever been able to collect more than about19.5 percent of GDP as a revenue share (seeFigure 6). Spending in excess of this share hasbeen funded with borrowing.There have been many debates about whythe receipts-to-GDP ratio is stable.12In ourview, the phenomenon can be traced to bothmarketplace and political-economic behav-ioral reactions stimulated by raising rates.Statistical analysis by the authors suggeststhat, in fact, efforts to increase federal gov-ernment receipts by raising maximum mar-ginal tax rates are neutralized by other be-havioral reactions. Specifically:• Raising the maximum marginal tax rate(causally) elevates the share of federalreceipts relative to GDP, but only by asmall amount and only briefly (less thanthree years).• The higher marginal tax rate reduces thelong-term growth rate of GDP. This, inturn, appears to stimulate an offsettingrestoration of lower statutory rates viapolitical-economic processes.• On balance, over the period depictedin Figure 6, there is a negative correla-tion (of about .33) between marginal taxrates or progressivity and the share ofrevenue in GDP.Interestingly, Hauser’s Law seems to operate for states,too. This is demonstrated graphically in Figure 7. (Themarginal tax rate series likely appears more stable thanit is because of the difficulty of computing a properlyweighted, precise, all-state marginal tax rate.13)Figure 6: Federal Tax Receipts are a Fairly Constant Share ofGDP (Hauser’s Law)Figure 7: A State Version of Hauser’s Law?01234560102030405060708090100195019521954195619581960196219641966196819701972197419761978198019821984198619881990199219941996199820002002200420062008ProgresivityofFederalTaxes(RatioofHitoLowRates)RevenueaspercentofGDPFederal Tax Revenue as Share of GDP (%) - Left ScaleHighest Marginal Rate (%) - Left ScaleProgressivity - Right Scale0%1%2%3%4%5%6%7%1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010State Tax Receipts as Share of GDPWeighted Average Max Personal Income Tax Rate
  15. 15. 16 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDFigure 7 suggests that total state tax receipts, as a shareof GDP, have also been mostly stable in the 5 percentrange, despite changes in the computed top marginaltax rate. The state tax receipts-to-GDP ratio has variedby less than one-half of 1 percent for almost 40 years.Although there is insufficient data to apply comprehen-sive statistical modeling, the data suggests that at boththe federal and state level, increases in marginal tax ratesmay not yield the anticipated increase in receipts relativeto GDP.This myth is a corollary of the notion that public spend-ing is stimulative and stabilizing in periods of weak pri-vate spending. The expectation of future, higher taxrates leads to an offsetting retrenchment in private con-sumption and investment that neutralizes any effect ofdeficit spending.Myth#3Raising tax rates will not harmeconomic growth.Progressives are fond of arguing that the rate of eco-nomic growth is not harmed by increased taxation. Theevidence they offer is that marginal tax rates were veryhigh in the 1950s, yet the economy enjoyed reasonablegrowth. Unfortunately, the multifactorial nature of thecauses of economic growth make such simple-mindedlogic—apart from additional evidence—treacherous.Anything that encourages economic growth will likelymake the economy and the collection of tax revenuesmore resilient to tax rate levels.To formulate policy properly, one must isolate the effectof a change in tax policy from other confounding factors.Modern statistical procedures allow economists to iso-late the effects of taxation from the multitude of otherfactors that influence economic growth.National and Cross-Country StudiesIronically, Professor Christina Romer, Obama’s own headof his Council of Economic Advisors, has provided (alongwith her husband David Romer) some of the strongestand most current evidence to the contrary. Specifically,their recent study concludes that:• Each 1 percent increase in taxation lowers real GDPby 2 to 3 percent.• These damaging effects on the economy are per-sistent and are not diminished by offsetting changesin prices.• Investment falls sharply in response to tax increases.It is very likely that this strong retreat of investmentis part of the reason the declines in output are solarge and persistent.Romer and Romer are not the only ones to measure ef-fects this large. A recent comprehensive study of tax pol-icy effects across many modern economies by the OECDconfirms the depressing effect of taxation. In addition, itoffers interesting insights into the effect of various meth-ods of taxation. This study finds that:• Corporate taxes are found to be most harmful forgrowth, followed by personal income taxes and thenconsumption taxes.• A revenue-neutral growth-oriented tax reformwould shift the revenue base from income taxes toless distortionary taxes, such as those on consump-tion.• High top marginal rates of personal income tax canreduce productivity growth by reducing entrepre-neurial activity.The findings of the OECD research highlight the foolish-ness of the current, progressive agenda that is aimedat making businesses and high-income individuals “paytheir fair share.” The OECD findings imply that pursuit ofthese policies would have a doubly-damaging effect onthe growth of the economy: Raising corporate rates andrates on high-income individuals would sap the strengthof the investment engine that produces jobs, income andrevenues for government.
  16. 16. 17State-Level StudiesResearch at the state level is consistent with these find-ings. States compete with each other for businesses andhard-working individuals. Thus, it is not surprising thatthe depressing effects of high rates and certain typesof taxation show up in migration data. Households andbusinesses can relatively easily react to differences intaxation among the states by migrating. Data from theInternal Revenue Service (IRS) on 20 years of interstatetaxpayer migration among all pairs of the 50 states pro-vide approximately 25,000 migration activity measuresthat can be linked to tax differences among the variousstate pairs.Using the IRS taxpayer migration statistics, we have beenable to isolate the influence on migration of tax policyand related factors. Tax rates matter in making importantdecisions about where to locate one’s family or business.It is therefore no surprise that we also find effects of therates of taxation on the rate of growth of state econo-mies. Although the effects are numerically modest on anannual basis, they accumulate over time as the higherrate of growth is applied to a larger economic base.The prevalence of the progressive myth that publicspending is stimulative, of course, means thatpolicymakers turn to that remedy first ratherthan considering permanent changes in taxrate policy as a stimulus technique. UnlikeKeynesian policy, which alleges to work at the“macro” level of the economy, tax rate cutshave their effects at the “micro” level of be-havior of participants in the economy. Namely,tax rate cutting as a policy has the potentialto increase the supply of labor, entrepreneur-ship and capital. This is because low marginaltax rates, in effect, raise the after-tax returnsto labor and capital. The quantity of labor andthe quantity of investment are both directlylinked to industry productivity potential.Proponents of big government, however, seetax rate cuts as a subterfuge to cut spending.Thus, few states implemented rate cuts to stimulate theireconomy during the 2007 recession and its subsequentslow recovery. In fact, most states increased marginaltax rates in a quixotic effort to preserve the governmentspending status quo.The evidence that lowering marginal tax rates grows theeconomy is voluminous and, because individual statesvary so much in the level and type of taxes levied againstthe backdrop of federal policy, it is relatively easy todemonstrate a causal relationship between lower mar-ginal tax rates and greater employment overall and mi-gration to those states with preferable, low income taxrates. Thus, instead of states cutting taxes—the mosttheoretically and empirically promising means of stimu-lating the economy—a standard prescription for them isto raise tax rates to preserve or increase public spendingduring a business cycle downturn. The irony is that bothhalves of this policy are, in fact, depressive, so there is anegative net effect on economic activity.In 2008, for example, Oregon raised its highest margin-al tax rates on both personal and corporate income tothe first and second highest rates in the country. The neteffect was to slow employment growth in Oregon signifi-cantly relative to U.S. employment growth on the backside of the 2007 recession, as illustrated in Figure 8.Figure 8: Oregon’s Income Tax Hike Slowed Oregon’sEmployment Growth Rate4%3%2%1%0%-1%-2%-3%-4%-5%-6%Jan-06Apr-06Jul-06Oct-06Jan-07Apr-07Jul-07Oct-07Jan-08Apr-08Jul-08Oct-08Jan-09Apr-09Jul-09Oct-09Jan-10Apr-10Jul-10Oct-10Jan-11Apr-11Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Oregon Change U.S. ChangeRateofEmploymentGrowth
  17. 17. 18 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDMyth#4Austerity in the form of spendingcuts will harm growth andemployment.Austerity or “fiscal consolidation” is a process by whichthe excess of government expenditures over revenuesare brought abruptly into line by spending cuts. Austeritystrategies are most often thought of in the national con-text, where the ability to push today’s deficits on futuregenerations is easier than it is in a state context. In thesecases, austerity is a last resort when the accelerated lev-el of debt-to-GDP is so high that the borrowing strategyis no longer tolerated in the marketplace. However, atany time of fiscal crisis—including the current economiclandscape of U.S. states, austerity measures are a viablepolicy alternative.14Evidence that Austerity Can Stimulate GrowthThe conventional wisdom is that austerity measures thatdo not include revenue increases will cause the econo-my’s growth to slow abruptly and unemployment to rise.However, this appears to be a myth. There is growing ev-idence that an austerity program need not have theseconsequences if the program is carefully designed.15Thisis a particularly important consideration for individualU.S. states, since most cannot borrow significantly to de-fer resolution of the excess of spending over revenue,and there appears to be no positive relationship be-tween tax rate increases and state growth rates.16The literature suggests that the secret to successful aus-terity measures is to combine spending cuts with taxcuts, not tax increases. The reason is that, if both cuts arecredible, then consumers and investors will have moreconfidence that expansionary monetary policy will lowerinterest rates and that future taxation will be less oner-ous. The resulting reduction in taxes, interest rates andthe increased resources in private hands is then morelikely to stimulate added investment and work effort.Unless the public sector labor that is initially idled by thespending cuts is completely unproductive, they will bedrawn quickly into the expanded and more productiveprivate sector.The result is that:• The fiscal consolidation is more likely to lead to amore stable budget.• By redeploying resources previously managed bythe public sector and reducing tax distortions in theeconomy, an adverse effect in terms of lost outputwill be smaller.• Any stumble by the economy as it adjusts to auster-ity is likely to be of shorter or even zero duration.All of these effects are more likely, of course, when otherpolicy is also supportive. Any policy that creates uncer-tainty about the commitment to the policy, or that pro-vides disincentives for labor and capital to aggressivelyseek deployment will hamper the prospects and pace ofrecovery.It is interesting to contemplate whether a well-designedausterity program might well have helped the statesrecover faster. However, between 2009 and 2011, 40states raised taxes and only eight states lowered taxrates.17Moreover, although many states did cut spend-ing, the $140 billion the states received from the StateStabilization Fund features of the stimulus buffered a sig-nificant proportion of 2009-2011 projected deficits.Because of the nature of the services provided by stateand local governments and the political and contrac-tual rigidity built into the provision of these services,there was never any widespread movement to use the“…the secret to successfulaus­terity measures is to combinespending cuts with tax cuts, nottax increases.”
  18. 18. 19opportunity of the recession to make structural changesto reign in the size of the state public sector. In fact, ac-cording to a recent Brookings Institution report, statesthat raised revenues the most (in percentage terms) gen-erally remain those with largest remaining budget imbal-ances, as they chose to maintain or enlarge programs.18Is Europe Really Practicing Austerity?Unfortunately, the austerity programs being implement-ed in Europe also involve significant increases in tax ratesand relatively modest spending cuts by most accounts.Europe’s austerity legacy may prove to be giving the pol-icy a bad name.Greece is a good example of a government that is relyingsignificantly on tax increases and less-aggressive changesin public spending. For example, a special set of progres-sive “solidarity levies” will be added to existing incometax rates, raising the latter by 1 to 5 percentage points,the value added tax will rise from 13 percent to 23 per-cent, and higher luxury and property taxes will be lev-ied. Spending cuts consist of reductions in public sectorwages (by 15 percent), reduction of 150,000 public sec-tor jobs through attrition, some defense spending cutsand changes in the national pension retirement age. Itis hard to see how such high marginal tax rates will notadversely affect work effort and investment.In the United Kingdom during 2011 and 2012, underPrime Minister David Cameron’s austerity program,spending increased from $1.15 trillion to $1.2 trillion,and public pensions have yet to be reformed. The gov-ernment has increased the capital gains tax, national in-surance tax and value-added tax along with other taxesmasquerading as fees. Only 5 percent of public spendingcuts thus far appear to have come from reductions in thepublic workforce.In Spain, the government austerity proposal to reducethe deficit by $35.2 billion uses a combination of tax in-creases ($16 billion) and spending cuts ($19.2 billion).They have increased the corporate income tax and willincrease public pension and unemployment benefits inthe course of cutting spending.In France, where public spending already is close to 60percent of GDP, the new socialist president, FrancoisHollande, also appears to misunderstand the economicsof austerity. He expects to increase revenues by 4 per-cent in the first year and plans to impose a 75 percentmarginal income tax rate for those earning more than$1.3 million, in addition to increasing the corporate in-come tax rate.Italy may prove to be an exception. Former Italian PrimeMinister Mario Monti attempted to reform the pensionsystem and promised to make $5.5 billion in spendingcuts to avoid a looming increase in the national sales taxfrom 21 percent to 23 percent.For those who believe that a larger public sector is pref-erable to a smaller one, raising revenues to preserve cur-rent or higher levels of public spending is greatly favoredover lowering tax rates to stimulate growth instead. Inthe United States this is especially true at the state level,since current public spending levels are, in effect, cappedat the rate of growth of current tax revenues, since bud-gets theoretically need to be balanced even in the shortrun (in most states).19Hence, there is a tendency forpublic spending to ratchet upward during periods of highrevenue and to seek means of increasing revenues, rath-er than reducing spending, in periods of low revenue.This mentality adds to the bias against cutting taxes toraise employment and incomes. It also causes policy-makers to be skeptical of the possibility that lowering taxrates might, in fact, increase revenues in the long run, ifnot also the short run.Myth#5Real household income has notgrown in the past 20 years.It is popular to assert that the incomes of averageAmericans have stagnated or fallen for the last three de-cades. Indeed, data from the Current Population Surveyof the Bureau of Labor Statistics began reporting anabrupt “flattening” in cash incomes adjusted for inflationin 1975 in its July 1986 Monthly Labor Review. The pop-ular press has attempted to connect the dots to argue
  19. 19. 20 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDthat deregulation, free trade and free-market policies ul-timately lead to languishing of household incomes.This blame-game logic, of course, evaporates if thepremise that incomes have been stagnant is incorrect. Amore careful review of the data shows that the premiseis, indeed, false. First, even using unadjusted U.S. censusdata, the median family income in the United States hasbeen on a fairly stable increase since the end of WorldWar II––despite ups and downs. Indeed, every decadesaw an average median income that was higher thanthe decade before. In real terms, family incomes weretwice as high in the 2000s as they were in the 1950s (SeeFigure 9).Second, over the decades, there havebeen significant changes in several oth-er factors that affect the correct mea-surement of the trend in incomes:• Many more households receivetheir income in some form oftransfer, from pension plans, SocialSecurity and various income assis-tance programs.• Tax policy has changed significant-ly and is more highly redistributivetoday than it was in the past. TheEarned Income Tax Credit (EITC),for example, uses the income taxsystem to supplement the in-come of low-earning householdswith direct cash subsidies in theform of an income tax credit.• Americans are receiving moreof their compensation in theform of benefits, especially pre-paid health care insurance cov-erage.• Finally, the trend in incomedepends upon whether one fo-cuses on individuals or house-holds as the relevant unit formeasuring economic well-being.Co-habitation, changes in family demographics andsizes have all influenced this trend.Burkhauser et al. (2011) have reconstructed thepath of real average income changes from 1979 to2007 to account for these changes in compensation,tax practice and social demographics. In Figure 10,the flat (near-zero) growth in real income during thisperiod becomes approximately 37 percent when allof the adjustments are incorporated. This is tanta-mount to a continuously compounding growth rateper annum of approximately 1.2 percent.Figure 9: Median Family Income and Decade Averages in 2010 DollarsFigure 10: Adjusted Real Income Growth, 1979 to 2007$20,000$25,000$30,000$35,000$40,000$45,000$50,000$55,000$60,000$65,000194519501955196019651970197519801985199019952000200520101950s$31,9001960s$43,2001970s$52,2501980s$54,5001990s$59,000 2000s$62,5000% 5% 10% 15% 20% 25% 30% 35% 40%Taxpayer BasisTaxpayer Basis(Size Adjusted)Household BasisHousehold Basis(Size Adjusted)Percent Change in Average Income, 1979-2007Cash IncomeCash Income + TransfersCash Income + Transfers + Tax Adj.Cash Income + Transfers + Tax Adj. + Health Care
  20. 20. 21It is unlikely that those who wish to find fault with theoutcomes of our economy will be satisfied by correctionof the prevailing mythology. However, it is important forpolicymakers not to tolerate propagation of the myth byprogressive organizations who are eager to find a prem-ise for social democratic remedies.Myth#6The distribution of income isincreasingly inequitable.Progressive advocates also allege that the country isquickly becoming one of “haves” and “have-nots” interms of equality of outcome. As Figure 11 illustrates, ifone examines the income trends of the various incomequintiles over time, one can be left with the impressionthat certain groups of people are enjoying higher rates ofincome growth than others.Although it should be noted that all quintiles have en-joyed some income growth over the period displayed inFigure 11, the highest quintile appears to have enjoyednearly a doubling of its income. Indeed, as one movesprogressively down the quintiles, this appearance of aregressive shifting of income shares persists even thoughthe percentile cutoffs (in real dollar terms) have risen forall quintiles. For example, using other data, we know thatthe real income of the wealthiest 5 percent of house-holds rose by 14 percent between 1996 and 2006, whilethe income of the poorest 20 percent of households roseby just 6 percent. This, in turn, means that the income ofthe wealthiest 5 percent of households grew (relative tothe lowest quintile) from 8.1 times the latter’s income to8.7 times the latter’s income by 2006.20The problem with this interpretation, of course, is thatindividuals who occupy these quintiles are not the sameindividuals from one year to another. Indeed, in a mar-ket economy where upward mobility is possible for manypeople, one would expect the highest quintile to be se-lectively occupied by individuals who have progressed,in a life-cycle sense, through their careers to occupy ev-er-higher quintiles.The level of performance, human capital accumulationand risks of failure likely increase as onerises through the ranks, so we would ex-pect:This is precisely what we find, in fact, when we ex-amine dynamic panel data that allow us to track in-dividuals year by year as they transition from one in-come bracket to another. Figure 12 was constructedfrom a special U.S. Treasury data collection effort onthe movement of taxpayers of various income class-es from one year to the next.21Figure 11: Percentile Cutoffs for Household Income Distributions,by Year, in 2010 dollars$0$20,000$40,000$60,000$80,000$100,000$120,000$140,000$160,000$180,000$200,0001967196919711973197519771979198119831985198719891991199319951997199920012003200520072009• It is easiest to exit the lowest quintile.• It is progressively more difficult to exithigher quintiles to the next highestlevel as requirements of experienceand capability (human capital) be-come sharper.• It is hardest to stay in the highest in-come categories because of high lev-els of competition and risk.• It is easier to stay in somewhat lowerincome categories where competitionand risk may be less significant.
  21. 21. 22 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKED• The lowest quintile workers have the highest prob-ability (56 percent) of being in a higher quintile in2005 than in 1995.• The probability of moving to a higher quintile de-clines as one achieves higher quintile status. For ex-ample, the probability of being in a higher quintile ifone is already in the fourth-lowest quintile (secondhighest) is about 30 percent.• The probability of falling from the highest incomelevels is correspondingly high. Those already in thetop one percentile of income in 1995, for example,had a probability of 58 percent of being in a lowerincome category in 2005.• The probability of falling even from the top 10 per-cent is almost 40 percent.It is clear, therefore, that the U.S. economy offers signif-icant upward and downward mobility. No given status isguaranteed. Put differently, the economy offers relative-ly ready opportunity to rise or fall in economic status,but it does not guarantee outcomes, only opportunity.Progressives, of course, would prefer to see equalizationof outcomes, rather than opportunity. Ironically, howev-er, the tax and redistribution policies necessary to movetoward equalized outcomes unwittingly risk damagingthe very engine of competition and opportunity that cre-ates wealth in the first place. Competition and efforts toavoid risk generate entrepreneurship, hard work, moti-vation to obtain education and the many other behaviorsthat are crucial to providing superior standards of livingfor all of our citizens.Myth#7Raising tax rates on the rich willnot harm the economy.During the 2001 recession, the Center on Budget andPolicy Priorities circulated a three-page memorandumarguing that when recessions reduce state revenues,legislatures would be better served by selectively raisingtaxes on the state’s highest income households ratherthan by cutting spending on social programs.22Their conclusion is that, if anything, tax increases onhigher-income families are the least damaging mech-anism for closing statefiscal deficits in the shortrun. Reductions in gov-ernment spending ongoods and services orreductions in transferpayments to lower-in-come families are likelyto be more damaging tothe economy in the shortrun than tax increasesfocused on higher-in-come families.Figure 12: The High Rates of Economic Mobility of U.S. Workers, 1995-20050% 10% 20% 30% 40% 50% 60%MOVED TO HIGHER INCOME GROUPLowest QuintileSecond Lowest QuintileThird Lowest QuintileFourth Lowest QuintileMOVED TO LOWER INCOME GROUPTop 10 PercentTop 5 PercentTop 1 PercentPercent that Changed Group Between 1995 and 2005
  22. 22. 23A thorough reading of Orszag and Stiglitz (2001) reveals,however, that even they recognize this advice is counter-productive to a prompt recovery:“In any case, in terms of how counter-productivethey are, there is no automatic preference forspending reductions rather than tax increases.It is worth emphasizing that any state spendingreductions or tax increases are counter-produc-tive at this time: they restrain the economy at atime when it is already slowing.”While Orszag and Stiglitz examined studies of consump-tion and saving by income level, they did not study theeffect of taxes on economic recovery. Moreover, thememo does not address the relationship between savingand investment and the role investments play to fuel fu-ture production and consumption. Thus, they make a farfrom compelling case for sacrificing private expendituresand investments for the preservation and expansion ofgovernment employment and programs.At almost every level of government—federal, state andlocal—politicians have painted themselves into a fiscalcorner. They dismiss cuts in entitle-ment benefits as touching the “thirdrail” of politics. They dismiss broad-based taxation out of fear of losingcrucial middle-class votes. In doingso, they are eliminating useful alter-natives and are left with one alterna-tive: tax the rich.Taxing the rich is politically attractive.It’s relatively easy to get 99 percentof the voters to turn against the oth-er 1 percent, no matter who the 1percent are. However, even if oneputs aside the counterproductive be-havioral reaction that higher rates oftaxation might engender in the rich,there are other serious problemswith relying on taxation of the rich toaddress U.S. budgetary woes.DoesitGenerateEnoughRevenue?Taxing the rich does not generate as much revenue asone might expect. Assume that there is no offsetting be-havioral response and one could find support for a 10percentage point increment to be applied to the incomesof the “rich.”• Taxing the incomes of the top 1 percent of taxpayersat this rate would yield only $93.8 billion. These areall taxpayers with incomes above $380,000 or so.• Taxing the incomes of the top 5 percent of taxpayerswould yield about $180 billion. This would requirea tax on all incomes over about $150,000 per year.• Taxing those in the top 10 percent of the income dis-tribution at the same rate would raise only $340 bil-lion. This would require bringing the taxable incomethreshold to about $110,000.Even the most aggressive of these policies would barelycover one fiscal year’s interest on the outstanding debt,assuming debt holders remain happy holding debt atFigure 13: The U.S. Laffer Curve Implies Low Revenue Productivity ofTax Rate increases20% 25% 30% 35% 40% 45% 50% 55% 60% 65%USAustriaBelgiumDenmarkFinlandFranceGermanyGreeceIrelandItalyNetherlandsPortugalSpainSwedenUKMaximum Revenue Sensitivity to Tax Rate Increases(Percent Increase in Revenue/GDP + Percent Increase in Tax Rates)
  23. 23. 24 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDtoday’s interest rates. Strictly from a fiscal sufficiencystandpoint, a selectively high tax rate on the rich wouldleave a very large problem to be solved by other means.Where are we on the Laffer Curve?A recent, multi-country attempt to characterize theLaffer Curve found that the responsiveness of reve-nues to tax increases is the lowest in the United Statesof any of the OECD countries studied by Trabant andUhlig (2012, see Figure 13). The maximum revenue po-tential is approximately 7 percent of GDP. Since our cur-rent debt-to-GDP ratio is roughly 100 percent, it wouldtake eight to 10 years at the revenue-maximizing taxrate on both labor and capital to bring the current U.S.debt-to-GDP ratio down to a level closer to the historicalnorm. Or, put differently, the total revenue generated bythe revenue-maximizing tax increase is approximatelyequal to the annual deficit expected under the Obamaadministration’s budget for the next 10 years.The history of taxation shows that taxes that are inher-ently excessive are not paid. The high rates inevitably putpressure upon the taxpayer to withdraw his capital fromproductive business and invest it in tax-exempt securitiesor to find other lawful methods of avoiding the realiza-tion of taxable income. The result is that the sources oftaxation are drying up; wealth is failing to carry its shareof the tax burden; and capital is being consumed ratherthan accrued.“The high rates inevitably putpressure upon the taxpayerto withdraw his capital fromproductive business and invest itin tax-exempt securities or to findother lawful methods of avoidingthe realization of taxable income.”
  24. 24. 25V. The Conundrum for StatesFor states, raising taxes on the wealthy is particularlychallenging. States like Oregon and Maryland haveraised the tax rates on higher income households only tofind themselves with what has been called in Oregon the“Mystery of the Missing Millionaires.” Neither Oregon’snor Maryland’s tax increases have raised the revenuespromised by the states’ official revenue forecasts.Capital is very likely more mobile between states thanbetween countries, and imposition of selective taxesneeds to be approached with trepidation. The relation-ship between taxation and migration dates back at leastas far as Adam Smith’s Wealth of Nations (1776), whenhe warned of stifling industry with taxes:“The proprietor of stock is properly a citizen ofthe world and is not necessarily attached to anyparticular country. He would be apt to abandonthe country in which he was exposed to a ...burdensome tax and would remove his stock tosome other country. ... By removing his stock hewould put an end to all the industry which it hadmain­tained in the country which he left.”Smith’s observations rang true in 2012 when one ofFacebook’s co-founders, renounced the American citi-zenship he gained as a teenager and become a perma-nent resident of Singapore, which levies no capital gainstaxes. This anecdote, however, highlights a relationshipthat has long been found in the economics literature.“Capital is very likely more mobilebetween states than betweencountries, and imposition ofselective taxes needs to beapproached with trepidation.”
  25. 25. 26 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDVI. Recent Research Supporting Free-Market ApproachesIn this section we review the recent work of the key,free-market advocates and the critiques promulgat-ed by progressive groups. In our view, the critiques areweak and offer opinions rather than useful researchcounterpoints to the professional research efforts of thefree-market advocates.We begin by summarizing the data and methods used tosupport the free-market position as expressed in certainkey, recent publications. We then evaluate the critiquespublished by their opponents.Rich States, Poor StatesLaffer, Moore and Jonathan Williams recently releasedthe 5th edition of Rich States, Poor States.23ALEC haspublished Rich States, Poor States for five consecutiveyears to examine what makes the economies of somestates rich and others poor. Rich States, Poor States isa compendium, state-by-state, of tax and regulatory in-dicators that theory suggests should influence the eco-nomic health and growth prospects of the respectivestates. The study measures 15 factors and presents thecomparative measures comprehensively on a state-by-state basis.This comprehensive report does what is rare among po-litical-economic treatises:• It lays out clearly the underlying economic principlesand logic for its policy focus on tax and fiscal policy.• It develops consistent measures of indicators ofthese policies on a state-by-state basis.• It provides clear and concise state rankings for eachof the 15 policy dimensions, as well as a consolidat-ed ranking for each state referred to as the “ALEC-Laffer Economic Competitiveness Index.”24The authors of Rich States, Poor States use an equalweighing method for developing their state scores fromthe 15 factors. However, the raw state scores are pre-sented so that those who would weigh the factors differ-entially can do so if they wish. This facilitates individualstates bringing their own weights and preferences to thedebate. In our view, the Rich States, Poor States reportis an informative source of comparative market-orientedstate characteristics.The rankings give state officials a useful starting point inthinking about how they might improve their state’s eco-nomic and fiscal prospects. Rich States, Poor States givespractical guidance to citizens and legislators sympatheticto ALEC’s principles of free markets, limited governmentand tax burdens.The Progressives’ CritiquesThe publication of the 2012 edition unavoidably coincid-ed with the kick-off of the 2012 presidential campaignseason, and its implied policy direction—and ALEC it-self—have been under very aggressive attack this yearas a result. The Institute on Taxation and Economic Policy
  26. 26. 27(ITEP) and its sister organization, Citizens for Tax Justice(CTJ), have seemingly led the policy attack on Laffer andALEC. However, their critique is short on analysis butlong on innuendo.25To wit:• “[T]he most laughable thing about the [Rich States,Poor States] index is the way it claims to provide alook at the important “policy variables” under thecontrol of state lawmakers but then ignores theones that actually matter” (e.g., public spending, inITEP’s view).Of course, if the ALEC-Laffer Competitiveness Indexwere missing key elements, it would do a poor job ofexplaining the comparative economic performance ofthe states. An index constructed agnostically of “bad”things will prove a terrible indicator of economic vig-or if it the omitted “good” things. Indeed, includingmissing “good” things would only improve its perfor-mance. Also, in a multifactorial economic world, onewould expect exceptions to the general case.More important, we have examined the relation-ship between the ALEC-Laffer State EconomicCompetitiveness Index and found it, in fact, to beusefully correlated with important economic per-formance measures and not “missing” the influenceof the “expenditure side” of the fiscal equation. Forexample, the rank correlation of the index withmedian household income rank of a state was mea-sured at 88 percent.26Other efforts failed to detecta significant, positive influence of state and localspending, in the aggregate or by major spendingcategory.27Figure 14 reveals that a higher state competitivenessranking is associated with superior economic perfor-mance ranking among the 50 states. Specifically, a highercompetitiveness score is associated with:• Lower state and local welfare expenditures.• Higher growth rate of GDP per capita.• A lower unemployment rate.• Lower unfunded pension liabilities.• Higher non-farm employment.• Higher per capita income.• A higher rate of migration.These are all positive effects for an economy. Theyare exactly what one would expect if market-orient-ed fiscal and labor policies (which is the heart of theLaffer ranking system) were in place in a state.Figure 14: The U.S. Laffer Curve Implies Low Revenue Productivity of Tax Rate increasesState + Local Welfare Cost, % of GDPState GPD Per Capita Growth RateState Unemployment RateUnfunded Pension Liabilities, % of GDPState Non-Farm PayrollState Per Capita IncomeState Migration-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1Spearman Rank Correlation
  27. 27. 28 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDVII. What do the Critics have to Offer?The studies by Laffer and ALEC have become tar-gets for criticism by progressives who see them asa threat to high tax rates and government involvementschemes that they favor. The distinguishing feature ofthe Laffer and ALEC studies is that they make their casein an academic-style manner. The theoretical underpin-nings of the analysis are presented in the documents,their appendices or in companion documents.28Theanalysis is strongly empirical, usually with the support ofstatistical modeling.In contrast, it is important to consider what progressivesare offering as alternatives.Dubious AnalysisThe progressives’ analyses are frequently simplistic, un-professional and technically flawed––but well promoted.A recent example is the critique of the ALEC-Laffer statepolicy rankings in Rich States, Poor States by Peter Fisherof the Iowa Policy Project. It has the provocative title,“The Doctor is Out to Lunch.”29It has been widely dis-seminated by a network of progressive organizations andfriends in the liberal press who have no interest in thequality of the work, only the conclusions. The quality ofFisher’s “analysis” is a case in point of the dubious quali-ty of progressive analytical claims.Specifically, Fisher’s analysis consists of inaccurate re-gressions of selected ALEC-Laffer policy factors (tax rev-enues and right-to-work indicators or the ALEC-Lafferstate rankings) on selected economic growth measuresof the states. As we will reveal, the approach used byFisher to evaluate ALEC-Laffer indicators has no hopeof identifying effects of individual policy variables orthe ALEC ranking with state economic health. Yet Fishermakes much, for example, of his finding that tax reve-nues or right-to-work statuses are not positively associ-ated with measures of state economic activity.30,31First, he includes shares of total employment enjoyed ina state by certain industries in his regression studies. Thisis to control (presumably) for other, non-policy sourcesof growth. But shares of employment in these sectorsare themselves an outcome of growth––meaning thathe is effectively trying to explain one measure of growthwith another measure with no attempt to demonstratewhich one is the cause of the other. It is a bit like ex-plaining a person’s height by the length of his legs–twocorrelated measures of the same thing. More important,however, the use of shares in the first place is theoreti-cally incorrect, since the total of all shares obviously can-not exceed 100 percent. Thus, if Fisher’s selected indus-tries keep growing until they represent 100 percent of allemployment, one can only conclude that Fisher expectsa state’s growth to cease–an obviously absurd implica-tion of his approach.Second, work by widely respected economists such asReed (2008) and Ohanian, Raffo and Rogerson (2008),find strong relationships between tax policy and eco-nomic health by properly measuring tax policy32and us-ing proper controls for other factors that might be affect-ing economic activity.33Neither ALEC nor Laffer wouldever claim that only policy factors matter to the econom-ic prospects of states.
  28. 28. 29Third, Fisher’s findings that the ALEC–Laffer state rank-ings bear no relationship to state economic health iscontrary to the data. But, once again, it is the oversimpli-fication of the analysis that leads him to the wrong con-clusion. He fails to recognize that the Rich States, PoorStates analysis consists of rankings, not predictions ofgrowth rates. Hence, the obvious appropriate compari-son is between ALEC-Laffer policy rankings and rankingsof state economic performance. Fisher could have donethis very simply by using well-known, consistent mea-sures of comparative state performance.We present the analysis Fisher easily could have done inthe following discussion.The Federal Reserve Bank ofPhiladelphia has prepared com-parable indices of state econom-ic health (for all months since1979).34Because the indices aresingle measures (comprised ofmultiple factors35), they are easilyranked.Those rankings can then be com-pared with ALEC-Laffer rankingsof the pro-market policy posturesby the 50 states.Figure 15 and Table 1 present theresults. They demonstrate clearlythat, contrary to Fisher and hisprogressive colleagues, there isa positive relationship betweenthe ALEC-Laffer rankings and stateeconomic health rankings. Figure15 shows the association graphi-cally between the policy rankingspresented in the 2008 Rich States,Poor States publication and theactual performance of the 50states in 2008, 2009, 2010, 2011and 2012 (as of June).36The pos-itive association is obvious fromthe graphic.Table 1 performs a more statistically-sophisticated test,measuringaspecialtypeofcorrelationwhenoneisstudy-ing ranks (the so-called Spearman Rank Correlation). Thisproperly measures the correlation between the ALEC-Laffer state policy rankings and the Philadelphia FederalReserve’s state performance rankings.37In this case, thecorrelation is presented for years contemporaneous withthe Rich States, Poor States publication as well as one,two, three and four years afterwards (to the extent thefuture years have occurred).Figure 15: Higher ALEC-Laffer Ranks are Associated with Higher StatePerformance RanksTable 1: The Correlation of ALEC-Laffer State Policy Ranks and StateEconomic PerformanceContemporaneous 38.9% 40.7% 28.7% 26.4% 27.1%1 Year Ahead 39.6% 38.6% 27.5% 27.4%2 Years Ahead 37.2% 37.0% 27.0%3 Years Ahead 35.8% 36.7%4 Years Ahead 35.7%Spearman Rank Order Correlation: ALEC-Laffer Ranks vs. FRB- State Performance Ranks2008 2009 2010 2011 2012ALEC-Laffer State Policy Rank Year0102030405001020304050PhiladelphiaFedStatePerformanceRank,2008-2012ALEC-Laffer State Policy Rank, 20082008 Fed Rank2009 Fed Rank2010 Fed Rank2011 Fed Rank2012 Fed Rank2012 Regression2012 Correlation
  29. 29. 30 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDThe findings are completely contrary to Fisher:• There is a distinctly positive relationship betweenthe Rich States, Poor States’ economic outlook rank-ings and current and subsequent state economichealth.• The formal correlation is not perfect (i.e., it is notequal to 100 percent) because there are otherfactors that affect a state’s economic prospects.All economists would concede this obvious point.However, the ALEC-Laffer rankings alone have a 25to 40 percent correlation with state performancerankings. This is a very high percentage for a singlevariable considering the multiplicity of idiosyncraticfactors that affect growth in each state––resourceendowments, access to transportation, ports andother marketplaces, etc.We encourage all policymakers to read the profes-sional literature on the effects of public policy fac-tors, such as tax rates and right-to-work policy andnot fall prey to flawed demonstrations. Earlier in thispaper, we further debunked the notion that factorslike tax rates don’t matter.Oklahoma: Lower Income Taxes Fuel FasterEconomic Growth38For the Oklahoma Council of Public Affairs, Arduin, Lafferand Moore Econometrics analyzed the effect of thegradual elimination of Oklahoma’s individual income tax.Currently, Oklahoma’s top marginal tax rate on individ-uals is 5.25 percent. The phase-out would drop the toprate to 2.25 percent in 2013 and completely phase it outby 2022.• Personal income growth would be an average of1.9 percentage points higher, adding $47.4 billion inpersonal income in 2022.• In 2022, state GDP would be $53.4 billion, or 21.7percent higher than if the current taxes remain inplace.• State employment growth would be an average of1.5 percentage points higher, with 312,200 morepeople working in Oklahoma after the phase out ofindividual income taxes.The proposed tax reform would lower revenues rela-tive to the no-reform case by $365 million in 2013 to$2.1 billion by 2022. However, the increased growthin GDP and personal income would buoy revenuesfrom other sources, such as sales taxes, excise taxes,business taxes and local tax sources.39• On balance, the share of total taxes relative to per-sonal income is anticipated to decline from its current8.7 percent to approximately 6.8 percent by 2022.Data and Methodology used by Arduin, Laffer andMoore EconometricsMany of the study’s conclusions are supported with em-pirical evidence. The key impact predictions, however,are derived from regression analysis provided in the re-port’s appendix. The statistical model calculates the rela-tionship between statutory marginal tax rates on individ-ual income with the rate of growth of personal income atthe state level, using actual historical data.The statistical model tests the supply-side propositionthat the top marginal tax rate influences state econom-ic growth. It also examines the extent to which totalstate and local expenditure burden relative to personalincome affect economic growth. In addition, the studyincludes the state population growth as a control vari-able. The analysis spans 50 states and eight years (2001through 2008).“...increased growth in GDP andpersonal income would buoy revenuesfrom other revenue sources, such assales taxes, ex­cise taxes, business taxes,and local tax sources”
  30. 30. 31It is noteworthy that the revenue relationship to taxrates is not established directly by the original LafferCurve itself, but rather by Laffer measuring the revenueimpacts of tax policy through the historical linkages forOklahoma, specifically between personal income andthe various (non-income) revenue sources. This enablesa relatively parsimonious model to be used in a transpar-ent and conservative way to convert its findings to thegrowth, revenue and other economic impacts associatedwith the proposed tax rate change.It is noteworthy, also, to observe that at no time does theArduin, Laffer and Moore Econometrics assume or findthat lowering the marginal income tax rate will pay foritself in higher personal income tax revenues, as manysimple-minded criticisms of supply-side economics takeas the central conclusion of the Laffer Curve notion. Therelationship between tax rates and revenues has alwaysbeen an empirical question to Laffer and adherents tothat theoretical notion.Why the Progressives’ Critique should be IgnoredThe Oklahoma study by Arduin, Laffer and MooreEconometrics has been subject to criticism by theInstitute on Taxation and Economic Policy (ITEP) andjoined by several Oklahoma-based economists.40Thetiming and formatting of the various critiques give theappearance of a coordinated effort to attack Arduin,Laffer and Moore Econometrics and ALEC studies.41Arduin, Laffer and Moore Econometrics’ regression anal-ysis used the combined federal and state top marginaltax rates. ITEP and Willner argue that federal tax ratesshould not have been included. Ironically, ITEP appearsto disagree with itself on this issue. In its own 2011 guideto state and local taxes, ITEP states:42When we evaluate the fairness of a tax system,we should also consider overlapping tax systemsthat affect the same taxpayers. It is important, inparticular, to consider state and local tax policy inthe context of federal tax policy.In fact, basic economics and common sense alone makeit obvious that a taxpayer’s response to a state tax ratewill be very different if that taxpayer is also subject to a15 percent or a 35 percent federal tax rate. The combinedlevels of taxation will influence marginal economic andtax avoidance behavior. Moreover, it is a long-acceptednotion in tax theory and practice that tax bases are thecommon property of different levels of government. Inother words, competition for a common tax base amongthe wide range of governments is a key feature of taxpolicy.ITEP and Willner complain that the statistical model doesnot include certain other variables that may affect eco-nomic growth, ranging from sunshine to oil production.ITEP cites one study as evidence that “more than 130”variables explain state economic growth.43Willner at-tacks Arduin, Laffer and Moore Econometrics for leavingout important variables. Willner provides a laundry list ofgeneral types of variables (human capital, infrastructure)that should have been included. Neither ITEP nor Willnerprovide specific variables that they believe to be crucialor how those variables should be measured.In fact, the types of econometric models performed byArduin, Laffer and Moore Econometrics use very short-term rates of change (e.g. year-over-year) and not levelsof the variables of interest in the study. Many fixed orslow-moving cross-state non-fiscal factors fall away ar-ithmetically in a rate-of-change. For example, the shareof the population with at least a bachelor’s degree doesnot change much from year to year.While economists tend to prefer more data to less, at thesame time the most potent econometric techniques arevery consumptive of data, which is why one must be cau-tious to include large numbers of factors in the analysis.Adding more variables is not a good substitute for wellthought out, a priori theoretical case for each variable.Indeed, an agnostic focus on the key variables is a less bi-ased research posture than a selective inclusion of manyfactors in a limited-data setting.Rogers also criticizes the use of percent changes in per-sonal income as the dependent variable in the Arduin,
  31. 31. 32 A M E R I C A N L E G I S L A T I V E E X C H A N G E C O U N C I LTAX MYTHS DEBUNKEDLaffer and Moore Econometrics study. Rogers fails toprovide an alternative measure that she believes to besuperior. Ironically, Rogers employs percentage changesin examining the employment impacts of tax changes ina paper she co-authored in 2004.44As the only study cited in ITEP’s critique, ITEP placesa great deal of weight on Alm and Rogers’ article. Almand Rogers paper is so muddled, however, that a recentworking paper reviewing the literature in this area hadto exclude the Alm and Rogers paper from the review.45Indeed, it thus comes as no surprise that the authorsthemselves find their results statistically “fragile.”46In fact, of the more than 130 variables examined by Almand Rogers, the study does not include statutory taxrates. This is despite Rogers’ earlier advice that researchshould include such data. While Alm and Rogers’ analysisincludes many variables from sunshine to oil production,the paper provides no indication of the significance orsize of these variables. The exclusion of statutory ratesfrom the paper suggests that many of the variablesused by Alm and Rogers are irrelevant. Olson attemptsto provide a highly technical criticism of the statisticalmodel used by Arduin, Laffer and Moore Econometrics.However, Olson’s memorandum fundamentally mischar-acterizes the independent variables used by Arduin,Laffer and Moore Econometrics, thus rendering nearlyall of Olson’s analysis meaningless.Rogers argues that the link between tax rates and eco-nomic growth has not been established. In contrast, in2010—two years before Rogers’ memorandum—one ofthe top journals in economics published a widely circu-lated article making such a link.47The results were dis-cussed in the pages of The New York Times and The WallStreet Journal. Indeed, the economics profession hashundreds of articles, working papers and other researchtesting the existence and size of the relationship be-tween tax rates and economic growth. An EconLit searchof the term “tax rates” with the term “economic growth”provided more than 400 articles—and that just since1960. Indeed, Rogers’ own work—which she cites in hermemorandum—advises the use of tax rates to evaluatetax effects.48Willner makes the bold and unsupported statement that“economists use real, inflation-adjusted data almost ex-clusively.” He argues that the data must be “inflation-ad-justed.” Willner does not explain what he means by “in-flation-adjusted,” but it seems that he is confusing con-sumer inflation with a GDP deflator. Nevertheless, thereare important reasons why researchers would avoidusing any form of inflation-adjusted data for a state-lev-el-analysis. The key reason is that much of the data thatis inflation adjusted by the data provider tends to applya national inflation rate to the state-level data. This thenraises the question whether the results are from actualstate-by-state changes or from use of an inappropriateinflation adjustment.Willner complains that Arduin, Laffer and MooreEconometrics’ use of state and local expenditures as ashare of personal income is problematic. However, heprovides no alternative that he believes to be superior.Tennessee Death Taxation: Elimination WouldStimulate Economy49In work done for the Beacon Center of Tennessee, Lafferand Wayne Winegarden examine the economic impactof Tennessee’s gift and estate tax policy. Gift and estatetaxation is a carryover from the early days of taxation inthe United States when it was difficult to measure andimpose taxes on income or sales or to assess and collectad valorem property taxes. In contrast, the resolutionand distribution of an estate is a centuries-old practice,and levying taxes on this activity can be administrativelyconvenient.In the modern setting, the gift and estate tax fails stan-dard criteria for efficient and equitable tax instruments.Its collection is unrelated to any burden placed on societyby the taxpayer and can have terribly inequitable effectson the well-being of the deceased’s survivors. Finally, formany, it is a tax on what is mostly the accumulations oflabor income that has already been taxed at the time ofreceipt. Some progressive proponents of the tax see it asa means of keeping family dynasties from accumulatingwealth over time. Others see the bequest motive as anatural aspect of the human family relationship.

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