Tuesday, July 1, 2014

Laffer & Co. on state policy and economic outcomes

Dr. Arthur Laffer, the WSJ's Stephen Moore, Travis Brown (author of How Money Walks; more later)  and one other co-author have produced a useful volume on state policies (tax and otherwise) and the state outcomes that follow.

Let's talk analysis first...
A key point: They rely on aggregate measures more than more-popular per capita measures. Why? In a nutshell, because declining population allow per capita measures to remain relatively constant while a state is losing economic prowess. Moreover, population is an excellent measure of "voting with one's feet"-- the extent to which policy and other variables are driving people from one state to a better state (p. 5-7).

As a matter of theory, it's more reasonable to choose measures which allow for mobile labor (and capital). "Any prosperity where the number of people is the denominator, such as income per capita or the unemployment rate, makes little or no sense when people can move to where income and jobs are located, or the jobs and income can move to where the people are located." (xv) In the case of struggling states, "some of the states lost people faster than income...reported relative increases in income per capita and tax revenues per capita." (xviii). When they analyze particular outcomes, they start with population, "because we cannot think of a better indicator of a state's quality of life." (54-55) While one certainly cannot dismiss per-capita measures outright, Laffer and Co. make a strong point that aggregate measures are at least as valuable in measuring aggregate performance.

In addition to a lengthy series of single-variable analyses (which tell a similar story), they use limited econometrics modeling (in chapter 6)-- both because they run limited models and because such models are inherently limited in trying to measure what's at hand. At least they recognize these limits and argue that these results should be interpreted in light of the other results in the book (which turn out to be consistent). They also provide what seems to be at least a decent literature review. But I don't know that area nearly well enough to say with any authority.

Chapter 1 provides an analysis of the 11 states that imposed an income tax after 1960. Public officials embraced a state income tax, anticipating/selling a future with a.) minimal damage to their economy; and b.) greater tax revenue to produce greater public services. In a nutshell, they were wrong on both counts. All of them declined in terms of GDP growth and tax revenue, compared to the other 39 states (5). In terms of public services, the results are sobering and perhaps/probably surprising (16-21): lower K-12 test results, smaller health/hospital personnel per capita, higher crime rates, higher poverty rates, and poorer highway systems. Ouch! (In terms of method, they explain their preference for direct measures, where available-- and the inferior measure of inputs when direct measures are not available [16].)

Based on economic and political economy theory, the results might surprise, but can't shock. There are links and thus, potential leaks in the chain of logic that takes one from higher tax rates to improved public services: higher tax rates do not necessarily yield higher tax revenues; higher tax revenues are not synonymous with more spending on public services; and more spending on public services is not equivalent to a greater provision of public services (224).

Not surprisingly, the authors make reference to the famous "Laffer Curve" (LC). The LC is a basic tool to explain the necessary qualitative relationship between income tax rates and income tax revenue. If tax rates are 0%, then you will raise $0. If tax rates are 100%, you'll raise $0. It follows that revenues will increase as rates rise above zero-- up to a point. After that, they must fall-- so that higher rates produce less revenue. And so, unless one is into taxing people just for grins (as some on the Left seem to want!), then higher rates can be counter-productive.

Applying the same analysis to other forms of taxation, you get a similar relationship: increasing tax rates can increase or decrease revenue. So, increasing them, without this general knowledge-- and knowledge about the particular contexts of a tax increase-- is not wisdom.

They also add a theoretical angle that was (somehow) an innovation for me: the difference between a short-run and long-run LC. Of course, people are more flexible/elastic if you give them more time to respond. So, the LC is more painful for tax rate increases in the long-run than in the short-run (11). "You can't balance a budget on the backs of the unemployed or collect tax revenues from people who leave your state. High tax rates are a double-edged sword. You collect more, of course, per dollar of income, but you get less income." (10)

Along the same lines, they note that most economic development models assume that capital is fixed or semi-fixed-- a relatively static (vs. dynamic) analysis that implicitly holds relevant policy variables (inappropriately) constant. Moreover, they note that the dynamics of this can easily become a "vicious cycle"-- where higher tax rates cause flight/migration which leads to a temptation to increase rates further, and so on (12-13). Hello Detroit and Cleveland!

In Chapter 3, they turn to analyze state tax policies in all states. Again, they recognize that their analysis is "limited" (54) and that many "non-policy variables...matter as well" (251-252). Here, they compare the top nine states to the bottom nine (55). They choose nine since that's the number of states without an income tax. They go back 50 years and calculate 10-year moving averages (67). There are exceptions (which get some anecdotal explanations/stories from the authors), but the general trend is consistent with economic theory and incentives on pro-growth vs. anti-growth policies. From population and GDP to tax revenues and public services, the results cannot be what the pro-tax people want (56-62, 72-73, 76).

In Chapter 4, they analyze other state policies-- other taxes, right-to-work, unionization, and the minimum wage (81-82). They find, unsurprisingly, that sales taxes are efficient (even if they're not equitable), since they tax a broader base (88). "The average of the nine states with the lowest sales tax burdens underperform the average of the nine states with the highest sales tax burdens." (87) Estate/inheritance taxes are deadly (88). Right-to-work and unions are correlated with low performance (90, 96). I think they over-reach on the minimum wage, since in part the minimum is merely a proxy for higher costs of living (96). Interesting news for objective observers and good news for those who value liberty more highly: "the blue states are getting bluer, but also that the red states are getting redder. [But] as interesting as the increasing polarization of the states is the drift in the overall population toward red states." (xvii).

In Chapter 5, they tease out the in/out-migration numbers, bringing in Travis Brown's work at HowMoneyWalks.com. This is simply an extension or application of the long-run version of the Laffer Curve. From 1995-2010, millions of Americans moved between states, taking $2 trillion in adjusted gross income with them (99). Large states account for the bulk of the gains and losses, but the smaller states indicate the same pattern-- and adjusting for state size yields the same result (121-123). The upshot: "Progressive income taxes don't redistribute income; they redistribute people." (270)

In Chapter 7, they go through a thorough comparison of Texas and California. From the poverty rate (207) to public services, California gets smoked by Texas. Over and over again, there's far more spending on the services, but far fewer workers providing the services (from roads and prisons to education and health). One might think that California is hiring better people, but the direct measures available on quality do not indicate this at all (231-242). Brutal.

-The title of this book (An Inquiry into the Nature and Causes of the Wealth of States: How Taxes, Energy, and Worker Freedom Change Everything) is a take-off from the full-length title of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations, usually known as The Wealth of Nations.

-The authors apparently drew some inspiration from Philip Ball's book, Curiosity. I hadn't heard of him or it, but will check it out. The quotes they provided from it were good-- on how we draw inferences from data, etc. Here are three of them: "Science needs much more in the way of prior hypothesis and theory than most [researchers are] willing to admit; there is no way to boil down a mass of raw data into a theory unless we are prepared to take a leap of faith by suggesting (and then testing) some generative mechanism for it." (xiii) "Data cannot be meaningfully collected without a prior hypothesis simply because there is so much of it." (23) "There is no scientific idea so absurd that you cannot find someone with a Ph.D. (indeed often with a Nobel Prize) to support it." (245)

-They also cite Colin and Rosemary Campbell's study of state policy and economic outcomes in VT and NH as a seminal work. Again, I was not familiar with it. (I'm not a big fan of empirical work in economic development, so this is not a literature of great familiarity for me.) 


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