More Mercatus Center Research on State Tax Reform

by Levi Russell

In a previous post I shared a comparison of the results of tax reform in Utah and Kansas. That comparison was part of a broader analysis of reform efforts in 5 states: Kansas, Michigan, North Carolina, Rhode Island, and Utah. The report provides a detailed analysis of reform efforts and draws some general conclusions about how reform should be implemented.

The  authors generally report good news for the states in terms of government fiscal health. Kansas is an exception. Here's one of the "common trends" identified in the report:

The most effective tax reforms seem to be those that both lower the rates of taxation and simultaneously broaden the scope of activities that are taxed. Such reforms improve the efficiency, convenience, and transparency of a tax system.

 This is the opposite of what Kansas has done. Unlike North Carolina, Kansas politicians failed to couple the tax reform effort with orderly spending cuts. Further, as the report notes, Kansas narrowed its tax base in a distortionary way:

Kansas also made the decision to exempt “pass-through” profits from corporate taxation; that is, business income that is taxed on individual business owners’ tax returns. While this lowers the tax burden on businesses, it creates distortions in the way business owners choose to classify their operations. Moreover, it is inequitable because it disproportionately benefits high earners and creates an unfair playing field among businesses.

There has certainly been a lot of media coverage of Kansas' state government budget information. Another Mercatus paper compares state government fiscal situation data from all 50 states and Puerto Rico in 2014. Kansas is 27th of the 51 states/territories examined. This doesn't sound consistent with the dominant narrative in the media.

How has the reform effort affected the private economies in these states? Below is a graph of private GDP indices for the five states listed above, the US as a whole, and two other states that are, to put it mildly, in big trouble fiscally: California and Illinois. It's tough to draw any general conclusions. Michigan, Utah and California are all doing quite well relative to the US as a whole. Michigan and Utah have had significant tax and spending reductions; California hasn't. Illinois, Kansas, North Carolina, and Rhode Island are all lagging relative to the US as a whole. Kansas and Illinois had pretty flat growth from 2012 to early 2014, but have picked up recently. Kansas in particular seems to be catching up to the US as a whole. North Carolina has been catching up at a feverish pace.


Quantity Index for Real Private State GDP - BEA

click image to enlarge

Yet another Mercatus paper provides a short review of the literature on the relationship between state tax policy and the economic health of the state. Here's the relevant paragraph:

Research finds that higher state taxes are generally associated with lower economic performance. There is somewhat weaker evidence that state and local taxes can significantly reduce income growth within a state, particularly when the revenues raised are devoted to transfer payments. More recent research corroborates this finding in relation to net investment and employment. However, when additional tax revenue is used to improve the quality of public goods and services, economic growth may increase. When looking at business activity more broadly, more comprehensive reviews of the literature find higher taxes to be associated with less economic growth. They also find this relationship to be stronger within metropolitan areas than across metropolitan areas, which means that local taxes have a larger effect on economic growth when it is less costly for firms and taxpayers to relocate to avoid the tax.