Tuesday, May 22, 2007

The price elasticity of our state's entrepreneurs 

Do not think, gentle reader, that this editorial escaped my gaze during my absence. It's clever, in that it strings together a set of fairly reasonable statements in order to make an unreasonable conclusion seem, well, reasonable. Let me demonstrate:
If Minnesota raises the top income tax rate, goes this refrain, wealthy citizens will flee the state, businesses will take jobs elsewhere, and entrepreneurs will be discouraged from coming here.
I don't think I've said that (read here and here.) Some of the wealthy will flee, certainly, but for many reasons, one of which will be better taxes. My parents left New Hampshire for Maine, a no-sales-or-income-tax state to one with both. Did they go for better schools or better roads? No, their kids were grown and gone, and they live on a private road. They moved there because it was a dream from their youth, when both visited the Downeast coast during the summer. Taxes reduced their income, maybe reducing the size of the addition they put onto the cottage they built or reduced the amount of labor they hired to help with landscaping or, ... you get the point. Money spent on taxes is not spent on other things they choose; it's spent on things the government chooses. Who would make the better choice?

So it is in Minnesota. Raising the tax rate on the wealthy does not lead to "caravans of limos, Hummers and Citations streaming over our borders -- "The Grapes of Wrath," Ch�teau-Lafite-Rothschild-style." This is an oversimplification, the creation of a straw man that is about the only thing Quimby and Smith can knock down.

But is it true?

Call it tried but not true, lacking in foundation. It's a worn-out argument that has always been thrown up against a more progressive tax system.
One thing to note is that the worn-out argument is still out there, and supported by a heckuva lot of economic research. Most of the research focuses on movement of people, though Scully finds tax rates above the low-20s to be negative for growth. Nobody that I see argues that taxes increase growth (though certainly from very low levels they may, by providing for the protection of private property rights).

It's not an argument about progressive tax systems per se. It's an argument against creating tax differentials for certain types of groups versus other states to which taxpayers may be highly mobile. So, for example, closing loopholes on foreign income earned by corporations in Minnesota changes the amount of tax paid by corporations without changing the after-tax return on the next dollar of profits re-invested into the state. It may affect location decisions for firms if there are other states with the loophole, but it's not likely to cause movement in capital already invested in Minnesota.
But unless you already believe that taxes are the root of all evil, it's impossible to look at the evidence and conclude that an income tax increase at the top would set off a massive millionaire migration from Minnesota.
What would constitute 'massive'? Suppose five firms hiring 25 workers each decide to change location from St. Cloud to Aberdeen. Would that be enough to discourage Quimby and Smith? It would matter quite a bit to those 125 workers now without jobs. Do you think anyone will support a worker retraining program for those jobs lost, or are they not enough to be considered 'massive'?

Interestingly, Quimby and Smith play a shell game by focusing on manufacturers:

Take businesses leaving the state. It is such a nonproblem, the Department of Employment and Economic Development doesn't even track business departures. When it did measure business outmigration, for nine years in the 1990s, Minnesotans paid higher income taxes and about 1.5 percent more of our income for government services than we do today. If businesses were going to flee the state because of taxes, that was the time to do it.

Yet during that period, only 95 manufacturers moved out of state, totaling an approximate peak employment of fewer than 5,000 workers. Over the same nine years, Minnesota gained nearly 400,000 jobs.
Did you catch that? Notice that the focus is on manufacturing, which is less than one-sixth of the state economy. The other 5/6ths of businesses? Minnesota gained 400,000 jobs, but what was this compared to the growth of other states? Minnesota ranked 18th in jobs created in this period, not much different from the national average; it was 16th in wage income growth in the period.

But the data show otherwise. Minnesota did no better than average in business start-ups. Most of its growth in the 1990s came from the expansion of existing businesses. Bureau of Economic Analysis data shows that proprietors income in the period grew less than 15%, versus nearly 22% nationally. So high taxes did hurt other businesses, but again, the G&J people have ducked this question by focusing only on manufacturing.

The data shows that in that period Minnesota was usually #6 of combined state and local tax burden. The ravages of Ventura and Pawlenty have taken us to ... #11. Hooray, we're out of the top 10! But in terms of combined federal, state, and local taxes, Minnesotans pay 32.7% of their income in 2007 under current law, versus 32.5% in 1997. We manage to stay high because other states have been engaged in tax cutting to a greater degree than we have.

The received wisdom of economists over the years is that of the Tiebout Hypothesis: People move to tax jurisdictions that offer the variety of services and tax prices that appeal most to their sensibilities. Progressives argue, with perhaps some justification, that Minnesota is a state that prefers high taxes and high services sorted through the years. But the high level of services that progressives and metro-area DFL legislators argue for require substantially higher tax rates that we see evidence does cause a shift in migration patterns. Moreover, one paper shows that increases in the size of the education industry is negatively correlated with growth in the fifty United States.

Quimby and Smith cite as evidence that taxes aren't stopping millionaires from living here the fact that we are 15th in millionaires per capita. Tiebout would argue that the rich would demand more services and thus would prefer Minnesota. So why aren't there more?

Most important, though, is that Quimby and Smith are focusing on too short a period to see the effects of taxation on growth. Capital, both physical and human, takes years to build and years more to achieve the amount of growth differential that would show up in the types of summary statistics they use. Richard Vedder focuses instead on a forty year period and shows that growth was much slower in the ten states with the highest state income tax rate increase between 1957 and 1997 versus the ten that increased the least. The effect is far more pronounced that the effect of changes in property taxes. His is also evidence of Tiebout's hypothesis:
People �voted with their feet�, preferring states where the government allowed them to keep more of their own income. I calculated the net movement of native born Americans within the U.S from the years 1990 to 1999, comparing the nine states that have essentially no personal income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming) with the other 41 states and the District of Columbia. Some 2,849,310 persons moved into the no income tax states from the states that levied taxes on the productive activity of their citizens. Excepting Sundays, some one thousand persons moved every day for nine years to the no income tax states! More persons fled to the no income tax havens than moved from East to West Germany during the Cold War. One of the great migrations in human history occurred �and most Americans do not even know about it!
Thus Quimby and Smith have focused on too short of period to provide evidence that taxes have no effect, have moved about the goalposts by ignoring the effects of taxes on five-sixths of the Minnesota economy, have failed to understand marginal analysis, and fail to understand their own theory of what the demand for government services are. Higher-income individuals move out, and lower-income individuals move in, meaning provision of the same level of government services is costing more than the income brought in to support it. While Minnesota has been a destination for people from the Dakotas and elsewhere in the past, it cannot expect to receive those in the future; those states cannot export population to us in the same way they did in the past. Minnesota must choose whether it will remain a state that drives away tax producers in favor of tax consumers or will combat the bleeding of productive individuals by allowing them to enjoy the fruits of their labor.

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