Wednesday, January 21, 2009

Who's discredited on state business taxes? 

After the State of the State speech, Senate Majority Leader Larry Pogemiller argued that Gov. Pawlenty's proposal to reduce corporate income tax rates to increase job creation is a "failed strategy" at the national and state level. See for yourself at the end of this clip.

There has long been debate over the responsiveness of business location and employment to state corporate tax rates, but to call it failed is almost certainly an overreach. Chile is a good example of a country that grew after tax rate cuts in the 1980s (see Perry and Leipziger, for example); evidence for the US could be found in Alan Auerbach's work (see for example the 1994 NBER Macroeconomics Annual.) More recently, Djankov et al. (2008):

We present new data on effective corporate income tax rates in 85 countries in 2004. The data come from a survey, conducted jointly with PricewaterhouseCoopers, of all taxes imposed on �the same� standardized mid-size domestic firm. In a cross-section of countries, our estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI, and entrepreneurial activity. For example, a 10 percent increase in the effective corporate tax rate reduces aggregate investment to GDP ratio by 2 percentage points. Corporate tax rates are also negatively correlated with growth, and positively correlated with the size of the informal economy. The results are robust to the inclusion of controls for other tax rates, quality of tax administration, security of property rights, level of economic development, regulation, inflation, and openness to trade.
Wheeler [2006] also documents the evidence on reduction of state taxes; she summarizes the findings:
  1. Employment -- "Four out of seven studies found small effect on employment; one found 6 percent increase in employment when 1 percent tax decreases were offset by transfer payment expenditures. Two studies found effects only in limited cases using data prior to 1975."
  2. Domestic investment-- "One study found that a 1 percent decline in the ratio of taxes to personal income that is financed by an equal reduction in transfer payments would lead to a 9 percent increase in investment."
  3. New firms -- "One study found that a 1 percent decrease in the effective tax rate leads to a 9.5 percent increase in the number of firm births in the communications industry and a 2.7 percent increase in the furniture industry."
I would hardly call this "discredited". I would argue instead that Sen. Pogemiller's reaction is informed more by ideology and a fear that he might have to make larger spending cuts, and without much concern for the level of economic activity in Minnesota.

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