Senator Russell Long famously described popular tax policy as “Don’t tax thee, don’t tax me, tax the fellow behind the tree.” Well, what happens when we tax that fellow or gal behind the tree? What happens when we tax an entire business hiding behind the tree?
The relationship between taxes and the economy is a complex one. Since most taxes collected in the country are levied by state and local governments, and states have very different systems and rates of taxation, the impacts of taxes on economies and communities will vary around the country.
The Tax Foundation, a private think tank, publishes an annual State Business Tax Climate Index that ranks states according to their tax burdens, with a focus on business taxes. Figure 1 shows the summary table for the 2020 index, with an overall ranking and separate rankings for five specific taxes. A low ranking indicates a favorable tax climate.
Washington sits in the middle of the pack overall, but with a high ranking for income tax (none) and a poor ranking for sales tax, with the second highest state rate in the country.
But how much do these rankings mean? Intuitively, we might imagine that higher taxes would inhibit economic activity and act as a disincentive for people to live in a place. And, conversely, low taxes would be an incentive for economic activity and in-migration. Let’s have a look at a few of these rankings and how they relate to other rankings of economic and social success. Washington is the red dot in Figures 2 through 5.
Figure 2 shows the relationship between the overall tax ranking (first column in Figure 1, shown on the Y axis) and the state’s rank in the growth of per capita gross domestic product in the past 10 years, a basic measure of economic success (low ranking number means high per capita GDP growth.)
There is no relationship at all between these two rankings. If tax climate were a major determinant of per capita economic growth, we would expect a line upward from the origin, with a favorable tax climate providing top ranking GDP growth and unfavorable taxes leading to a poor GDP growth ranking. But, instead, we have an R-squared value of nearly zero, and high tax states like New York and California showing the highest GDP growth, and low tax states like Alaska and Wyoming having the lowest GDP growth.
Figure 3 narrows the question a bit to look at the corporate tax ranking (column 2 in Figure 1) and total GDP growth.
Favorable corporate tax conditions should attract and retain businesses and generally lead to GDP growth. But again, there is no relationship between the tax climate and economic growth. Washington, ranking a poor 41 on corporate tax climate, has the second best rate of GDP growth in the past ten years. At the same time there is a cluster of states in the lower right-hand part of the chart that have low economic growth rates in spite of a favorable tax climate. Colorado follows the expected pattern, ranking sixth for GDP growth and seventh for tax climate.
Discussions of income inequality often lead to discussions of taxes, or lack thereof, on high income individuals. So we might expect to see some relationship between income taxes and inequality. Do states with high levels of income inequality impose higher taxes to ameliorate that inequality? Figure 4 shows the relationship between the individual income tax rankings and state rankings for income inequality, using the Gini index.
Here we see a slight relationship, as it is somewhat more likely that states with higher levels of income inequality impose higher income taxes. We see both New York and California in the upper right part of the chart. And we see, in the lower left part of the chart three states—Wyoming, Alaska and South Dakota—with no income tax and a lower Gini index. But as with other measures, most states are all over the place, and an R-squared figure of 0.0445 does not tell us much.
Washington is highly dependent on sales taxes at the state and local level, and sales taxes are known to be regressive—poor people pay a higher share of their income in sales taxes than wealthier people. So, what is the relationship between poverty and sales taxes? A strong causal relationship—high sales taxes cause poverty—seems unlikely, but states with higher rates of poverty might be sensitive to the impact of sales taxes and lean toward less regressive taxing systems. Figure 5 shows the relationship between sales tax rankings and the ranking of states for poverty rates (lower ranking number means lower poverty).
Here we do see some relationship, but not the one we might expect: states with higher levels of poverty are slightly more likely to have high sales tax rates. Washington, the red dot, is an outlier, with very high sales tax rates and quite low levels of poverty. One wonders a bit about Louisiana, which has the second highest poverty rate and the third highest sales tax rate.
None of this is to suggest that there are no meaningful relationships between tax policy and economic and social outcomes. But it is complex. It would be very difficult to sustain an argument that high taxes will automatically harm a local economy or that low taxes will grow one. Tax policy will attract and repel individual businesses, but in the aggregate, finding large effects is difficult.
In the wake of both temporary and permanent pandemic-driven changes in state and local economies, governments will be looking for ways to adjust their tax systems to fill short term holes and to make their revenue systems more robust. Those considering changes to tax systems should be careful about imputing too many economic and social impacts, either positive or negative, to those changes. There are a number of other important measures of sound tax policy to follow.