May 17, 2002

May 17, 2002 | WebMemo on Taxes

How to Cut Taxes and Balance State Budgets

"You cannot reduce the deficit by raising taxes. Increasing taxes only results in more spending, leaving the deficit at the highest level conceivably accepted by the public. Political Rule No. 1 is: Government spends what government receives plus as much more as it can get away with." -- Milton Friedman

Some state governments are concerned that the recently enacted economic stimulus package, that allows businesses to reduce their taxes by accelerating some of their depreciation, will cut deeply into state revenues. This concern is misplaced. Rather than hurt state revenues, lower business taxes leads to greater prosperity, which ultimately means stronger state revenues. States that pass legislation that counters the federal stimulus package will only delay their economic recovery and job creation.

"Indeed, Congress's recently enacted economic stimulus legislation will lead to thousands of new jobs all across the country," writes Heritage's Bill Beach in Depreciation Tax Breaks for Business Means Stronger Revenues for State Governments. "Additional job growth means stronger sales and state income tax revenues, more income from property tax levies, and healthier revenues from business profits and franchise taxes."

Historically state business communities become the cash cow of first resort and are seen as a piggy bank that can be tapped to make up for revenue shortfalls.

As Fred Anton, chairman of the Pennsylvania Manufacturers' Association, writes in the most recent Lincoln Institute Journal, "Lost is the message that "business don't pay taxes, people pay taxes."

Business tax increase are funded through work force reduction, higher consumer prices, reduced shareholder dividends, reduced salaries for employees, moratoriums on growth plans or some combination thereof.

Ultimately, business look to locate another area of the nation, or the world, which will enable them to remain competitive and profitable. ....

Our state lost 51,000 manufacturing jobs in 2001 alone -- about on-half the total of the prior decade. We have the second oldest state in the nation. Minimally qualified workers are difficult to find. Our largest out-migration is in the 21-29 years of age group.

Below is a primer on taxes and how states can make the most of their policies.

1) Tax increases are one of the worst steps that can be taken to make up revenue shortfalls. This specifically includes taxes on capital and businesses.

2) Tax cuts and keeping tax rates low lead to greater economic growth and more jobs for a state.

More jobs for a state means a higher income base that can be taxed.

Heritage's Dan Mitchell dissects economic forecasting in his recent Backgrounder, The Correct Way to Measure the Revenue Impact of Changes in Tax Rates, writing:

As tax rates rise taxpayers gradually become discouraged and businesses discover that it is not profitable to employ as many people. These factors combine to reduce earnings--and therefore lead to a reduction in taxable income. Dynamic scoring captures this relationship, but static scoring ignores the changes in income caused by higher tax rates.

  • Learn from history.
    Static scoring routinely overestimates how much revenue will be generated by tax increases. The 1990 luxury tax, the income tax rate increases of 1990 and 1993, and the 1986 capital gains tax rate increase are all examples in which revenues fell far short of static predictions. Conversely, the 1981 Reagan tax cuts, the 1978 capital gains tax reduction, the Kennedy tax cuts of the 1960s, the 1986 Tax Reform Act, and the 1997 capital gains tax cut all demonstrate how pro-growth tax changes will generate revenue feedback.
  • Not all tax cuts are created equal.
    The higher the tax rate, the bigger the supply-side response when the rate is reduced. Likewise, since capital is more mobile than labor, reducing tax rates on capital will have a greater impact than similar tax reductions on labor income. And some tax cuts, such as credits and rebates, will have little or no revenue feedback effects since incentives to engage in productive behavior remain unchanged.
  • The goal of tax policy is to maximize economic growth, not tax revenues.
    For years, budget deficits and surpluses have played a big role in the political debate. As a result, some tax policy proposals, such as reductions in the capital gains tax, are judged primarily by their effect on tax collections. Yet there is no evidence that fiscal balance has any impact on the economy. Putting revenue maximization ahead of sound tax policy is therefore a misguided approach and should be discarded.

3) Many states have encountered budgetary shortfalls because of excessive spending. Indeed, 47 out of 50 states increased their spending by over 4% a year.

4) Most states, 28 to be exact, are not trying to raise taxes to counteract the Stimulus bill of 2002.

5) Reducing the spending by an amount equal to the revenue reduction would balance budgets and provide better economic growth.

Other resources

  1. Identify the core governing principles and the functions of government.
  2. Review and reorganize the existing functions of government.
  3. Build an accountable budget for the future. 

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