Can Income Tax Cuts Boost a State's Economy?

Two researchers say the answer comes down to how a tax cut is financed.
by | October 16, 2014

Nebraska is trying to get rid of it. Kansas has made massive cuts to it. Georgia may set a cap on it. There's no doubt that the state income tax, which accounts nationally for roughly one-third of state tax receipts, is under assault.

The current argument against income taxes is that a low- or no-state income tax will provide a great leap forward for a state's economy. According to Nebraska Gov. Dave Heineman, "it's a fact" that states with lower income tax rates grow faster. In his State of the State address last January he noted that "lowering Nebraska's income tax rates are essential to attracting higher paying jobs."

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No one can argue with the goal of juicing up an economy, but does the income tax have an impact on economic expansion? That question was addressed in the September report "Effects of Income Tax Changes on Economic Growth" by William Gale of the Brookings Institution and Tax Policy Center, and Andrew A. Samwick of Dartmouth College and the National Bureau of Economic Research. The short answer is "it depends."

At a recent briefing at the Urban Institute on the report, Gale and Samwick were quick to point out that their research was focused on long-term growth, not on stimulating a slumping economy in the short run, something that tax rate cuts have proven they can do effectively. Their "maybe" answer took into account how the tax cut is financed. Or, to put it in a more academic way, because of the potential to negatively affect investment, the structure of the tax cut and its financing are critical to achieving economic growth.

Gale ticked off five ways income tax cuts are generally financed: The first is borrowing money to cover the revenue losses, a method he suggested had negative effects. The second is to put in place offsetting tax hikes. Third is to cut "unproductive spending," which, Gale said, would make the economy better even if you didn't cut taxes. Fourth is to cut productive spending, such as education. Those kinds of cuts in public capital investments, he warned, can be counterproductive in the long run. Fifth is making the cuts part of a revenue-neutral tax reform. Gale saw the federal 1986 Tax Reform Act, which simplified the income tax code, broadened the tax base, and eliminated many tax shelters and preferences, as one that came close to reaching the ever-elusive goal of boosting the economy.

For a long-term pay-off, two of the financing methods stand out. It's crucial, the authors noted, that income tax cuts be paid for with offsetting tax hikes or spending cuts. The authors were focusing on federal tax efforts, but a state example would be Kansas, which cut income tax rates but failed to make sufficient spending cuts or raise other taxes to cover the revenue loss. Ultimately, state officials found that the benefits of a lower income tax rate were offset by budget deficits. The second key method: broadening the base. "If you broaden the base you generate revenue," Gale said. One way to broaden the income tax base is to trim back or curtail tax expenditures.

The authors took note of other studies on the effects of both tax cuts and tax hikes in the U.S. and overseas. The conclusion of those studies: Income tax cuts don't boost the overall economy. They may increase incentives to work, save and invest, but, because those tax cuts increase people's after tax income, people may instead work less, consume more and, as a result, save less. Moreover, tax rate cuts tend to subsidize old capital, and in that way reduce incentives for new investment.

The authors' overall conclusion is that not all tax changes have the same impact on growth. "Reforms that improve incentives, reduce existing subsidies, avoid windfall gains and avoid deficit financing will have more auspicious effects on the long-term size of the economy."