| March 6, 2013

Tax Myths Debunked

The U.S. economy has recently suffered its deepest and most prolonged recession since the Great Depression. The fundamental causes of the recession and the slow recovery are two decades of poorly conceived housing credit and other policies and the adoption of long-ago discarded Keynesian policies.

The latter policies have failed to rejuvenate the economy and have left behind a massive accumulation of national debt. This accumulation has significantly constrained the policy options of the Federal Reserve, Congress, and state and local governments.

State fiscal policy reform therefore needs to include policies that will support economic growth and break with the long tradition of high levels of taxation, government spending, and intervention at the state level. The states must do this alone because the federal government will be in no position to provide financial assistance.

In this setting, defenders of the status quo and advocates for the so-called “progressive” reforms of higher taxes and greater government involvement have sought to discredit legitimate, research-based state fiscal policy reforms. The purpose of this article is to set the record straight regarding recent pro-growth reform proposals, and to illustrate the theoretical and empirical mythology that is used to discredit reform efforts.

Various scholarly articles and papers are referenced throughout this article. Detailed citations are available in the bibliography to the report “Tax Myths Debunked,” published last month by the American Legislative Exchange Council (ALEC), from which this article is excerpted.

Free-Market View vs. ‘Progressive’ View

States must increasingly devise their own methods of balancing service demands and revenue realities. At the same time, they are faced with a range of competing policy tools. In choosing the correct tool, state policymakers must recognize several inescapable facts:

  • Economic growth—especially employment growth—is the key metric by which the electorate grades its policymakers. Elected leaders must evaluate revenue-raising schemes and spending programs with an eye toward how the policies would stimulate or stifle economic growth.
  • Fiscally speaking, it’s much easier to balance a budget with reduced spending than with increased revenues.
  • Private-sector spending and investment has a much greater impact on economic growth than public-sector spending.
  • Public-sector spending forces out private sector spending and investment.

The debate is between free-market economists and those who would preserve or enlarge the role of government as a growth strategy.

At one end of the range are those who advocate free-market approaches. Free-market economists demonstrate that greater economic freedom fosters economic growth and that government intervention stifles that growth. Policies that liberate the private sector from onerous taxes and regulations will spur economic growth. Greater economic growth simultaneously will reduce the demand for costly government services and increase government revenue.

At the other end of the range are those who advocate for a large and growing role for government and the public sector. This approach is born out of a belief that the free market is fundamentally flawed and subject to numerous market failures. The implicit belief system of such advocates is that regulations can mitigate market failures without any economic cost. This belief system supports the notion that public enterprise can replace private firms and that taxes serve the dual progressive role of raising revenue to support the public enterprises while redistributing wealth to those who are deemed to deserve it more, whether earned or not.

To avoid pejorative labels, we will simply refer to these two positions as the free-market and status quo/progressive positions, respectively.

OCPA/Laffer Study ‘Well Founded’

Well-respected economics authorities have advanced tax reform proposals that offer the prospect of helping states grow their economies. These proposals are referred to as “free-market” proposals because their intent is to remove impediments to real recovery of the private economy. This is necessary not only to advance the economic well-being of the states’ residents, but also to provide an economy with enough vigor to support key public activities and services.

One such analysis was “Eliminating the State Income Tax in Oklahoma: An Economic Assessment,” published in 2011 by OCPA and Arduin, Laffer and Moore Econometrics (ALME). We found the proposal to be well founded in widely accepted theory and empirical work. We also reviewed “progressive” critiques of the OCPA/ALME study and other tax-reform proposals. The critiques, coming primarily from affiliated progressive organizations and networks, came across as “sound-bite” public relations campaigns.

There is virtually no part of the record of the critics that can be construed as having contributed in a meaningful way to the theory, measurement, and analysis of the tax reform debate. Yet, they have been distributed widely as if they are research products.

The authors of the critiques appear to labor under mythological or, at best, ambiguous appreciation of what the professional literature has to say about the issues relevant to the work of Arthur Laffer, et al.

The OCPA/ALME study analyzed the effect of the gradual elimination of Oklahoma’s individual income tax. Currently, Oklahoma’s top marginal tax rate on individuals is 5.25 percent. The phase-out would drop the top rate to 2.25 percent in 2013 and completely phase it out by 2022.

  • Personal income growth would be an average of 1.9 percentage points higher, adding $47.4 billion in personal income in 2022.
  • In 2022, state GDP would be $53.4 billion, or 21.7 percent higher than if the current taxes remain in place.
  • State employment growth would be an average of 1.5 percentage points higher, with 312,200 more people working in Oklahoma after the phase-out of individual income taxes.
  • The proposed tax reform would lower revenues relative to the no-reform case by $365 million in 2013 to $2.1 billion by 2022. However, the increased growth in GDP and personal income would buoy revenues from other sources, such as sales taxes, excise taxes, business taxes, and local tax sources.
  • On balance, the share of total taxes relative to personal income is anticipated to decline from its current 8.7 percent to approximately 6.8 percent by 2022.

Many of the study’s conclusions are supported with empirical evidence. The key impact predictions, however, are derived from regression analysis provided in the report’s appendix. The statistical model calculates the relationship between statutory marginal tax rates on individual income and the rate of growth of personal income at the state level, using actual historical data.

The statistical model tests the supply-side proposition that the top marginal tax rate influences state economic growth. It also examines the extent to which the total state and local expenditure burden relative to personal income affects economic growth. In addition, the study includes state population growth as a control variable. The analysis spans 50 states and eight years (2001 through 2008).

It is noteworthy that the revenue relationship to tax rates is not established directly by the original Laffer Curve itself, but rather by measuring the revenue impacts of tax policy through the historical linkages for Oklahoma, specifically between personal income and the various (non-income) revenue sources. This enables a relatively parsimonious model to be used in a transparent and conservative way to convert its findings to the growth, revenue, and other economic impacts associated with the proposed tax rate change.

It is noteworthy, also, to observe that at no time does the OCPA/ALME report assume or find that lowering the marginal income tax rate will pay for itself in higher personal income tax revenues (which many simple-minded criticisms of supply-side economics take as the central conclusion of the Laffer Curve notion). The relationship between tax rates and revenues has always been an empirical question to Laffer and other adherents to that theoretical notion.

Why the Progressives’ Critique Should Be Ignored

The OCPA/ALME study has been subject to criticism by ITEP—the Institute on Taxation and Economic Policy (“Arthur Laffer Regression Analysis Is Fundamentally Flawed, Offers No Support for Economic Growth Claims”). ITEP identifies itself as a “non-profit, non-partisan research organization” in its IRS filings. Even so, approximately half of ITEP’s board members appear to have ties to organized labor organizations such as AFSCME, AFL-CIO, and SEIU. In addition, two board members co-founded The American Prospect, a publication with a stated mission “to counteract the growing influence of conservative media.” ITEP’s self-described “sister” organization is called Citizens for Tax Justice (CTJ), and appears to serve as a government, public relations, and press relations organization for ITEP, especially at the state level. CTJ pens op-eds and other syntheses of ITEP research, customized to state and local tax initiatives and other policy issues.

Criticism of the OCPA/ALME study has also come from several Oklahoma-based economists, including Kent Olson (“The Voodoo Economics of Phasing Out Oklahoma’s Personal Income Tax”), Cynthia Rogers (“The Flawed Case for Eliminating Personal Income Taxation in Oklahoma”), and Jonathan Willner (“Putting Real Economics into an Economic Assessment of the Oklahoma Income Tax”). The timing and formatting of the various critiques give the appearance of a coordinated effort to attack the OCPA/ALME study.

The OCPA/ALME regression analysis used the combined federal and state top marginal tax rates. ITEP and Willner argue that federal tax rates should not have been included. Ironically, ITEP appears to disagree with itself on this issue. In its own 2011 guide to state and local taxes, ITEP states: “When we evaluate the fairness of a tax system, we should also consider overlapping tax systems that affect the same taxpayers. It is important, in particular, to consider state and local tax policy in the context of federal tax policy.”

In fact, basic economics and common sense alone make it obvious that a taxpayer’s response to a state tax rate will be very different if that taxpayer is also subject to a 15 percent or a 35 percent federal tax rate. The combined levels of taxation will influence marginal economic and tax avoidance behavior. Moreover, it is a long-accepted notion in tax theory and practice that tax bases are the common property of different levels of government. In other words, competition for a common tax base among the wide range of governments is a key feature of tax policy.

ITEP and Willner complain that the statistical model does not include certain other variables that may affect economic growth, ranging from sunshine to oil production. ITEP cites one 2011 study by James Alm and Janet Rogers (“Do State Fiscal Policies Affect State Economic Growth?”) as evidence that “more than 130” variables explain state economic growth. Willner attacks the OCPA/ALME study for leaving out important variables. He provides a laundry list of general types of variables (human capital, infrastructure) that should have been included. Neither ITEP nor Willner provide specific variables that they believe to be crucial or tell how those variables should be measured.

In fact, the types of econometric models performed by OCPA and ALME use very short-term rates of change (e.g., year over year) and not levels of the variables of interest in the study. Many fixed or slow-moving cross-state non-fiscal factors fall away arithmetically in a rate-of-change. For example, the share of the population with at least a bachelor’s degree does not change much from year to year.

While economists tend to prefer more data to less, at the same time the most potent econometric techniques are very consumptive of data, which is why one must be cautious to include large numbers of factors in the analysis. Adding more variables is not a good substitute for a well-thought-out, a priori theoretical case for each variable. Indeed, an agnostic focus on the key variables is a less-biased research posture than a selective inclusion of many factors in a limited-data setting.

Rogers also criticizes the use of percent changes in personal income as the dependent variable in the OCPA/ALME study. She fails to provide an alternative measure that she believes to be superior. Ironically, Rogers employs percentage changes in examining the employment impacts of tax changes in a paper she co-authored in 2004.

As the only study cited in ITEP’s critique, ITEP places a great deal of weight on the aforementioned article by James Alm and Janet Rogers. Alm and Rogers’ paper is so muddled, however, that a recent working paper reviewing the literature in this area had to exclude it from the review. Indeed, it thus comes as no surprise that the authors themselves find their results statistically “fragile.”

In fact, Alm and Rogers do not include statutory tax rates among the more than 130 variables examined in their study. This is despite Rogers’ earlier advice that research should include such data. While Alm and Rogers’ analysis includes many variables from sunshine to oil production, the paper provides no indication of the significance or size of these variables. The exclusion of statutory rates from the paper suggests that many of the variables used by Alm and Rogers are irrelevant.

Kent Olson attempts to provide a highly technical criticism of the statistical model used by OCPA and ALME. However, Olson’s memorandum fundamentally mischaracterizes the independent variables used by OCPA and ALME, thus rendering nearly all of Olson’s analysis meaningless.
Cynthia Rogers argues that the link between tax rates and economic growth has not been established. In contrast, in 2010—two years before Rogers’ memorandum—one of the top journals in economics, The American Economic Review, published a widely circulated article by Christina D. Romer and David H. Romer making such a link (“The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks”). The results were discussed in the pages of The New York Times and The Wall Street Journal. Indeed, the economics profession has hundreds of articles, working papers, and other research testing the existence and size of the relationship between tax rates and economic growth. An EconLit search of the term “tax rates” with the term “economic growth” provided more than 400 articles—and that’s just since 1960. Indeed, Rogers’ own work—which she cites in her memorandum—advises the use of tax rates to evaluate tax effects.

Willner makes the bold and unsupported statement that “economists use real, inflation-adjusted data almost exclusively.” He argues that the data must be “inflation-adjusted.” Willner does not explain what he means by “inflation-adjusted,” but it seems that he is confusing consumer inflation with a GDP deflator. Nevertheless, there are important reasons why researchers would avoid using any form of inflation-adjusted data for a state-level analysis. The key reason is that much of the data that are inflation adjusted by the data provider tend to apply a national inflation rate to the state-level data. This then raises the question whether the results are from actual state-by-state changes or from use of an inappropriate inflation adjustment.

Willner complains that OCPA and ALME’s use of state and local expenditures as a share of personal income is problematic. However, he provides no alternative that he believes to be superior.

Failed ‘Progressive’ Policies Should Be Shunned

The policies of the progressive movement in the United States spring from a philosophy that has neither theoretical nor empirical foundation. It has its foundation in a mistaken belief that personal effort, entrepreneurship, and risk-taking are unrelated to the economic health of the nation and that the benefits of that initiative can be redistributed without adverse consequence.

In contrast, it is clear that free markets, low marginal tax rates, fiscal restraint, and small government constitute the real foundation for economic growth. The divisive progressive agenda of policies that punish success and reward failure should be shunned and Americans should return to the principles of unfettered markets and equal opportunity.

Implementation of the progressive agenda undoubtedly will succeed in reducing the wealth of a minority of Americans but will impair the prospects and economic well-being of the least fortunate even more dramatically. Free-market policy and the growth it engenders are the most effective means of improving the lives of all Americans.

Eric Fruits, Ph.D., is an adjunct professor at Portland State University and Pacific Northwest College of Art. His economic analyses have been widely cited and have been published in The Economist, The Wall Street Journal, and USA Today. His statistical analyses have been published in top-tier economics journals, and his testimony regarding statistical analysis has been accepted by international criminal courts.

Randall Pozdena received his B.A. in economics, with honors, from Dartmouth College and his Ph.D. in economics from the University of California, Berkeley. His former positions include senior economist at the Stanford Research Institute (SRI International) and research vice president of the Federal Reserve Bank of San Francisco. He has written more than 50 refereed articles and books and has been cited in The Wall Street Journal, USA Today, and numerous other national and regional publications.

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