| March 2004 | published by the Economic Policy Institute
Rethinking Growth Strategies: How State and Local Taxes and
Services Affect Economic Development
By Robert G. Lynch
To purchase a copy of the full book, go to
http://www.epinet.org/content.cfm/books_rethinking_growth
Executive Summary
Creating jobs and growing the economy are top priorities for state and local officials.
Their tools of choice to achieve these goals may, however, be the least effective among
those available to them. Too often public officeholders first embrace lowering taxes and
creating tax incentives as their chief economic development tools, with public investment
usually ranking as a distant third option. An analysis of the relevant research
literature, however, finds little grounds to support tax cuts and
incentives—especially when they occur at the expense of public investment—as the
best means to expand employment and spur growth.
It is commonly thought that firms will migrate to a particular state for the purpose of
reducing costs, since lower costs may result in higher profits for business owners. But
state and local taxes are not typically a significant cost of doing business. All state
and local taxes combined make up but a small share of business costs and reduce profits
only to a limited extent. Indeed, the costs of taxes pale in comparison to many other
location-specific costs, and numerous location factors —including qualified workers,
proximity to customers, and quality public services—can be more critical than taxes.
The availability of these vital location factors depends in large part on each state and
locality's commitment to public investment—and their ability to pay for it. Research,
in fact, substantiates that public investment plays a positive role in helping lower costs
for firms.
Ultimately, the proof of the power of tax cuts and incentives to attract or retain
business and create jobs lies in how firms respond to them. On this score, the evidence
fails to support the claim that growing the economy requires shrinking the public sector
and reducing taxes. In particular, there is little evidence that state and local tax
cuts—when paid for by reducing public services—stimulate economic activity or
create jobs. There is evidence, however, that increases in taxes, when used to expand the
quantity and quality of public services, can promote economic development and employment
growth.
There are five main types of arguments given for cutting taxes and offering tax incentives
at the state and local level; these arguments raise issues such as the tax burden, the
supply-side effects, the demand-side effects, the business-climate impacts, and the
competitiveness implications of taxation. These kinds of arguments have been repeated so
frequently that they are often accepted uncritically. Almost any time a tax increase on
individuals or businesses is proposed, politicians or special interest groups invoke one
or more of these arguments to assert that the proposed tax increase will seriously damage
the economy and cause a significant loss of jobs. While not totally without merit, these
five arguments overstate the case for reducing taxes, as well as ignore counter evidence
and disregard the economic impacts of the spending alterations that governments take in
response to tax changes. The significant weaknesses in these arguments show them to be
less than persuasive as justifications
for state and local tax cuts.
A review of the hundreds of survey, econometric, and representative firm studies that have
evaluated the effects of state and local tax cuts and incentives also makes clear that
these strategies are unlikely to stimulate economic activity and create jobs in a
cost-effective manner. A close examination of the recent econometric literature on the
effects of tax cuts (analyzed in detail in Chapter 4) demonstrates how these kinds of
studies have been misused to justify tax cuts on economic grounds. In particular, this
literature review points out that some recent econometric studies find that state and
local taxes have either a positive or no effect on economic activity, and most of the
studies that suggest taxes have a small negative effect on economic activity do so only
when public spending is held constant as taxes increase—a circumstance that is highly
uncommon in the real world. Moreover, even the small negative effects of state and local
taxes that some econometric studies find are likely somewhat exaggerated and do not
support the notion that state and local tax cuts and incentives can be counted on to
create numerous jobs or to do so in a cost-effective way. The bottom line is that state
and local taxes, at their current low levels, may be largely irrelevant to business
investment decisions.
The literature on the effects of state and local public services indicates that state and
local spending may stimulate economic growth and create jobs. In addition, the studies
that have examined the net effects of simultaneously changing taxes and public
spending—arguably those studies that provide the best "real world" measure
of the effect of state and local tax cuts—generally find that raising taxes and using
the additional revenues to pay for more public services enhances economic growth and
expands employment.
It follows that, if taxes are not a decisive factor and public spending can be a positive
force, then the use of tax cuts to create jobs can carry uneconomical "costs per
job." Even with optimistic assumptions, for each private-sector job created by state
and local tax cuts, governments may lose between $39,000 and $78,000 or more in tax
revenue annually. This substantial revenue loss forces governments to lay off public
employees in numbers that probably exceed the number of jobs created in the private
sector. The net effect of tax cuts is thus likely to be a loss of employment. In
addition, the public would lose the value of the public services that would no longer be
provided. So, while access to jobs is clearly a vital concern in today's economy, public
officials and voters should focus not solely on faith in tax cuts but on the best ways to
get employment results. In the end, any jobs that might be gained by cutting taxes can be
more than offset by the jobs lost as a result of cuts in public services.
State and local tax cuts and incentives are probably not the best use of public revenues,
even when the object is to encourage business firms to put more people to work. This
finding confirms that state and local officials should take into account the effects of
public services as well as tax effects on the economy when considering fiscal policy
designed to promote optimal job growth. Tax increases used to enhance public services can
be the best way to spur the economy. By stimulating growth, generating jobs, and providing
direct benefits to residents, improvements in state and local public services can be one
of the most effective strategies to advance the quality of life of citizens.
Introduction
Over the past 35 years, nearly every state and local government has expanded its efforts
to promote economic development. While the primary goals of these efforts are
laudable—more jobs and faster economic growth—the techniques employed are too
often of dubious value. Not only may these techniques be ineffective, but they may also
undermine the ability of state and local governments to invest adequately in the public
services and infrastructure that are necessary for long-term economic growth and
development.
Although state and local economic development strategies are
numerous and varied, by far the most expensive techniques involve broad-based tax cuts and
targeted business tax breaks. For seven consecutive years from 1995 to 2001 state
governments cut taxes, with the total tax cuts amounting to over $35 billion.1 Much of
this tax cutting was in the name of economic development. Perhaps more significantly,
special state and local tax loopholes, tax credits, and tax abatements to business
(generally referred to collectively as "tax expenditures") have grown
dramatically over the past 35 years and now total billions of dollars annually. Data from
eight states suggest that state and local business tax breaks and subsidies summed
nationally to $48.8 billion in 1996.2 Tax expenditures now easily
dwarf all the other money spent on state and local economic
development programs.
The record economic expansion that started in March 1991 and ended in March 2001 caused
incomes to soar and allowed state and local revenues and spending to rise despite tax
cuts. During the booming 1990s, state and local government spending (excluding federal
grants-in-aid) more than kept pace with growth in the economy, increasing slightly from
9.8% of the gross domestic product (GDP) in 1991 to 10% of GDP in 2001.3 However, the
effects of these tax cuts, in combination with the slow economic growth of the recent
past, are starting to catch up with state budgets, and in 2002 and 2003, most states cut
spending on programs.4 The pressure to cut state and local
spending is likely to persist as long as these jurisdictions continue to face budget
deficits, demands for additional tax cuts, and calls for a smaller role for government.
The almost universal justification for tax cuts and business tax
incentives is that they are the best ways to create jobs and spur
growth. This assertion is made even when state and local
governments must cut public services as a consequence of tax
incentives and tax reductions. Taxes, and many of the government programs they pay for,
are seen as burdens on the private sector and impediments to economic growth.
But do tax cuts and incentives create jobs in a cost-effective manner? Conversely, do
state and local public services undermine growth? A review of the available data strongly
suggests that the answer to both of these questions is no. And while state and local tax
cuts may in theory stimulate economic activity, in practice they are unlikely to do so.
This means that state and local governments may be wasting billions of dollars annually on
tax cut policies that are failing, while underfunding programs that can promote long-term
growth and job creation.
The following section discusses the five main arguments generally
cited in support of cutting taxes and offering tax incentives at the state and local
level. It also critically examines each of these tax cut arguments. This examination of
the basic economic arguments for tax cuts is followed by a thorough review of the studies
that have evaluated the effects of state and local tax cuts and incentives. The literature
review includes survey research, the statistical and econometric studies, and the
"representative firm approach" research. An analysis of this literature explains
why state and local tax cuts and incentives are unlikely to stimulate economic activity
and create jobs in a cost-effective manner. The literature on the effects of state and
local public services, which indicates that state and local spending may stimulate
economic growth and create jobs, is also discussed. Finally, the studies that have
examined the net effects of simultaneously changing taxes and public spending are
reviewed. These studies generally find that raising taxes and using the additional
revenues to pay for more public services enhances economic growth.
About the Author
Robert G. Lynch is an associate professor and chairman of the Department of Economics at
Washington College, where he has taught since 1998. Previously, he taught at the State
University of New York at Cortland, where he served as chair of the department of
economics from 1991 to 1993. His areas of specialization include public policy, public
finance, international economics, economic development, and comparative economics. In the
past he has evaluated the adequacy and effectiveness of various state and local government
economic policies, reviewed economic growth strategies, and analyzed the efficiency,
fairness, and stability of state and local tax systems. Professor Lynch is also the author
of several papers that have analyzed the effectiveness of state and local government
economic policies in promoting economic development and creating jobs. He graduated with a
B.A. degree in international and development economics from Georgetown University in 1979,
earned a master's in economics from the State University of New York (SUNY) at Stony Brook
in 1981, and received a Ph.D. in economics from SUNY Stony Brook in 1984.
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To purchase a copy of the full book, go to
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