Misplaced Faith in Tax Cuts

Whatever the problem, a tax cut will fix it. And under no circumstances ever increase taxes. So goes the conventional conservative mantra. New research from two Oklahoma State University economists (Rickman and Wang, 2018) finds that reality is far more nuanced than this rigid perspective suggests. Tax cuts can promote economic growth—or they can harm it. The correct policy response is dependent on the situation.

Rickman and Wang reviewed scores of academic studies conducted since 2003, from which they gleaned several insights. The first of these is that overall state and local taxes are not a major determinant of economic growth differences among states. The research concludes that:

The vast majority of the academic studies that examined the relationship between state and local taxes and economic growth found little or no effect. Where significant effects were found, they generally were modest at most. A corollary then is that tax cuts do not pay for themselves.

The literature review also reveals that the impact of state and local taxes has changed over time. Studies that indicate a negative impact of higher state and local taxes are ten to twenty years old. More recent studies found “no effect or positive effects of increased taxes.”

In addition to reviewing academic studies, Rickman and Wang also used a “synthetic control method” to assess the impact of personal income tax increases and decreases in several states. For each of these states, a group of other states that have similar characteristics during the period from 2006 to 2011 are identified to establish a “synthetic control.” Finally, the researchers measure the extent to which the states with the income tax increase or decrease deviate from other states in the control group in terms of non-farm employment, real per capita gross state product (GSP), and per capita income growth.

Among the states with significant income tax increases or decreases examined in the research were Kansas, Wisconsin, and Minnesota. As a result of an extensive round of supply-side-inspired tax cuts enacted in 2012, Kansas is considered “one of the cleanest experiments for measuring the effects of tax cuts on economic growth in the U.S.” After huge income tax reductions, real per capita GSP and employment growth in Kansas significantly under-performed the synthetic control and slightly under-performed in terms of per capita income growth.

Wisconsin has also enacted significant income tax reductions. As in Kansas, “Wisconsin’s growth in real per capita GSP and total nonfarm wage and salary employment are much lower than those of the synthetic control unit,” while “Wisconsin’s growth in per capita income slightly exceeds that of the synthetic control.”

Unlike Kansas and Wisconsin, Minnesota increased its personal income tax in 2013. The research found that “Minnesota’s growth in real per capita GSP exceeds that of the synthetic control. But there is not much difference in growth in the other two indicators for Minnesota and its synthetic control.”

Based on their analysis of data from Kansas, Minnesota, Wisconsin, and three other states, Rickman and Wang conclude that:

States recently reducing their personal income taxes more likely harmed economic growth and states increasing their personal income taxes more likely spurred their economic growth. Across eighteen possible outcomes, six states and three economic outcome variables, the most likely result is stronger growth from higher personal income taxes. The next likely outcome is no effect, while the least likely outcome is a negative growth effect from higher personal income taxes.

The authors do not argue that tax increases always accelerate the rate of economic growth. Rather, they make the more nuanced argument that “fiscal policy should be tailored to the culture, economy, history, institutions and politics of the state.” They urge policymakers to “eschew ideology and non-academic analyses” in favor of research that directly addresses the “particular circumstances” of each state.

However, the research of Rickman and Wang does refute three often-heard conservative absolutes. The first is the belief that “tax cuts pay for themselves.” They don’t. The second is that tax increases are always bad. They aren’t. The third is that tax cuts are always good. Tax cuts driven by reflexive ideology or political expediency can and often do hinder economic growth more than enhance it.