Economics 101

2012 February

Economics is all about incentives.

Because people really do care about after-tax income, pro-growth economic policies really do matter. The results of recent Laffer/OCPA research are consistent with economic theory, historical facts, academic and policy literature, and common sense: incentives drive economic behavior.

Arthur Laffer, Ph.D. Jonathan Small, CPA Wayne Winegarden, Ph.D.

About OCPA The Oklahoma Council of Public Affairs (OCPA) is an independent, nonprofit public policy organization— a think tank—which formulates and promotes public policy research and analysis consistent with the principles of free enterprise and limited government.

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If you have the law on your side, pound on the law.

If you have the facts on your side, pound on the facts.

If you have neither facts nor law, pound on the table.1

rates don’t matter and who believe that progressive income taxes are necessary to redistribute income are opposing these supply-side economic policy reforms. Those who have this view have written critiques attempting to counter the research that Dr. Arthur Laffer, the Oklahoma Council of Public Affairs (OCPA), and others have directed in support of these progrowth policy changes. The national discussion now taking place about the efforts of Kansas and Oklahoma provides a great opportunity to consider “Economics 101.”

OCPA’s OCPA’s speakers speakers don’t don’t disappoint. disappoint.

States are leading a pro-growth counterrevolution across the country.2 Two states at the forefront of these pro-growth changes are Oklahoma and Kansas.3 In response to this nationwide state pro-growth political momentum, those who believe that state income tax

Economics 101: The Basics of People, Work, and Taxes

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rom a theoretical perspective and in everyday life, incentives drive all economic behavior. Taxes are a negative incentive. People do not work, invest, or engage in entrepreneurial activities in order to pay taxes. They engage in such economic activities in order to earn after-tax income. When the government increases its share of the income earned by its citizens, the incentive to engage in growth-enhancing economic activities falls; alternatively, the disincentive to these activities rises. The higher the tax on the next dollar earned (the marginal tax rate), the larger the disincentive.

By lowering the income tax rate in Oklahoma and Kansas, both states will reduce the costs of work and investment compared to leisure, encouraging more work and investment. The primary benefits to the economy from phasing out Oklahoma’s income tax are: • Work effort • Work demand (and subsequently wages) • Savings • Investment and, subsequently, greater capital accumulation The results of the Laffer/OCPA analysis/model are consistent with economic theory, historical facts, academic and policy literature, and reality.

In its analysis “Tax Strategies for a Strong Minnesota” (Michael P. Ettlinger, Tyson Slocum, and Robert

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G. Lynch, January 1998), the Institute on Taxation and Economic Policy (ITEP) concurs that taxes can change behavior. That ITEP study argues for a broad carbon tax as a means to change behavior and reduce pollution: “A more sophisticated approach [to improve environmental conditions] that would impose a broader carbon tax could also be adopted. It could treat different polluting fuels evenhandedly instead of targeting just gasoline.”

When discussing a carbon tax, ITEP gets the theory of taxation just right: high taxes discourage economic behaviors. What is true for pollution is just as true for economic activity and income: high taxes on income discourage income-producing activities.

The historical record is consistent with the theory described above. As presented in the Laffer/OCPA study, multiple other studies, and this document, those states that tax too much, spend too much, or levy a high and progressive marginal income tax tend to experience slower rates of economic growth; states that implement the opposite policies (a pro-growth policy environment) tend to experience more robust rates of economic growth.

The results of the Laffer/OCPA analysis are also consistent with the vast academic and policy literature (cited in the appendix) that confirms the relationship between robust economic growth and progrowth economic policies.

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Economics 101: People Follow Incentives

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ince people do not work to pay taxes and since they respond to incentives, it makes sense that people in a free society move where the incentives to work, and the return from work, are greatest.

In its paper entitled “‘High Rate’ Income Tax States Are Outperforming No-Tax States,” ITEP makes one and only one point to counter the view that people and businesses move from state to state to take advantage of favorable economic conditions resulting from low state taxes. ITEP argues that the U.S. population is naturally moving to regions that happen to be where the zero personal income tax rate states are located (e.g., the south and west). According to ITEP, “Demographers have identified a large number of reasons for the population growth occurring in the south and west that are completely unrelated to these states’ tax structures. Lower population density and more accessible suburbs are important factors, as are higher birth rates, Hispanic immigration, and even warmer weather.”

According to ITEP, the Laffer measures of success are driven solely by these population flows. ITEP states that “the growth of states lacking an income tax is no more than coincidental.” For proof, ITEP points to factors other than state tax rates that motivate migration from state to state, thus implying that state tax rates do not matter. These non-tax motives create the very prosperity we find to be correlated with tax rates.

ITEP states, “Since a larger population brings with it more demand, it’s only natural that states experiencing the fastest population growth would also experience more growth in the total number of jobs and total amount of economic output.”

ITEP then cites as proof that tax rates do not matter the fact that real state GDP per capita growth and median household income growth are higher for some of the higher-taxed states than they are for some of the no-income-tax states.

Separately, Dr. William Terrell, in testimony to the Kansas Senate Tax Committee, compares Kansas to the no-income-tax states and all other states based on state per capita personal income growth, tax revenue

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growth, and unemployment rates. He concludes that because different categories of states (high tax, low tax, etc.) create different growth rankings, “it is very difficult to know which states [Kansas should] use” to base its tax policy changes upon.

Criticisms not based on sound economics 1. The sources of error in these studies are the following: a. Just because some high-tax-rate states perform well from time to time does not mean that high tax rates do not retard growth. The issue is whether high tax rates raise or lower the likelihood of a state achieving prosperity—not whether there is the occasional exception.

The field of cancer research provides a perfect illustration of this issue.4 According to a 2006 study in Europe, the risk of developing lung cancer for male smokers was 15.9 percent.5 This also means that 84.1 percent of male smokers will not develop lung cancer. Simply because many male smokers will not develop lung cancer does not mean that smoking does not cause lung cancer. We are all well aware of the fact that there are a number of other factors influencing both cancer and state economic performance. Based on the ITEP and Terrell logic, one would have to argue that because some smokers do not get lung cancer, smoking must not be an important factor. This is not sound thinking. Just as smoking reduces one’s chances of being healthy, so too high taxes reduce a state’s prospects for achieving prosperity. And high taxes do reduce a state’s prospects for prosperity. b. Taking this analogy further, smokers are not the only people who develop lung cancer. In the same 2006 study in Europe, 0.2 percent of men who never smoked developed lung cancer (i.e., out of every 1,000 nonsmoking males, 2 will contract lung cancer at some time during their lives).

Just as there are cases where nonsmokers

ECONOMICS 101 • FEBRUARY 2012

develop lung cancer, so too there are states with pro-growth policies that at times do not outperform states with significantly higher tax policies.

Again, we are all well aware that while some high-tax states can from time to time perform well, we are also aware that some low-tax states can from time to time perform poorly. One swallow does not a summer make. The issue again is whether high tax rates raise or lower the likelihood of a state prospering. And high tax rates most definitely lower the likelihood of a state prospering. c. From a statistical economic perspective, whether highly progressive state income tax rates are likely to lead to a slower growing economy depends upon whether there is an overwhelming correlation between high state progressive personal income-tax rates and diminished economic performance. While correlation in and of itself does not prove causation, correlation is necessary for causation. In addition to correlation, proof of the certainty of causation requires “isolation” of the one variable from other correlated variables and also the “introduction” of the one variable into a controlled

situation to be complete. And, while certainty in economics is almost never achieved, correlation increases the likelihood of causation, especially when the cause is politically determined and when both the correlation is widespread and overwhelming causation is highly likely. d. In the figure and two tables below, Figure 1 shows the excess 10-year population growth differences of the zero-income-tax-rate states with the same number of the highest-income-taxrate states from 1970 to the present; Table 1a presents the past 10-year (2001–2010) relationship between the 9 lowest tax burden states and the 9 highest tax burden states (both including and not including Alaska and Wyoming)6 and a series of key state metrics; Table 1b is the same as Table 1a for the period 1998–2007 (Terrell’s preferred time period); and lastly, Table 2 exhibits what was the experience of each of the 11 states that introduced a progressive personal income tax since that tax was introduced during the past 50 years. The historical evidence presented is overwhelming: pro-growth economic policies really do matter.

Figure 1 10-year Population Growth Rate for No Personal Income Tax States and 10-year Population Growth Rate for States with the Highest Personal Income Tax Rate and Premium (dark) for No Personal Income Tax States 1970–2010

ECONOMICS 101 • FEBRUARY 2012

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2. In addition to the comprehensive cross-section time series data on all states, individual case studies show that income taxes diminish economic growth consistently over time. The histories of New Jersey and California, as well as those of the states

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that implemented a progressive state personal income tax, exemplify the overwhelming correlation between higher state tax rates and slower economic performance. a. Until 1966, New Jersey had neither a general

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sales tax nor a progressive personal income tax; a progressive personal income tax was not introduced in New Jersey until 1976. While New Jersey winters have always been cold, during the pre-1966 period New Jersey was consistently

ECONOMICS 101 • FEBRUARY 2012

one of the top-growing states in the nation, attracting population from everywhere, and the state had a balanced budget.

In 2010, just prior to Governor Christie’s taking office, New Jersey had one of the highest sales-

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tax rates in the country, one of the highest personal-income-tax rates in the country, and one of the higher property-tax burdens in the country. New Jersey was also one of the slowestgrowing states in the country, repelling people profusely, and its budget was a mess.

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b. California is also a textbook example of how high tax rates chase people and income out of the state, only to be encouraged back in again once the punitive tax rates have been repealed or lowered.7 c. Over the past 50 years, 11 states have intro-

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duced a progressive personal income tax. In each case—with no exception—the share of the national economy and national population represented by each one of these states is smaller now than it was prior to the introduction of the progressive personal income tax. Again, these are basic economic principles.

3. ITEP fails to differentiate between income growth and population growth—and the causal relationship between the two. The reason why personal income per capita data across states fail to show a consistent correlation with tax burdens is simply that tax burdens impact both population and income data negatively. Lower tax burdens create greater income growth and greater population growth. Higher tax burdens create less income growth and less population growth. What happens to personal income per capita in either the prospering states or the stagnating states is not determinable; nor is the unemployment rate for similar reasons. a. Texas is one of the fastest-growing states because people are moving into it. People are also moving into Texas because there is economic opportunity there. It is pretty straightforward; good state tax policy attracts both people and income. b. Of course, population growth helps spur additional income growth, but that is the whole point.

Good policies attract people, especialy job creators. Creating a pro-growth environment of prosperity encourages people to relocate to a state, increases in-migration, and increases state income growth. c. As people leave the high-income-tax states, in pursuit of better economic opportunities and following the job creators, it is natural for the unemployment rate to remain relatively comparable or even slightly lower, as those remaining are doing so because they have been able to tolerate and withstand anti-growth policies. The basic principles of supply and demand explain this point. Where there is less opportunity to succeed and find work, there will be less present

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looking for those opportunities. Moreover, many things factor into a state’s unemployment rate, which is just a snapshot in time of those working and those not working in that particular state. d. Oklahoma, as noted in the Laffer/OCPA analysis, is performing better than the national average and better than some no-income-tax states in some years. Oklahoma’s success over the last few years is a result of its adoption of progrowth policies such as Right to Work, elimination of death taxes, and cutting its personal income tax rate by 20 percent over the last decade. According to IRS data, which are the most sound source for in-depth comparisons of migration between two states, Oklahoma has fared slightly better than Texas in terms of migration over the last two years. But when one considers a longer period, Texas is beating Oklahoma soundly in terms of migration between the two8 and many other measures. Oklahoma and Kansas must compete with their southern neighbor, which historically is beating them and the nation soundly in several economic measures. Oklahoma and Kansas do not seek simply to do better, they seek to be the best— and to remove any competitive advantage that Texas or any other states in the region may have.

4. Save for Louisiana in 2005 after Hurricane Katrina, climate does not usually change all that much, yet population flows change dramatically when state economic policies change, encouraging people to change where they live and work. a. A key part of the nine-state comparisons is that people and businesses move to states with progrowth tax environments. b. Population flows help top-line GDP grow faster in the states into which people migrate. Population inflows into a state in turn create an offset for GDP per capita increases (higher population flows increase the denominator, while higher income flows increase the numerator).

The effect on GDP per capita is a combination of these two effects and is generally unknown.

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c. When people are leaving a state, income growth on the top line falls because there are fewer people; again changes in per capita GDP growth are unknown.

5. Neither ITEP nor Terrell provide a theory that shows why higher tax rates, or increasing income-tax rates, increase economic growth. And the reason that they do not provide such a theory is that such a theory makes no sense. Whether we are looking at countries, states, or counties, it stands to reason that people and businesses will move from locations where opportunities are absent and/or declining to locations where opportunities are high

and/or rising. State tax policies are one important factor in determining the level and change of economic opportunities. Taxes do not just redistribute income; they redistribute people.

Ask yourself the following question: If there are two locations, A and B, and then taxes are raised in B and lowered in A, where do you think people and business will move from and to? This is not rocket surgery; it is common sense. Economics is all about incentives.

Our position on the role of taxes and economic growth is supported by a vast literature over many generations. A small sampling of that literature can be found at the end of this document.

Economics 101: People Care About After-Tax Income

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hen analyzing and modeling the behavior of people to tax-policy changes and its impact on the economy, it is important to consider all income taxes faced by the individual. This is the soundest modeling because of the simple fact that people can only use after-tax income, no matter which level of government is taxing it. If only one level of income taxes is considered when analyzing and modeling the behavior of people with respect to taxes, this will yield distorted results which don’t account for the complete impact on the economy of the individual’s income.

Taxpayers do not care about which entity is collecting the tax revenues; taxpayers care about their after-tax rate of return, including all taxes.

In its own analysis, “Tax Strategies for A Strong Minnesota” (Michael P. Ettlinger, Tyson Slocum, and Robert G. Lynch, January 1998), ITEP concurred that federal income taxes are an important consideration when examining state income tax policy. In describing recommendations for Minnesota, the ITEP report attempted to justify higher income taxes on the rich by arguing, “Tax increases that affect only higher income taxpayers are offset to a large degree by lower federal income taxes.” While their argument fails to consider the important incentive effects, the argument does recognize the importance of all income taxes from the taxpayer’s perspective.

Economics 101: Every State Is Unique, But People Respond the Same

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ne of the great things about the United States of America is its diverse terrain and the unique sectors that are found across the states. Each state relies on a unique conglomeration of industries, but this still does not change the response of people to incentives. Some states also have many industries in common—for instance, Texas and Oklahoma both rely heavily on the mining and oil industries. Whether a state generates a lot of activity from agriculture, mining or energy, manufacturing, tourism, or technol-

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ogy, if the incentives are right, people will move where they can maximize the return on their investment and minimize the extraction of their returns in the form of taxes. With the advancement of technology, rapid transportation, and the fluid mobility of capital, every state has the possibility to support existing and new industries.

For example, the development of horizontal drilling and what many refer to as “fracking” has turned a northern state such as Pennsylvania into a state with a

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mining boom almost “overnight.” Pennsylvania has seen significant economic returns, while its neighbor to the north, New York, which has much of the same fossil-fuel opportunities, has suffered because it has succumbed to high regulatory and tax burdens.

It is no secret that Oklahoma is a state with a mining presence and is home to some of the largest producers of fossil fuels. One needs only to look at Oklahoma’s state revenue sources to see how important the mining or energy sector is to Oklahoma. According to 2010 census data on state tax collections, severance taxes comprised 10.5 percent of Oklahoma’s tax collections. Comparatively, state tax collections from severance taxes comprised 4.4 percent of total state tax collections in Texas. With Oklahoma’s legacy and leadership in the energy and mining industry, and its success and potential in the agriculture, manufacturing, and health sectors, com-

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paring Oklahoma to other states with significant energy or mining sectors and other states across the nation is necessary. Moreover, it reveals the endless opportunities for Oklahoma if further pro-growth policies, such as phasing out the state personal income tax, are implemented.

States like California, which are losing population to lower-tax states with less-desirable weather and attractions—such as Colorado, Nevada, Oklahoma, and Texas—provide evidence that maximizing aftertax returns is a more important consideration than geography or weather.

Finally, for any state competing for people, what better way for a state to position itself against a state with perceived industry advantages than to create the economic environment where people can receive the greatest after-tax return on their income? %

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Appendix • Bania, Neil, Jo Anna Gray, and Joe A. Stone. “Growth, Taxes, and Government Expenditures: Growth Hills for U.S. States.” National Tax Journal 60, no. 3 (June 2007).

• Barone, Michael. “The Fall of the Midwest Economic Model.” The Wall Street Journal, August 16, 2011.

• Barone, Michael. “The Great Lone Star Migration.” The Wall Street Journal, January 8, 2011.

• Barro, Robert J. “Economic Growth in a Cross Section of Countries.” Quarterly Journal of Economics 106, no. 2 (May 1991).

• Batchelder, Bill, Jack Boyle, and Dick Patten. “Ohio Shows the Way on Death Tax Repeal.” The Wall Street Journal, July 2, 2011.

• Becsi, Zsolt. “Do State and Local Taxes Affect Relative State Growth?” Economic Review 81, no. 2 (March/April 1996).

• Campbell, Colin D., and Rosemary G. Campbell. A Comparative Study of the Fiscal Systems of New Hampshire and Vermont, 1940–1974. Hampton, NH: Wheelabrator Foundation,1976.

• Canto, Victor A., and Robert I. Webb. “The Effect of State Fiscal Policy on State Relative Economic Performance.” Southern Economic Journal 54, no. 1 (July 1987).

• Finley, Allysia. “The Chicago Expulsion Act of 2011.” The Wall Street Journal, December 17, 2011.

• Fund, John. “California Dreamin’—of Jobs in Texas.” The Wall Street Journal, April 22, 2011.

• Gordon, John Steele. “The Rise and Needless Decline of the Golden State.” The Wall Street Journal, July 5, 2011.

• Gwartney, James, Robert Lawson, and Randall Holcombe. The Size and Functions of Government and Economic Growth. Report prepared for U.S. Congress, Joint Economic Committee, April 1998.

• Hall, Arthur P., Scott Moody, and Wendy P. Warcholik. “The County-to-County Migration of Taxpayers and Their Incomes, 1995–2006.” Technical Report 09-0306, Center for Applied Economics, March 2009.

• “The Heartland Tax Rebellion.” The Wall Street Journal, February 8, 2012.

• Holmes, Thomas J. “The Effect of State Policies on the Location of Manufacturing: Evidence from State Borders.” Journal of Political Economy 106, no. 4 (August 1998).

• Landau, Daniel L. “Government Expenditure and Economic Growth: A Cross-Country Study.” Southern Economic Journal 49 (January 1983).

• Malanga, Steve. “How California Drives Away Jobs and Business.”

Endnotes Barrister proverb.

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Arthur B. Laffer, “The States Are Leading a Pro-Growth Rebellion,” The Wall Street Journal, February 11, 2012, http://online.wsj.com/ article/SB10001424052970203711104577201391354733460.html; Stephen Moore, “The Most Important Non-Presidential Election of the Decade,” The Wall Street Journal, January 28, 2012, http:// online.wsj.com/article/SB100014240529702045737045 77186830049178636.html; and “The Heartland Tax Rebellion,” The Wall Street Journal, February 8, 2012, http://online.wsj.com/article/ SB10001424052970203889904577200872159113492.html.

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The Wall Street Journal, October 15, 2011.

• “Maryland’s Son of Obama.” The Wall Street Journal, February 7, 2012.

• Mitchell, Daniel J. “The Impact of Government Spending on Economic Growth.” Executive Summary Backgrounder 1831, Heritage Foundation, March 31, 2005.

• Moody, J. Scott. “Leaving Illinois: An Exodus of People and Money.” Tax and Budget Brief, Illinois Policy Institute, January 12, 2011.

• Moody, J. Scott. “Still Leaving Illinois: An Exodus of People and Money.” Policy Brief, Illinois Policy Institute, December 20, 2011.

• Moody, J. Scott, and William J. Felkner. “‘Leaving Rhode Island’: Policy Lessons from Rhode Island’s Exodus of People and Money.” Ocean State Policy Research Institute, January 2011.

• Moody, J. Scott, and Wendy P. Warcholik. “Voting With Their Feet.” Policy Brief, Oklahoma Council of Public Affairs, April 29, 2010.

• Moody, J. Scott, and Wendy P. Warcholik. “Oklahoma Losing Taxpayers to No-Income-Tax States.” Policy Brief, Oklahoma Council of Public Affairs, January 5, 2012.

• Moore, Stephen. “Can Rick Scott Put Florida to Work?” The Wall Street Journal, December 31, 2010.

• Moore, Stephen. “The Most Important Non-Presidential Election of the Decade.” The Wall Street Journal, January 28, 2012.

• Moore, Stephen. “The Taxman Cometh to Illinois—With a 75% Hike.” The Wall Street Journal, January 8, 2011.

• Reed, Robert W. “The Robust Relationship between Taxes and U.S. State Income Growth.” National Tax Journal 61, no. 1 (March 2008).

• Scully, Gerald W. “Taxes and Economic Growth.” NCPA Policy Report no. 292, National Center for Policy Analysis, November 2006.

• Strassell, Kimberley A. “Wisconsin 1, Illinois 0.” The Wall Street Journal, January 14, 2011.

• Vedder, Richard. “Right-to-Work Laws: Liberty, Prosperity, and Quality of Life.” Cato Journal 30, no. 1 (Winter 2010).

• Vedder, Richard. “Taxation and Migration.” The Taxpayers Network, March 2003.

• Vedder, Richard, Matthew Denhart, and Jonathan Robe. “Rightto-Work and Indiana’s Economic Future.” Indiana Chamber of Commerce study, January 2011.

In Oklahoma, the idea of phasing out the personal income tax is under consideration, thanks in part to the publication of a recent report by the Oklahoma Council of Public Affairs and Arduin, Laffer & Moore Econometrics (“Eliminating the State Income Tax in Oklahoma: An Economic Assessment,” November 2011). Wisconsin, Ohio, Indiana, Tennessee, and New Jersey, among others, have all recently implemented strong pro-growth policies.

Siddhartha Mukherjee, The Emperor of All Maladies: A Biography of Cancer (New York: Scribner, 2010).

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Lynne Eldridge, “What Percentage of Smokers Get Lung Cancer?” February 28, 2011, http://lungcancer.about.com/od/LungCancer-And-Smoking/f/Smokers-Lung-Cancer.htm.

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Alaska and Wyoming have exceptionally large severance taxes, which some people argue make them less comparable to other states. Of course, every state is in some ways different from every other state, which alone does not invalidate all comparisons. But when significant differences do appear, the research analyst must be careful.

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See Arthur Laffer and Wayne Winegarden, EUREKA! How to Fix California (Pacific Research Institute, 2012) for more on this topic.

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Moody, J. Scott and Wendy P. Warcholik. “Oklahoma Losing Taxpayers to No-Income-Tax States.” Policy Brief, Oklahoma Council of Public Affairs, January 5, 2012.

Oklahoma Council of Public Affairs 1401 N. Lincoln Blvd. • Oklahoma City, OK 73104 Tel: 405.602.1667 • Fax: 405.602.1238 • ocpathink.org