You decide: What are the impacts of tax changes

Published January 17, 2015

By Michael Walden

by Michael Walden, William Neal Reynolds Professor of Economics, NC State, January 16, 2015.

Get ready for some tax debates in 2015. At the national level, pundits think a proposal to lower the federal income tax rate may be one piece of common ground between the President and the Congress. Here in North Carolina, Round 2 of tax changes – focusing on lower tax rates and a broader tax base – may be debated in the General Assembly.

Of course, there are many reasons for altering the tax code. During recessions, taxes are often reduced to boost households’ disposable incomes and stimulate spending. Sometimes a tax is lowered to encourage more purchases of a particular product (a tax break for energy-efficient vehicles is an example) or to discourage purchases of other products (cigarette taxes could be put in this category). Other times, a tax may be added or altered because of changes in consumer spending, like proposed taxes for on-line purchases.

In this column I will focus on one specific purpose of some proposed tax changes: that, by lowering tax rates, economic growth (including jobs) will accelerate. This idea has been behind much of the recent tax changes implemented by North Carolina.

The idea of linking tax rates and economic growth is not a new one. It gained momentum during the economically challenged 1970s, when traditional stimulus plans seemed not to work. Critics of so-called “Keynesian economics” shifted the focus from encouraging consumer spending (“demand”) to encouraging business investment (“supply”). The menu of proposals – lowering tax rates, curtailing litigation and evaluating regulations – became known as “supply-side” economics.

The notion that lowering tax rates can spark economic activity is based on the idea that taxes are considered a cost to businesses, workers and consumers. So, the thinking goes, if taxes are lowered on businesses, costs fall and profits rise, thereby motivating firms to make and sell more and to hire additional workers. If taxes are reduced on workers, they keep more of what they earn, and so work becomes more attractive. And if taxes are decreased for consumers, total prices (including taxes) drop, and buyers are prompted to spend more.

Supply-siders who promote a linkage between tax rates and economic activities, such as business production, worker earnings and retail sales, say that in some circumstances lowering tax rates can lead not only to more economic growth, but can also mean more, not less, tax revenue. This means there could be a “having your cake and eating it, too” situation:  lower tax rates but more tax revenues.

Yet, notice I said “in some circumstances.” Economist Arthur Laffer, one of the intellectual promoters of supply-side ideas, posits that the “having and eating cake” result can apply when tax rates are cut from very high initial levels. However, at moderate and low initial tax rates, his writings indicate a loss of tax revenues following a reduction in tax rates.

Of course, there is a debate about what is considered a “high” tax rate. There are also questions about the exact relationships between tax rates and economic growth, especially at a state level. As might be expected, there has been much research by academics and others trying to establish a linkage between state tax rates and state economic growth. Unfortunately, the findings have not been consistent – and in some cases, they have been contradictory.

Critics of the supply-side approach to state taxes cite the inconsistent studies and suggest that many other factors – like worker skills and wages, energy costs, transportation, education, the weather and, importantly, the national economy – impact how fast states grow.

But critics also question the core of the supply-side argument – that taxes are considered only a cost. Of course, taxes are used to fund public programs, like roads, K-12 and college education, police and fire protection, and many others. Businesses, households and the general economy benefit from these programs, although not all to the same degree, of course.

This sets up an interesting “on the one hand, this; but on the other hand, that” comparison when taxes are altered. Let’s say tax rates are reduced and, as a result, tax revenues fall. On the one hand, businesses, workers and consumers are helped by paying lower tax rates. But on the other hand, they are hurt if the reduced tax revenues mean a reduction in government programs and services they enjoy.

So what can our policy-makers do when faced with this predicament? Here are some recommendations.

First, recognize that, while reducing tax rates may stimulate economic growth, not enough growth may be forthcoming to prevent tax revenues from falling. So be prepared to possibly face a tighter revenue situation, especially in the early years of the tax reductions.

Second, if tax rate cuts do reduce tax revenues, be ready to deal with paring back some program spending. This will be hard.

Third, recognize that many elements – in addition to taxes – impact state and local economic growth. A comprehensive review of all these factors, and of what government can do to impact them, is the place to start when focusing on improving the economy.

Taxes are a big part of our discussion and debate about government. This may be the year we have some very spirited debates. You decide if there’s a logical way of going about this discussion that can lead to more agreement, rather than disagreement!