Arizona Fiscal Issues
Higher Taxes Won’t Hurt Arizona’s Economy
By Alberta H. Charney, Ph.D.
June 19, 2003
What effect does state and local government spending have on Arizona’s economy? The politically popular, but unsupported, arguments that lower taxes positively impact economic activity are all too familiar: 1) We need to give tax dollars back to the people so they will spend it and generate economic activity. 2) Lower taxes will make the economy grow, thereby making up all the lost revenues. 3) Lower taxes make the state more attractive for people and businesses to locate here.
While there is an element of truth in these, they represent only a small part of the whole truth. Argument #1 completely ignores the fact that governments, as well as consumers, spend money and generate economic activity as they spend. And, because of balanced budget requirements, lower state taxes necessarily mean lower spending as well (only the federal government can spend more than it collects). In fact, it can be argued that during a recession, short-term tax increases can actually stimulate the state’s economy because a) the government spends every dollar it gets while consumers save a portion, and b) the government buys in-state produced goods and services (such as roads and teachers) while consumers buy things produced elsewhere (such as clothes, cars, appliances and electronics). Therefore, government spending generates a stronger short-run multiplier, or ripple effect, than consumer spending.
Argument #1 also ignores the fact that Arizona residents value both private and public goods and services. Some public services actually reduce other, non-tax, costs to residents: quality fire protection reduces insurance costs; police protection reduces property losses and loss of life; health care for low-income kids reduces future health care costs; quality education reduces crime and future welfare costs, and produces a quality workforce that is the foundation for increased prosperity. Public services also have an intrinsic value to residents that extend far beyond just cost saving. For example, the feeling of ‘safety’ is valued much more than only the reduced costs of theft and fire insurance; residents value beautiful and functional state and local parks, even if they don’t use them regularly; and most derive satisfaction from the knowledge that there is a safety net for families during hard times.
Argument #2 is just plain wrong. Tax cuts are not self-financing. When tax rates are cut, revenues fall by almost the full amount of the tax cut. Estimates of the percentage of revenues “created” by a tax cut are in range of 5-10% of the original tax cut, according to the preponderance of empirical evidence. Thus, for each dollar of a tax cut, only 5-10 cents is recouped as a result of additional activity, but the remaining 90-95 percent of the cut is a permanent reduction in government revenues and services.
In addition, recouping the 5-10% of the tax cut may take years to occur. Consider a $100 million tax cut that generates a 10% revenue ‘feedback’ with a 10 year adjustment period. This means that $100 million in revenues is lost the first year, $99 million the 2nd year, $98 million the third year, …until the 10th year, in which only $90 million in revenues are lost to the government. Also, the models that have been used to estimate these revenue ‘feedback’ effects do not adequately account for the growth enhancing potential of government spending on public infrastructure, university research and technology transfers, or investment in human capital (education). Thus, even the 5-10% estimates are overstated.
During the 1990’s, employment in Arizona grew by 32.5% and some have jumped to conclude that the tax cuts caused the strong growth. In fact, the converse is likely true: the legislature was able to cut taxes because of the economy’s growth. With strong growth, revenues expand faster than inflation and population growth, but in a recession, revenues fall despite ongoing inflation and population growth. An ASU study comparing Arizona’s growth during high-tax years vs. low-tax years found no perceptible effect of tax cuts or tax increases on economic growth.
Argument #3 ignores the fact that quality public services are just as important to the location decisions of individuals and companies as are the level of taxes. The academic literature on the locational effects of taxes is very mixed, but if there is a consensus statement that can be made it is the following: If two states have identical levels of public services, then the state with lower taxes will have a slightly higher level of economic activity and the state with higher taxes will have a slightly lower economy. Further, the tax/expenditure package can affect the type of growth and type of activity attracted to the state. This completely overlooked point is critical to Arizona’s future.
High tech companies and high tech professionals cite ‘quality of place’ as the most important consideration for choosing where to locate, where ‘quality of place’ includes numerous publicly provided services: high education spending, quality universities, parks and recreational facilities, and so forth. In contrast, low tax environments attract retirees and companies providing low-skilled low-wage jobs. The tax/public expenditure mix does affect locational decisions, but focusing only on the tax side has been detrimental to Arizona’s ability to compete in the New Economy. Our per capita real income has fallen from 5% below the national average in the mid-1980’s to 20% below the national average today. If the persistent tax cuts can be credited for part of Arizona’s growth, they can also be blamed for the type of growth created in Arizona.
With state and local public spending as a percentage of Gross State Product in Arizona one-third below the national average, with educational spending ranked 49th in the country (just above Mississippi), Arizona has left behind its image of a progressive, high-tech player to become a tax haven for retirees and low-wage companies. How and why have our public policies de facto emulated the state of Mississippi?
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