COLLEGE DIRECTORY       :      VISIT ELLER      :      LOG IN 

Arizona Fiscal Issues

Public Services Positively Impact Growth: A Review of Taxation and Growth Literature

By Alberta H. Charney, Ph.D.
May 6, 2010

Summary
Introduction
The Literature
Misinterpretation of Empirical Results
End Notes

Summary

Public services have been found to positively impact economic growth. This finding is drawn from 35 years of empirical literature on the effects of taxes on growth. The following literature review finds the following:

• The phrases so commonly heard, that "higher taxes hurt growth" and that "lower taxes stimulate growth," are complete misrepresentations and oversimplifications of the taxation and growth literature.

• Both public service and tax measures are included in growth model equations, but only the effect of the tax variable is discussed or interpreted. Impacts of the public service variable are largely ignored.

• The level of public services is shown to have an important positive impact on growth.

• Because in these models growth is negatively affected by taxes and positively affected by the level of public services, then the correct interpretation of the impact of taxes on growth is: "lower taxes may increase growth, but only if public services levels are not cut at the same time."

• Including public service measures in growth models increases the size of the measured negative tax effects.

• Removing public services from growth models renders the tax variable statistically insignificant.

back to top

Introduction

Common wisdom does not always represent truth. The following is typical of the common wisdom:

"Changes in tax rates have measurable effects on taxable activities. The weight of evidence shows that state-level tax increases have significant negative effects on state economic activity. "1

The source information to support this statement (it was not a quote) was a 1991 book by Timothy J. Bartik2. The following is Bartik's actual conclusion, based on his analysis of 84 studies of the effects of state and local taxes on business activity:

"The review of previous research suggests that state and local policies can have significant effects on local growth. A state and local business tax reduction of 10 percent, without reducing public services to businesses, probably increases business activity in a state or metropolitan area in the long run by 2.5 percent. Improved state and local public services to business can increase growth. Some evidence suggests that increasing state and local taxes to finance improved business services will have a net positive effect on local economic growth (Bartik, 1991, emphasis added by current author)."

Based on this statement, I would not be able to argue that "the weight of the evidence shows that state-level tax increases have significant negative effects on state economic economy." I ask the reader to read Bartik's quote again and focus on the part that says "without reducing public services to businesses." This is a critical point in my comments to follow and I will be returning to this again.

Bartik also published an overview of these same studies in 1992.3 The conclusions in that overview are more specific:

"Lowering state and local business taxes can significantly increase business activity n a state, metropolitan area, or suburb, but such a strategy may have large costs. For a state or metropolitan area, the annual costs of a business tax reduction strategy per job created are probably somewhere between 2 thousand and 11 thousand dollars - that is, the costs range from 'expensive but maybe worth it' to 'much too expensive.' Business tax reductions financed by cutting education or infrastructure spending will probably destroy jobs (Bartik, 1992, p.109, emphasis added by current author)."

The rest of this article discusses the articles reviewed by Bartik and others.

back to top

The Literature

The 84 studies included in Bartik's book included intermetropolitan or interstate studies (i.e., states that analyzed business activity across metropolitan areas or across states), intrametropolitan studies (studies of business activity within a single metropolitan area), mixed intra- and inter-area studies (mainly studies of city vs. suburban, compared across metro areas), and intrastate studies (studies within a single state). The nature of studies that focus on business activity across an individual metropolitan area, within a single state, or deal with city/suburb issues are very different than studies that are conducted across states, counties or metropolitan areas, so the rest of this discussion focuses on only on the latter 60 studies. For discussion purposes, states, counties and metropolitan areas will all be referred to as "regions" or "areas."

These studies addressed a wide variety of questions that relate to businesses activity and, depending on the question, the studies are categorized differently. Broadly speaking, most of these studies asked three different, but related, questions:

• Why do some regions (states, counties, metropolitan areas) grow faster than others?
• These studies test "growth models," and measure growth using investments, employment, gross state product, labor demand, personal income, or other measures
  Why do some regions create more new businesses?
• These "business formation" studies compare areas according to their effectiveness in generating "start-up" firms.
• Why do some areas attract more businesses?
• These are referred to as "location studies," which study the location pattern of firms or attempt to measure the likelihood of firms locating in different regions, based on various measures.

Trying to summarize the results of these very different studies is difficult, but a few generalizations can be made. The studies included in Bartik's book were published between 1979 and 1991. The earlier of these studies were less likely to control for public services. Less than one-third of pre-1987 studies controlled for public services; 60 percent of the 1988-1989 studies controlled for public service; and in the ten studies from 1990-1991, 70 percent controlled for public services.4 Relatively few of the more recent empirical studies that examine the role of taxes on growth, location or start-ups do not include some measure or measures of public services.

The measured magnitude of the tax effects across of these studies varied substantially. In 1995, Phillips and Goss,5 using Bartik's estimated tax effects for each of the studies, attempted to determine why the measured tax effects varied so much across these studies. They conducted what is known as a "meta-analysis," or a statistical analysis of the statistical results of other studies. They estimated an equation with the measured tax effects (from the studies) on the left and a list of 15 variables on the right. Only two factors were found to be important in explaining why tax effects are larger in some studies than others. The first represents the finding that, for some reason, estimated tax effects are lower when growth is measured as investment or personal income than when measured as something else, such as employment. The second variable, highly significant in determining the size of the tax effect, is whether or not the study included one or more public service variables in the equation. When public services variables are included, the measured tax effects become significantly larger.

Although the Phillips and Goss study found that including public service variables affects the size of the tax effects, their results raise another question. If putting public service variables in growth and location studies increases the size of the estimated negative tax effect, what happens if the public services variables are removed? Modifi and Stone6 (1990), in an attempt to help resolve the inconsistencies in earlier studies, estimate/test a growth model across states for four different 5-year periods. They estimate two versions of the model, one using investment and once using employment as measures of business activity. The variables in their equations include: two revenue variables (taxes and other revenue), seven public service variables (health, education, highways, other expenditures, surplus/deficit, UI benefits, and transfer payments), and 13 other control variables. For both the investment and employment models, both revenue variables had negative estimated coefficients and were statistically significant from zero. In addition, all public service variables were positive except for UI benefits and transfer payments. The positive public service variables were all significant when employment was the dependent variable and although not all separately significant in the equation for investment, they were significant as a group.

The results of Modifi and Stone, to this point, are similar to many other empirical studies that examine taxes - negative and significant effects of taxes and positive and significant effects of expenditures. They then re-estimate the equations without the public service variables. What happens? The tax variable becomes insignificant (not different from zero) in both equations and the tax variable coefficient switches to positive in the employment equation.

In summary, these two studies show that:

• When public service variables are included in growth and location studies, the measured negative tax effects are significantly larger than they otherwise would be.
• When public service variables are removed, the effect of the tax variables becomes statistically insignificant (not different from zero).

back to top

Misinterpretation of Empirical Results

It is critically important the empirical results are interpreted correctly when both a tax variable and public service variable are included in growth and location studies. In particular, interpretation of a negative coefficient on a tax variable in a growth model cannot be "taxes decrease growth." It must be "taxes decrease growth, holding public services (and any other variables in the equation) constant." This latter interpretation has a very different meaning than the first one. The correct interpretation means that if there are two states that have the same level of public services (and are alike according to the other variables in the model), the state with lower taxes has a growth advantage. If a state happens to be endowed with great wealth to start, then it might have a growth advantage because it can maintain public service levels similar to its neighbors, but do it with lower taxes. This is an extremely weak statement compared to constant mantra of "tax cuts are good for the economy," or "tax increases are going to hurt the state econom." The actual literature findings are much more nuanced. It is extremely difficult to cut taxes without also cutting public services at the state and local government level. Unlike the federal government, states and local governments have balanced budget requirements.

As an example, consider a 2004 study, "The Effect of State Income Taxation on Per Capita Income Growth7," that examined differential growth rates between matched pairs of counties that straddle state lines to examine the effect of tax differentials. They report in their abstract that:

"...the results show that over the 30-year period from 1960 to 1990, states that raised their income tax rates more than their neighbors had slower income growth and on average, a 3.4% reduction in per capita income."

In their conclusions, they state:

"The empirical results consistently show that states that increase their income tax rates more than their neighbors have slower per capita income growth. Increases in average state tax burdens also have a negative impact on per capita income growth..."

Wow, based on the abstract and these conclusions, one would have to conclude that maybe we should cut taxes so that we can have higher per capita income growth. Not so fast. There were 10 variables in their estimated equations - among them were the two tax variables mentioned in the conclusion and a public service variable: state and local per capita government expenditures. The tax variables were negative and highly significant, but the state and local per capita government expenditures variable was positive and also highly significant. Thus, the finding should read: states that increase their income tax rates more than their neighbors without changing their state and local per capita government expenditures, have slower per capita income growth.

Applying the same method used by the authors to determine the estimated 3.4% reduction in income (quoted in the abstract) to the public services variable, results in the finding that having the higher state and local government per capita expenditures can result in 6.1% higher per capita income! Note that both of these findings are exaggerated. This study was conducted across more than 1300 pairs of counties that straddle state lines. The 3.4% tax effect was computed for the pair of counties with the highest state tax differential. Similarly, the 6.1% state and local spending effect was computed for the pair of counties with the largest differential in state and local government per capita expenditures (that data was all that was available in the published summary statistics).

Unfortunately, this is typical of too many of the articles on this subject. They include one of more public service variables, but they call them "control" variables and don't interpret them. And too many authors don't seem to understand the connection between them.

back to top

End Notes

For further information, please contact us.