October 12, 2008

Looking Too Closely to See the Reality

Justin Katz

On one level, Tom Sgouros's attempted proof that the Laffer Curve can't be accurate is rhetorically ludicrous:

Let's go to the numbers. The corporate tax is 9% of income and is paid by about 2,500 corporations. Not counting the companies who pay the $500 minimum (44,000 of them!), this tax raised $134 million in 2007. Were we to trim it to 8%, we'd need to raise $14 million in new revenues to make the cut pay for itself. Counting income and corporate taxes, that's the equivalent of 130 new companies with income of around half a million each, and with an average payroll of more than $2 million. Do you think this is a likely outcome of a small cut in one tax?

What about the income tax? Rhode Islanders earn around $40 billion a year these days. Out of that, we pay about $1 billion in income tax each year. In order for a 5% cut in the income tax to pay for itself, it would have to cause a 5% rise in personal income, roughly equivalent to the growth rate in 2003 and 2004. But ask yourself: what effect would a 5% cut in your state income tax have on you?

If you're part of a family earning around $75,000, a 5% cut in your income tax will be worth around $100. That's going to net a lot of economic stimulus, isn't it? Maybe you expect more rich people to move in, or put your hopes on the merchants and tradespeople they pay to re-spend the money they receive (the "multiplier")? Well, if we were actually an island, if nobody put their tax cut in the bank, if everyone spent it all as fast as they could on local businesses and if five hundred really rich people moved in because of the cut, then there'd be a fighting chance of making it pay for itself. Maybe. A larger cut would require a larger effect. Applied to the real world of Rhode Island's taxes, the whole proposition is completely absurd, but it so often comes masked in economic gobbledy-gook that people are routinely taken in.

Regarding the first paragraph, on what experiential basis does Sgouros expect his readers to answer his question? Will a 1% lower tax rate generate specifically $14 million dollars? I don't know, but I'd remind Sgouros that not every source of additional revenue has to be "new companies"; that percentage decrease in taxation (although clearly too small, in my estimation) might be the determining factor for some multimillion-dollar businesses to shift or add operations in the state.

Regarding the second paragraph, note the inconsistency in Sgouros's handling: With the corporate tax, he wants us to consider the hugeness of aggregate amounts; with the income tax, he wants us to consider the smallness of effects on the individual family. Nice trick, but his mocking the amount of economic stimulus would seem less credible if stated in the context of a new $50 million in disposable income pumped into the state's economy.

On a related note, the fact that Sgouros ignores the sales tax points to the larger issue at hand — namely, the state's business and commerce environment:

According to the 2008 U.S. Economic Freedom Index from the Pacific Research Institute, which measures how friendly or unfriendly state government policies are toward free enterprise and consumer choice, the northeast region of the country continues to lag behind the rest of the United States. New York stood out as the most economically oppressive state for the third time in a row.

Rhode Island, New Jersey, Pennsylvania and Vermont all ranked in the bottom 10. Massachusetts, Maine and Connecticut came out slightly ahead, ranking 33, 35 and 39, respectively.

The lesson of the Laffer Curve is that taxation is an active force in the economy, not some disconnected stream, and when taxation discourages economic transactions, as it does in Rhode Island, it has counter-intuitive results