Is America about to catch tax-cut fever again? In 1978, it was California that started the last tax revolt with Proposition 13, which capped property taxes. This time, New Jersey is leading the way. During last fall's campaign for governor, Christine Todd Whitman proposed slashing state income taxes by 30% over the next three years. Then, she upped the ante at her inauguration in January, pledging to immediately cut income taxes by 5%, retroactive to Jan. 1, 1994.
Whitman's tax-cutting plan faces formidable political and financial obstacles. But even if slhe fails, other states seem likely to pick up the tax-cut banner. In part, that's because lower taxes are always popular with voters. But they also may make economic sense, even though the result is likely to be a painful reduction in public services. The reason? States with low taxes have shown clearly superior economic performance in recent years.
STRIKING. According to a new analysis by BUSINESS WEEK, job growth in low-tax states over the last eight years has been a stunning 65% higher than in high-tax states (chart). In the 10 states with the highest tax burden--as measured by state and local taxes on businesses and individuals as a share of personal income--the number of jobs in the private sector has risen by some 13% since 1985. By comparison, the 10 states with the lowest tax burden have enjoyed job growth averaging almost 22% over that same period. That's a striking difference at a time when states are struggling for every job they can get.
And there's a growing consensus among economists that state and local taxes have a significant effect on almost every other aspect of economic activity--business-location decisions, startups, and income growth. That view, based on better data and new econometric studies, is far different from the prevailing economic wisdom of just a few years ago, which said taxes didn't have much impact. Even liberal Democrats are pushing for tax cuts to boost growth, including Governor Mario M. Cuomo of New York, who leads one of the nation's most heavily taxed states.
VOODOO REDUX. But there's a catch: Creating jobs by reducing taxes is an expensive proposition. Each new job generated by cutting business taxes costs $130,000 in foregone revenues, estimates Timothy J. Bartik, senior economist at the W.E. Upjohn Institute for Employment Research in Kalamazoo, Mich. And most economists believe that personal tax cuts, such as the ones Whitman is proposing, would be an even more costly means of fostering new jobs.
The overall revenue loss from a low-tax strategy can be considerable. Take New Jersey. Whitman's tax cuts are projected to cost some $1.5 billion over three years. On top of an already yawning deficit for the next fiscal year, that represents a giant hole that needs to be plugged by making state government more efficient, cutting services, or reducing payments to individuals and local governments. Many county and town efficials oppose Whitman's plan, worrying that it will force them to raise property taxes to make up for diminished aid from the state.
Some advocates of state tax cuts claim that lower rates could boost growth enough to pay for themselves by encouraging entrepreneurial activity and business startups. Remember, that's the argument used by supply-side economists to justify the Reagan tax cuts of the early 1980s. But George Bush was right when, during his campaign against Reagan for the 1980 Republican Presidential nomination, he aalled that idea "voodoo economics." After the tax cuts were passed in 1981, the federal budget deficits soared and the national debt rose from $994 billion in 1981 to $3.2 trillion in 1990.
Likewise, economic studies show that a state that cuts its taxes should expect a big drop in tax revenues along with faster growth. To be sure, the revenue drop is not likely to be as big as the one experienced by the federal government in the Reagan years since a low-tax state can lure jobs from elsewhere in the country. Still, says Bartik: "You're not going to get enough increase in business activity to outweigh the rate cut."
The fact is that there's an unavoidable trade-off: States with lower tax burdens have less money available to spend on public programs such as education, transportation, and crime prevention. Economists have found evidence that in the long run, states that pay for tax cuts by slashing spending on critical areas such as highways or higher education may actually become less attractive to business.
Moreover, big tax cuts and the spending cuts that come with them are sure to bring immediate distress for residents, who expect good schools for their children, protection from crime, and well-plowed streets after a snowstorm. The poor, too, will suffer as social services are cut. "The money paid for taxes is used to provide services that people want," observes Howard Chernick, a public-finance expert at New York's Hunter College. "It doesn't just disappear into a black hole."
"OUTER LIMITS." But more and more, the balance is shifting in favor of cutting taxes. For one, states increased taxes during the recession to keep their budgets balanced. As a result, state and local taxes as a share of personal income have risen to their highest level since the mid-1970s, which was the time when the last tax revolts started. Now that the national economy is finally recovering, incomes and overall revenues are rising, giving many states some leeway to roll back rates again.
In addition, the penalty for being a high-tax state is increasing as businesses become more cost-conscious. For years, state and local governments have been willing to cut taxes on a case-by-case basis, offering tax breaks to woo large employers. Now, there may be a new wave of wholesale tax-cutting as states try to attract startups and small high-tech businesses. "As locations become more interchangeable, standing out with high taxes becomes more anticompetitive over time," says Chernick.
Even where tax cuts don't have a dramatic economic impact, they can signal a change in the business climate. That's what happened in Massachusetts, which made some relatively minor tax cuts in 1992. While the gradual recovery of the state cannot be attributed to the cuts, "they've been of significant symbolic importance for the economy," says regional economist Peter P. Kozel of Babson College in Wellesley, Mass. "The state was getting into the outer limits in terms of its overall tax burden, but now we're more in line with other states. There has been a significant improvement in business attitudes" as a result of the cuts, Kozel says .
What Whitman is doing in New Jersey is trying to reverse a rising tax burden. Over the past 10 years, New Jersey has moved from being a low-tax state to having a tax burden above 11%, very close to the national average (chart). That means New Jersey has lost the low-tax competitive advantage enjoyed by states such as Tennessee and Nevada, which have shown far better job growth in recent years.
But New Jersey is still a tax haven compared with New York. State and local taxes there total 15% of personal income, far higher than almost anywhere else in the country. The only state higher is Alaska--a special case because of hefty taxes on oil production. For years, New York was able to offset high tax rates with its strengths as a financial and cultural center, but that may no longer be enough. Indeed, Cuomo is proposing to pare back several different kinds of taxes and fees on business in hopes of reviving the state's moribund economy. "It makes sense for New York to come back" to the national average, says Chernick. "It's too far out of line."
Tax-cut fever is spreading to other parts of the country, without regard to party lines. Georgia Governor Zell B. Miller, a Democrat, wants to cut personal income taxes by $100 million, as does Republican Governor Fife Symington of Arizona. In Massachusetts, Governor William Weld has recently proposed a new budget that would slice personal income taxes by $270 million, on top of his earlier cuts. And tax-cut rumblings can be heard in other states, such as Washington, where Governor Mike Lowry, a Democrat, has pledged tax breaks for high-tech industries.
The latest round of proposals to reduce taxes is a welcome relief to Americans, especially in light of higher taxes on the federal level. Tax-cutting states will have to tighten their belts, but the gain may be worth the pain.