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Chapter 5 Economic Consequences of State Tax Policy The effect of state Ascal policy in boosting or restraining economic performance remains an unsettled question, despite its obvious relevance to policymakers. The existing empirical research provides surprisingly little clarity. Chapter 1 described the persistent growth rate differentials among states in the 1970s, 1980s, and 1990s. The absence of long-run,“automatic” economic convergence depicted in chapter 2 suggests that state policies may exert an important inBuence on the relative performance of state economies. At least conceptually, it is hard to think of an inBuence on economic activity that would be more direct than taxes. Yet, the sizable number of empirical studies offers a host of conBicting results concerning the degree to which taxes affect state economic performance.1 The conBicting results in large part stem from technical difAculties inherent in the empirical estimation problem. Three studies provided critical breakthroughs in the empirical research program: Koester and Kormindi (1989), Mullen and Williams (1994), and Besci (1996). The latest of these studies, by Besci, incorporates and expands upon the two earlier studies, and the analysis that follows adopts the Besci methodology with a few new wrinkles. The Besci method corrects several problems in the methods employed in prior articles that estimated the impact of taxes on state economies. First, prior studies used proxies for the average tax rate as independent variables in state growth regressions. In contrast, economic theory stresses that marginal tax rates inBuence behavior and ultimately the factors that determine aggregate economic performance.2 Besci follows Koester and Kormindi and Mullen and Williams in using marginal tax rates in the empirical speciAcations. The second innovation in the Besci method is to control for the degree of progressivity of state tax policy and thereby isolate the distortionary effects of changes in marginal tax rates.This control technique relates to the way a state government balances its budget in response to a change in the marginal tax rate. The way a government’s budget 64 is balanced (e.g., by raising or lowering taxes generally and raising or lowering spending) may have independent effects on a state’s economy . The effect of changes in other Ascal policies potentially biases the estimates of tax effects unless the empirical model properly controls for such inBuences.As an example, suppose a state raises its personal income tax rate and in turn tax revenues rise.The uses to which these new revenues are put may convey economic consequences. Funding additional infrastructure investments, education, public safety programs, or public welfare programs may have different effects on the state’s economy, independent of the consequences associated with the change in the income tax per se. Alternatively, the state’s Ascal response might be to cut some other tax, thereby leaving total revenues and total spending unchanged. This framework for analysis is commonly referred to as a revenue-neutral change in taxes. The Besci technique adopted here provides a method to control for possible differences in the economic impact from these sorts of secondary, or indirect, responses to tax changes.3 In effect, it examines the impact on state economies from a revenue-neutral change in the marginal tax rate. The third desirable feature in the Besci method is its focus on the relative economic performance of American states.4 Examining each state’s economic performance relative to other states does two things analytically. First, it Alters out the impact of global and national economic conditions, as well as the impact of national Ascal and monetary policies that inBuence all state economies. Second, it takes into account the competitive nature of state governments, in contrast to an encompassing national government that has considerable monopoly power in setting tax rates. Taking the competitiveness of state governments into account is particularly important in analyzing and comparing the effects of speciAc types of taxes. For example, suppose the federal government imposes a national consumption (sales) tax. This might reduce consumption, increase national savings, and redirect resources into growth-enhancing capital investment activities. However, the impact of a sales tax at a subnational (state) level may be quite different. Rather than redirecting resources from consumption to investment activities, a state sales tax may simply encourage the location or migration of productive factors or it may encourage consumers to cross state boundaries to make purchases. The potential inBuence of factor and consumer mobility illustrates the importance of using a state’s relative tax rate in the analysis. Suppose a state leaves its tax rate unchanged...

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