Commentary: Income taxes decrease economic growth, prosperity
This article first appeared in the St. Louis Beacon, Dec. 21, 2010 - With the 2010 Census complete, Congress will soon reapportion seats in the House of Representatives, and Missouri will lose one of its nine congressional districts. According to a new report by Americans for Tax Reform, our state shares a feature with the other nine states likely to lose representatives: relatively high state income tax rates and government spending.
Four of the eight states gaining seats -- including the biggest winners, Texas and Florida, with four and two new seats, respectively -- have no income tax. The average top income tax rate for all eight states is 2.8 percent, compared to 6.05 percent in the losing states, which is just higher than Missouri's top rate of 6 percent. The governments of states that gained representatives spent only $4,008 per capita -- almost 22 percent less than their counterparts in the states that lost seats, which spent $5,117.
These figures suggest that high taxes and government spending tend to drive people away. They also lower the standard of living for those who remain. Two new studies released by the Show-Me Institute explain why and suggest alternatives that can once more set Missouri on a path for growth.
In his new policy study, "A Review of Cross-Country Evidence on Government Fiscal Policy and Economic Growth," University of Missouri Columbia economics professor Shawn Ni compares economic growth and taxation rates, along with government spending, for a number of countries. He finds that taxes reduce economic growth by discouraging businesses and entrepreneurs from creating the capital that raises productivity and, ultimately, wages.
Ni estimates that a 10 percent cut in the corporate income tax rate will lead to a 1- to 2-percent increase in the rate of GDP growth. This may not seem terribly significant, but if two economies started at the same level and one of them grew by an extra 2 percent each year, it would be twice the size of its rival in a little more than 35 years.
Nobel laureate economist Robert Lucas once said, when contemplating the differences in international economic growth rates, "The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else." A similar idea is expressed more succinctly by a quote usually (but inaccurately, in all likelihood) attributed to Albert Einstein: "The most powerful force in the universe is compound interest."
Long-term economic growth rates are affected not only by the rate of taxation, but by the form of taxation. Show-Me Institute Chief Economist and University of Missouri Columbia professor Joseph Haslag, along with Washington University economics doctoral student Grant Casteel, argue in a new essay that replacing Missouri's income tax with a sales tax will lead to a higher growth rate and therefore higher lifetime consumption than we would have under the current system. Casteel and Haslag concede that shifting the tax burden to a broad-based sales tax would result in consumption falling initially, because it would increase total prices for goods and services. However, eliminating the income tax provides a greater incentive for people to create new income -- and, therefore, wealth -- for society as a whole. This translates to a higher economic growth rate.
The authors estimate that, absent the state income tax, the average annual growth rate for Missouri would rise from 0.6 percent to 1.4 percent. Over time, consumption would rise along with people's real incomes. Within nine years, consumption would be as high under the sales tax system as under the income tax -- and it would continue to rise. After a generation (29 years), according to Haslag and Casteel's calculations, consumers would derive more overall satisfaction in a sales tax system, with even bigger gains to come in the future.
Using statistics from Gapminder, we can see that in 1910 Russia and Japan had very similar per capita GDPs: $1,731 and $1,736, respectively, adjusted for inflation. However, after a century of marginally better than average GDP growth, the average citizen of Japan enjoys a standard of living more than twice that of the average Russian. If we want to give Missourians a higher standard of living, we should strive for better economic growth by keeping taxes and spending low and broadly based. Furthermore, the few necessary taxes should not be designed to punish people for creating new wealth, thereby slowing down the engine of economic growth, as the income tax has been shown to do. Over time, small changes can make a huge difference.
John Payne is a research assistant for the Show-Me Institute, a Missouri-based think tank.