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Commentary: Lower tax rates are more efficient than tax credits

This article first appeared in the St. Louis Beacon: Tax credits are a hot topic in the Missouri Legislature. Fans of these instruments assert that tax credits are necessary for Missouri to compete with other states and to signal that we are “open for business.” Such devotion to helping the state grow is admirable. Fans, however, are not experts and a careful review of the evidence and some basic economics helps us understand why these herculean efforts are misguided. When asked whether Missouri can stay open for business while avoiding the pitfalls of the tax credit, the answer is unambiguously yes.

Missouri state government is expected to redeem about $500 million in tax credits during the fiscal year that ends June 30, 2008. Net general revenue is roughly $8 billion. The static picture is straightforward; for every dollar of tax credits redeemed, there is one less dollar in the general revenue fund. When economic development is concerned, tax credit fans argue that the bigger picture is much more complicated as tax credits induce businesses to form or expand, thus adding tax base for general revenues.

Tax credits and tax rates are tools used to determine the amount of money available for the General Assembly to spend. Both operated on the dollars collected into the general revenue fund. Holding everything else constant, tax credits reduce the amount of money available to spend. A reduction in the tax rate would accomplish the same change in money available to the state. In other words, there is an equivalence between tax credits and tax rates in the sense that each can affect the amount of general revenue funds collected. To reduce general revenue funds, one can use only tax credits, use only tax rates, or some combination of the two. In terms of lowering the tax bill, each is equally capable. So, Missouri can signal that it is open for business by increasing tax credits or decreasing tax rates.

The next question is whether one tool is better than the other. The answer is yes. Tax credits are targeted reductions in tax bills. For example, tax credits specify that actions a, b, and c are necessary to receive the credit. For the largest source of Missouri revenue, tax rates apply to people’s income. People who cannot perform actions a, b, and c are excluded from receiving the credit. Everyone who pays the individual income tax would realize lower tax bills if the tax rate were reduced. From an equity viewpoint, the tax rate is preferred to the tax credit.

From an economist’s viewpoint, efficiency is a more powerful argument than equity. Which tool has a bigger bang for the buck in terms of the effects on economic growth? It is in trying to answer this question that tax credit fans confuse identifiable actions with the engines of economic growth.

Sure a big plant is easy to see and it is easy to count the number of jobs and the tax collected from the workers at the plant. Looked at that way, one might conclude that the economic development tax credit “causes” that plant and improves the larger state economy.

Economic growth is more subtle than the big plant. Everyday, people solve problems that lower the costs of doing business. It is difficult to point to anyone and say that person has the same effect as the big plant. Size notwithstanding, however, the accumulated effects of these little changes show up in productivity growth. This growth in productivity is much more meaningful for a state economy than a big plant. Some of this has to do with simple compounding: even small differences in the growth rate translate into big differences in living standards after a generation or so. But some also has to do with the tax credits actually finding their way to the absolute “best” candidates.

One little mistake of picking the second best instead of the best plant can also affect the state economy for years to come. With a universe of potential candidates, it is hard to imagine that the state would ever find the best without real competition among the candidates.

Here is where tax rates matter again. Higher tax rates reduce the incentive to perform all these little actions that translate into faster productivity growth. If I have the choice of being more productive in a state with a lower tax rate, holding everything else constant, where I can keep more of the gains I created, I will move to the state with the lower tax rate. I am not suggesting there is a giant sucking sound out of Missouri. I am saying that these decisions go on everyday and the evidence suggests that states with lower tax rates grow faster, on average, than states with higher tax rates.

Overall, economic growth is fascinating to study. It is not easy. However, one policy decision is easy after you accept the economic facts; if you want to lower people’s tax bills, the tax rate is a more equitable and more powerful tool to stimulate a state’s economic growth than tax credits. Admittedly, the tax credit is easier to show, but I hope our legislators are not in this for the show.

Can Missouri unilaterally disarm in the tax-credit competition? Once one understands a little about economic growth, it most certainly should unilaterally disarm for the welfare of its citizens.

About the author

Joseph Haslag is a professor in the Economics Department at the University of Missouri-Columbia.

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