Do High Local Taxes Really Hurt Economic Growth?

Federal taxes get most of the headlines. But there are plenty of debates on the local level as well.

Many states and cities are facing huge deficits, leading policymakers scrambling to find new sources of revenue. In March, Illinois Governor J.B. Pritzker announced a plan to introduce a progressive income tax that would increase rates on the state’s wealthiest 3 percent, which he claims would generate $3.4 billion in new annual revenue. And intense media coverage of Amazon’s HQ2 fiasco has raised questions about whether corporations are paying their fair share.

Those who oppose increasing taxes (or eliminating tax breaks) say they’re bad for business—that raising rates will scare off investors, entrepreneurs, and corporations. But according to Therese McGuire, a professor of strategy at the Kellogg School and a tax policy expert with experience working for state governments, this is a false narrative.

“The evidence doesn’t support it,” she says. “I wouldn’t feel confident telling a policymaker that the best way to boost your economy is to lower your taxes—in fact, I think it would be malpractice to make that kind of pronouncement.”

For McGuire, the best tax policies for state and local governments seeking to grow their economies are those that (1) offer long-term certainty to businesses and individuals, (2) are coupled with wise public investment, and (3) are designed with the principles of efficiency, simplicity, and equity in mind. Such policies—based on economics principles, not political whim—also have the best chance of promoting fairness across the board.

“The most important thing policymakers can do is create a tax strategy that offers fiscal certainty,” she says. “Businesses have a longer time horizon than politicians—they need to know what the tax rate will be five years from now, and they need confidence that the system will fund the infrastructure and services cities and states require. Because otherwise, their cost of doing business goes up, and their odds of long-term success go down.”

The Myth that Taxes Stifle Economic Growth

For decades, studies have taken up the question of whether taxes are a significant factor in the growth of state and local economies. The answer has varied over time—in part because economists built more sophisticated tools, and in part because the U.S. evolved from a manufacturing economy into a service-based economy.

“Sixty years ago, you could put your widget factory anywhere, so taxes were a more significant factor in business-location decisions. But in a service-based economy, companies need to be near customers and close to a wide pool of labor. And there’s now strong agreement in the field that state and local taxes are not typically an important factor in business decisions.”

Indeed, many studies have shown that higher income tax rates—especially in the highest income brackets—do not stifle local economies.

For example, in 2006, McGuire examined the effects of the Taxpayer Bill of Rights, a 1992 amendment to the Colorado state constitution that set a cap on spending growth and forbid lawmakers from raising income taxes without voters’ permission. The idea was that fiscal discipline would boost the state’s economy. But McGuire and coauthor Kim Rueben found that TABOR failed in this regard. In fact, over time, limiting taxes and spending may have actually slowed employment growth in Colorado, perhaps because lower taxes led to lower spending on the goods and services valued by people and businesses.

“You can cherry-pick studies to show that raising taxes on high earners has a detrimental effect,” she says. “But the preponderance of studies—and the best ones—find that this will not harm local economies.”

A recent study by Princeton economist Owen Zidar, for instance, distinguished between cutting taxes on higher earners and lower ones. The study found that tax cuts for the lower 90 percent of income earners proved a boon to job creation, whereas tax cuts for the top 10 percent had little to no effect.

Of course, it is possible for progressive tax policies to be taken to a harmful extreme.

When McGuire worked for the Minnesota Tax Study Commission in the 1980s, the state’s individual income tax system had the top marginal rate in the country. The government asked McGuire and her colleagues to study whether it may have been pushing companies to move south, where the tax rate was lower.

“It was plausible they had gone too far. We didn’t find a lot of empirical evidence for that, but the study did find that relatively high individual income tax burdens were associated with relatively slower growth rates in those states,” she says.

In other words, there’s reason to be cautious. In the case of Illinois, for example, it wouldn’t be difficult for companies to relocate to Indiana, where they would be in the same labor pool.

But those who argue for business-friendly tax cuts usually leave out a crucial part of the fiscal equation: cutting taxes means less revenue to spend on public investment. There is plenty of evidence that investment drives growth in local economies, especially when directed toward infrastructure and education. In fact, according to an Economic Policy Institute report, investments in public capital contribute significantly to private-sector productivity, with estimated rates of return averaging around 30 percent.

“Every company wants educated workers, a well-functioning transportation system, dependable utilities, and so on. Cities and states that invest in themselves are attractive places to do business,” says McGuire.

For a state like Illinois, ballooning deficits and liabilities—which significantly hamper future investments in infrastructure and education—are a greater concern than a handful of potential corporate defections to Indiana.

“If what Illinois plans to do with its expected increase in tax revenue is buy down our unfunded liabilities to the pension system, I think that could be the greatest boost to economic growth in the state.”

Corporate Tax Breaks: A “Race to the Bottom”

Too often, local and state governments think they can boost their economies by offering companies generous tax incentives to move to (or stay in) their area. According to McGuire, this isn’t sound policy.

“It’s essentially a race to the bottom,” she says. “Governors and mayors always feel like they have to play the game, whether or not it makes sense for economic development. It’s like the prisoner’s dilemma.”

Take the recent drama over Amazon’s new headquarters. City after city promised enormous tax relief, only to watch the tech giant choose New York and Washington, D.C., the two most developed metropolitan areas in the running. Clearly, the company had considered other factors beyond taxes. (Somewhat ironically, criticism over generous tax breaks ultimately led Amazon to drop its plans to expand into New York City.)

These dynamics aren’t new. When McGuire was policy advisor to the Minnesota government in the 1980s, the freight railroad network Burlington Northern complained that taxes were too high and moved its global headquarters out of state. The state set up a tax study commission to evaluate whether its tax system was at risk of driving other firms to leave the state. As part of that commission, McGuire spoke to a number of executives, including at 3M.

“When 3M executives saw states throwing out incentives, they thought, ‘that’s a sign of desperation.’ In reality, what they wanted was a rational tax system designed to raise enough revenue to do the work of government while treating all players fairly, including other companies,” she says. “What’s fair about giving tax breaks to some companies and not others? Governments have never been good at picking winners—that’s the market’s job. Just create a rational, fair system that gives companies confidence and let the thing run.”

In McGuire’s view, expecting governments to design sound policies is more effective than demonizing companies for seeking tax breaks.

“Firms are just trying to do right by their shareholders,” she says. “It’s policymakers who need to figure out how to get this right.”

Don’t Forget Other Sources of Revenue

McGuire also suggests that state and local governments take a closer look at their sales and the property taxes.

The sales tax was created more than a century ago when most purchases were tangible goods—not services, as is the case today—and has become an “antiquated” tax, McGuire says. Most experts agree that it’s not serving state and local governments well.

“Most consumer purchases today are services, which in many states are not adequately captured by the sales tax, and that’s a big problem when it comes to raising revenue.”

Services are disproportionately purchased by wealthier people, so including them in the sales tax is a simple way to make the overall system more progressive. But even apart from fairness, services are a growth sector, which means the potential tax base is broadening. And a basic premise of tax policy is that the most efficient tax is one with a broad base and a low rate.

“Sometimes the most efficient tax is not the most popular,” McGuire says, “but that doesn’t make it less efficient.”

This is especially true when it comes to the property tax.

One of the reasons the property tax is constantly under siege is that it’s by far the most salient—homeowners pay a large chunk of money all at once, whereas income tax is siphoned off discretely from the average paycheck, and sales tax is forked over in (mostly) small increments. As a result, most voters view the property tax as uniquely loathsome.

Moreover, the tax relies on property assessments, which can be imperfect or subject to manipulation. “It’s very hard to measure properly the market value of properties because they don’t change hands very often,” says McGuire. “And there aren’t always perfect comparables.” This can lead to charges that the tax is unfair.

Because of its unpopularity, state policymakers often put constraints on the tax rate, how fast it can grow, or what types of property can be taxed, which can cripple local governments’ ability to use it to its greatest effect.

But in McGuire’s view, the property tax—when properly implemented—has a lot going for it.

“Economists love this tax,” she says. That’s because it is efficient, insofar as it empowers local governments to make responsible decisions about which services are worth paying for. “If instead we just funded everything the local government does through grants from the state government, then I’m not accountable as a district or as a city,” says McGuire.

It’s also equitable, in that people with less ability to pay are generally paying less. (McGuire doesn’t buy the popular argument that the burden isn’t also shared by renters: “When the jurisdiction raises property taxes on that rental building, part or all of that property tax increase will generally be passed on in the form of higher rents,” she says.)

As an added bonus, it is stable. “For governments who have to balance their budget every year, having wildly swinging revenues is a problem. Property tax is a very stable source of revenue,” she says.

And stability—in revenues, rates, and rules—is a pillar of smart tax policy.