Friday, December 24, 2010

What the Census Says About Taxes

You can almost see the conservative smirk on Michael Barone's face as he contemplates the fact, revealed by the latest census,  that people are voting with their feet for state governments with low taxes. 
“[Population] growth tends to be stronger where taxes are lower. Seven of the nine states that do not levy an income tax grew faster than the national average. The other two, South Dakota and New Hampshire, had the fastest growth in their regions, the Midwest and New England.

“Altogether, 35 percent of the nation’s total population growth occurred in these nine non-[income] taxing states, which accounted for just 19 percent of total population at the beginning of the decade.”
The eroding tax base and threatened insolvency of high-tax states, of course, is the other side of the same coin.  That sounds to conservatives like a pretty good reason why every state should lower its tax rates to the level of the states that are gaining population.  As far as I can see, the best counter-argument goes something like this:

Liberals and conservatives disagree about what, relative to a given tax base, the optimal tax rate for state governments is.  But for the purposes of this argument just pick your favorite rate and we'll call it the “presumptively optimal rate.” Now imagine that every state government currently adheres to the presumptively optimal rate and that you’re the governor of state X, asking yourself whether you should sign a bill cutting taxes.  Since you’re already taxing people at the presumptively optimal rate, all other things being equal, lowering tax rates will make your state worse off by definition.

You know, however, that other things aren’t likely to remain equal for very long. Other states will either keep their tax rates at or above the presumptively optimal level or they won’t. If they do, and you cut your state’s rates, capital and labor will flow to your state, expanding your tax base enough to make up for the fact that, by your own lights, you’re under-taxing it. If other states lower their rates below the presumptively optimal level and your state doesn’t, however, they’ll steal capital and labor from you, shrinking your tax base.

That means that, wherever you peg it, the presumptively optimal tax rate isn't likely to stay optimal for very long since it’s rational for every state to undercut it. Yet when all states do the rational thing, every state ends up being worse off by definition than it was when they all taxed at the presumptively optimal rate. That’s how we all end up in states with crumbling infra-structure and unfunded pension liabilities despite our best intentions. Seen in this light, the latest census is just a snap shot showing where things happen to stand at the moment in a mutually debilitating race among states to the bottom.

In our constitutional system the prescribed avenue of escape is the federal regulation of interstate commerce. The federal government can use its taxing power to subsidize state and local governments who tax their inhabitants at or near the presumptively optimal rate by, for example, allowing people to deduct the payment of state and local taxes on their federal tax returns. In extreme circumstances, the federal government could promote the fiscal solvency of those states (as it promotes the solvency of too-big-to-fail banks) by helping them access capital markets by making it known that it will bail them out if they become insolvent.

That sort of solution can work, but only as long as capital and labor doesn’t flow readily across international borders. In a global economy in which international borders present ever-less-formidable barriers to the flow of capital and labor, the same dynamic affecting tax policy among the states will assert itself among nation-states, depriving the federal government of the resources to solve the problem generated at the level of state governments. This is just one more respect in which the world is getting more hostile to conventional liberalism all the time.

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