Economics Update (January-March 1997)

State and Local Tax
Policies Spur Growth

W hy do certain regions of a single country grow faster or slower than other areas? Can certain public policies like lower taxes promote faster growth than would occur otherwise? Traditional economic theory suggests that automatic forces of convergence—and not tax policies—have propelled certain states like those of the Southeast toward catching up with the rest of the nation. But more recent economic models recognize that convergence and low tax rates may not be mutually exclusive explanations for stronger growth in some states.

In an article in the Atlanta Fed's Economic Review, economist Zsolt Becsi presents an overview of relative state growth, and relative state and local taxation from 1960 to 1992. After discussing the theoretical issues, Becsi surveys simple—but revealing—correlations across states and across time; these correlations characterize states' experiences. The correlations indicate convergence; but these correlations also imply that shocks, including tax policy, are significant for long-term growth.

Becsi argues that the evidence on the growth effects of taxes has been mixed because empirical models imperfectly separate the growth effects of other government policies that occur simultaneously with tax policies. He demonstrates a simple way to achieve a more accurate specification. His analysis shows that state and local taxes appear to have temporary growth effects that are stronger over shorter intervals and that those taxes also have a long-term growth effect.

In terms of policy implications, if long-term growth rates seem too low (relative to other states), then lowering aggregate state and local marginal tax rates is likely to boost long-term growth rates. However, such a policy also reduces the progressiveness of the tax system and possibly the revenue it produces. No matter what emphasis is placed on growth, Becsi cautions, states should be aware of the potential trade-off.

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