Regional Update (July-September 1996)

Index The state of the states Southeastern manufacturing survey Views from the region Southeastern economic indicators

Cover Story - Full Speed Ahead for the Southeast's Maritime Industry

Have Taxes Contributed to the South's Economic Rise?

The Southeast's Economy Claims Its Olympic Prize

The Growing Symbiosis in Southeastern Business

Have state and local taxes
contributed to the South's economic rise?

The South has seen remarkable growth during the past three decades. Was this growth simply a result of catching up with the rest of the nation? Were state and local tax policies a prime ingredient of this economic rise? Traditional economic theory suggests that state and local taxes do not affect state growth rates. But the available data and recently developed economic models suggest otherwise, says Zsolt Becsi, regional economist at the Atlanta Fed.

Table 1 - Relative Incomes and Growth Rates by State T he South has experienced a remarkable economic rise over the past thirty years. Coincidentally, southern states have also had, on average, low state and local taxes. While policymakers often believe that taxes matter for growth, until recently economic theory suggested that the forces of convergence had moved the southern states toward catching up with the nation. However, it is increasingly being recognized that convergence and low tax rates may not be mutually exclusive. So have state and local tax policies actually contributed to the South's economic rise?

Economic growth models have often assumed that long-term growth is determined by demographic and technological factors, but not subject to policy influence (exogenous). In this scenario, taxes can have only short-term effects on growth rates. Given the same resources, these exogenous models imply that all states should converge over time to a common long-term, steady growth rate. More recent endogenous economic growth models suggest otherwise, allowing growth rates to register shocks (including tax policy) as influencing demographic and technological variables.

Convergence or divergence among states?

What can be inferred from the data about states' growth experiences? The columns of the table compare relative per capita personal income in 1960, 1976, and 1992 and states' rankings in these years. Comparing relative per capita personal income in 1960 with 1992 figures, states' rankings tended to be stagnant, suggesting a lack of mobility. However, for some states dramatic changes did occur. For instance, in 1960 the poorest ten states were southern states, with average per capita personal income 34 percent below the national average. By 1992, however, only seven of the lowest-ranking ten states came from the South, and the region as a whole stood just 17 percent below the nation.

Now consider long-term average growth rates of per capita personal income relative to national growth. For example, from 1961 to 1992 Alabama grew on average 0.57 percentage points faster than the national average annual growth rate of 6.84 percent—the ninth-fastest growing state. Indeed, most of the South grew faster than the nation. Some of this rapid growth can be explained as catch up given southern states' lower-than-average per capita personal incomes: in 1960 Alabama's per capita personal income was almost 38 percent below the national average, a rank of 47th. By 1992, this rank improved to 40th and per capita personal income improved to slightly less than 20 percent below that of the nation. Even though Mississippi ranked last in 1960 and 1992, it grew at the fastest rate, 0.76 percentage points above the national average.

Simple correlations involving growth rates and state incomes suggest convergence among the southern states. But weak continuity in growth rates is evidence that shocks may have mattered, too. For example, from 1961 to 1976 convergence in the South was faster than in the nation as a whole. However, from 1977 to 1992, the relationship between initial per capita personal income and growth was positive, signaling divergence within the South.

The taxation effect

So how do state and local taxes affect growth? When talking about the distortionary effects of taxes, economists are really talking about marginal tax rates, essentially a tax bracket. However, average tax rates (ATRs) can give a feel for the tax climate of a state. Average tax rates are defined as the ratio of total state and local tax receipts to state personal income.

With the principal exception of Louisiana, southern states tend to have much lower ATRs than the nation. In fact, out of the lowest ten over the sample period (1961-92) five—Alabama, Tennessee, Florida, Virginia, and Arkansas—were southern states. Also, the (unweighted) ATR of the South was 9.34 percent below that of the nation.

Table 2 - Relative Average Tax Rates and State Growth Rates, 1961-92 State growth is affected by local taxes

So state and local taxes do affect relative state growth. The data covering relative state growth and relative state and local taxation from 1960 to 1992 indicate that shocks (including taxes) matter for long-term growth (see chart). Tax rates (both average and marginal) are negatively related to growth and are sufficiently variable over time to explain fluctuations in growth rates.

It also appears that state and local taxes have temporary growth effects that are stronger over shorter intervals and a permanent growth effect that does not disappear. In terms of policy implications, if long-term growth rates seem too low relative to other states, lowering state and local tax rates is likely to have a positive effect on long-term growth rates. This likelihood is greater if the reduction in rates is sustained. However, such a policy may also reduce the progressivity of the tax system. No matter what emphasis is placed on growth, states should be aware of the potential trade-off.

The full research article upon which this summary is based was published in the March/April 1996 issue of the Atlanta Fed's Economic Review.