Do State and Local Taxes Affect Relative State Growth?

Zsolt Becsi
Economic Review, Vol. 81, No. 2, 1996

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The South has seen a remarkable economic rise during the past three decades. Was this growth a result of automatic forces or was it fueled by state and local tax policies? Traditional economic theory suggests that forces of convergence, not tax policies, have moved the southern states 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 the South's stronger growth.

This article presents an overview of relative state growth and relative state and local taxation from 1960 to 1992. After a brief discussion of the theoretical issues, the article surveys simple—but revealing—correlations across states and across time that characterize states' experiences. The correlations indicate convergence but also imply that shocks, including tax policy, matter for long-term growth.

The author 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 get a more nearly accurate specification. His analysis shows that state and local taxes appear to 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 aggregate state and local marginal tax rates is likely to have a positive effect on long-term growth rates. However, such a policy also reduces the progressivity of the tax system. No matter what emphasis is placed on growth, states should be aware of the potential trade-off.

March/April 1996