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Do State and Local Fiscal Choices Matter?

Stephen Lile is a professor of economics at Western Kentucky University and a past president of the Kentucky Economic Association.

States differ dramatically in overall levels of taxation and spending, and in the relative use of income, sales, property, and other tax types. They also differ in population and economic growth rates. Whether or not fiscal choices affect economic outcomes is of interest, particularly during a period of slow economic growth such as the present.

Milton Friedman (Newsweek, July 12, 1976, p. 58) commented on a study[1] of fiscal differences between Vermont and New Hampshire and observed that “Vermont spends more; Vermont relies more on the state relative to the local community, and Vermont has little to show in return.” This note extends Friedman’s fiscal comparisons to three pairs of neighboring states—Kentucky-Tennessee, New Hampshire-Vermont, and Oregon-Washington—in an effort to see if there is any systematic relationship between fiscal choices, in particular taxation and economic vitality as measured by income per capita and net migration.

The chart on the following page shows the latest data available on expenditures, taxation, net migration, per capita income, and growth in per capita income for three pairs of adjacent states. States with low taxes are shown to outperform their high-tax neighbors in terms of income and immigration. Tennessee, for example, collects about 13 percent less than Kentucky in state-local taxes relative to state personal income ($94 vs. $108). Tennessee’s 1990 per capita income is about 6 percent higher. Moreover, because Tennessee and Kentucky had the same per capita income in 1960, Tennessee income growth over the past 30 years is also about 6 percent greater than Kentucky’s.

An obvious indicator of a state’s economic vitality is whether people are on net moving into or leaving that state. In each of these pairs of states, the low-tax state attracted more people as compared to its high-tax neighbor. Kentucky actually lost 110,000 people during the 1980s, while Tennessee gained 124,000.

Does the correlation between taxation and income/migration demonstrate that low taxes cause growth? No, but taxes influence location decisions of people and businesses and business decisions to expand, if non-tax factors are roughly equal. Non-tax factors are most likely to be similar in the case of neighboring states.

An example based on family tax burdens[2] illustrates why tax burdens can affect growth. The 1990 tax burden on a Memphis family ($2,591) with $45,000 adjusted gross income is about $1,800 less than the tax burden on a family with the same income living and working in Louisville ($4,407). This implies that, other things the same, the Tennessee employer has a clear advantage over the Kentucky employer because he can pay labor less and still be competitive on an after-tax basis. The migration data for Kentucky (-110,000) and Tennessee (+124,000) suggest that a portion of the benefit from Tennessee’s lower tax burden accrued to labor in the form of greater employment opportunities and/or greater after-tax earnings. The differences in family tax burden between Portland ($5,465) and Seattle ($1,996) and between Burlington ($2,885) and Manchester ($2,121) suggest that a similar argument could be used to explain in part why immigration and income growth in Washington and New Hampshire exceed that in Oregon and Vermont, respectively.

No doubt many variables (some historical) account for why one state enjoys greater prosperity relative to another. The influence of fiscal choices, and taxation choices in particular, is likely to be greatest in the case of neighboring states because other factors such as climate and location are similar. Policy-makers in high tax states, who might be inclined to dismiss supply-side arguments as they apply to the national economy, might wish to reconsider the role that fiscal choices play at the state-local level where the opportunity for business and families to “vote with their feet” is greater. Both theory and experience seem to suggest that a state’s fiscal choices do matter.

  1. Colin D. Campbell and Rosemary G. Campbell, A Comparative Study of the Fiscal Systems of New Hampshire and Vermont, 1940-1974, The Wheelabrator Foundation, Inc., 1976.
  2. Stephen E. Lile and Joel E. Philhours, Interstate Comparisons of Family Tax Burdens for 1990, Institute for Economic Development and Public Service, Western Kentucky University, 1991.

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