Sunday, December 18, 2011

Phased-in state tax cuts would boost capital

Published in The Tennessean, Sunday, December 18, 2011

by Richard J. Grant

Economists call it the “shortsightedness effect.” Government decisions tend to be biased against actions with easily recognized current costs and less-obvious future benefits. Politicians prefer it to be the other way around. They prefer the benefits to show up before the next election — the costs later.

It also applies to tax policy and the timing of tax revenue. Such is the dilemma faced by the governor of Tennessee. Gov. Bill Haslam is worried about a legislative proposal to eliminate Tennessee’s estate tax and its Hall Income Tax on dividends and interest. The governor knows that both of these taxes hurt the state’s economic development. As he put it, they “chase capital away from the state.”

Enough capital is chased away by these taxes to have reduced Tennesseans’ income growth measurably. Recent research by economists Arthur Laf-fer and Wayne Winegarden compared Tennessee to other states with similar policy characteristics. In general, they found that states with the lowest personal and corporate income tax rates had the highest rates of employment and economic growth over the past decade. This high-growth effect was especially pronounced for right-to-work states.

But Tennessee tended to lag in economic performance when compared to other states in each of these categories. Laffer and Winegarden identified Tennessee’s estate tax and the tax on investment income as the main culprits.

So why is Haslam worried? The issue is timing. The governor knows that states without personal income taxes have more stable tax revenues. Also, the elimination of estate, gift and Hall taxes would result in higher economic growth and higher total revenues from sales taxes. These tax cuts would pay for themselves, but not instantly.

State tax revenues fell significantly during the recent economic downturn, and the recovery has been slower than expected. Although the estate and Hall income taxes combined contribute only 2.8 percent of the state’s total revenue, Tennessee has depended on federal transfers to maintain budget balance. When every dollar counts, the governor is right to worry about short-term revenue needs. He also needs to worry about excessive government spending.

Here’s the trade-off. The trouble with waiting for better times is that it delays the income growth that would result from the tax cuts. It also delays the growth in sales tax revenues that would more than make up for the tiny estate and Hall tax revenues. The sooner the cuts are legislated and brought into effect, the higher will be Tennesseans’ lifetime earnings and their spending power.

Proactive legislators should be able to construct a bill that incrementally reduces the tax rates and raises the exemptions. The phase-out of the taxes can be timed according to estimates of net revenue needs. The important thing is to get the legislation enacted so that everyone can make firmer plans and markets can adjust to the state’s improved investment environment.

For many reasons, Tennessee is a fine place to live. But for those who do well in business, and for those who build their investments, incentives change as they grow older. States with lower tax rates on dividends and interest attract more investors. States with neither gift nor estate taxes are more family-friendly. Fewer family farms and businesses are sold to pay taxes.

Shortsightedness is expensive. The legislature can give the governor the tax cuts he needs when he needs them, which is now.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.


Twitter: @RichardJGrant1

Copyright © Richard J Grant 2011