Chapter 6
The Competitive Economic Environment: Lessons From the States
Abstract
If one thinks of the United States as one large economy in the global economy, the parallels also apply. Increases in the tax rates will elicit a capital outflow and an outmigration. The mobile factors will move to arbitrage the differences in tax rates. Worse yet, given the progressivity of the tax code, the people who will leave the state will be the very successful with very high income. Add to this an expansion of the social safety net and other programs, and as it was with the states’ data, the social programs will be a magnet for lower income people who qualify for these programs. The overall migration away from the high tax states to the other states documented by the data is in line with the competitive environment framework that we have outlined. More importantly, if the high tax rates are the result of profligate spending, whether in large benefits to public employees or expansive social programs, these policies may attract lower income taxpayers who could take advantage of these mean-tested programs. The result may be an outflow of taxpayers with a high taxable income combined with an inflow of taxpayers of lower taxable income. Some may call that a tax-driven “brain drain.” The policy and investment implications are clear. Tax rates changes, the social safety net, and other programs will alter the attractiveness of an economy. The analysis shows that different policies attract different factors. Politicians should be careful to design policies that attract the factors of production that the electorate desires and the economy needs. Keeping a tab on the policies relative to the actions of the neighboring states or for that matter of other countries in the world, one may be able to identify trends that benefit the local factors or for that matter the foreign factors. Either way one has a profitable investment insight.
Keywords
brain drain
business location
migration
Right to Work
state competitive environment
tax competition
free trade and mobility
Much has been written about the impact of tax rates on the aggregate economy, as well as the states’ relative performance. While political campaigns in the United States are focused on federal tax policy and whether the top personal income tax rate should be increased or not, we believe that the states’ experiences have much to teach us about what happens when tax rates are changed. The parallel between the United States and the world economy is an obvious one. The United States consists of 50 separate state economies and factors of production, and as a result of the interstate commerce clause, the states enjoy free trade of goods and services and the factors of production enjoy freedom of movement. Thus, businesses and people can relocate anywhere within and across the states. The choice of location may be based on a multitude of factors, such as climate or other endowments. We contend that a state’s fiscal policies can also alter these conditions and make relocation to their jurisdiction more or less attractive. Hence, the state and local fiscal policies can become a key driver of the economic well-being of a state, a significant driver of the state revenue coffers, as well as an important determinant of the internal migration patterns within the United States.
At the national level, the political debate regarding the impact of increases in tax rates is focused on the aggregate labor supply elasticities. We contend that the relevant elasticities are larger than the ones cited in the academic literature. One of the reasons for this conclusion is the fact that most people acknowledge and are aware that earners can move taxable income between different years, as well as change the timing of charitable contributions and capital gains realization. In addition, some taxpayers are able to convert earned income into capital gains, that is, the carried interest in private equity.
Interestingly, these measures, without affecting the aggregate labor supply, either reduce the tax base or the marginal tax rate to which income is subjected. Another effect is simply relocation or moving away from the tax jurisdiction. Outsourcing and outright migration are just two examples of how the tax base of a particular tax jurisdiction can change, even though the supply per worker remains the same. Migration and outsourcing reduces the number of workers and factories and thus the tax base of the tax jurisdiction where companies were previously located, while it increases the tax base of the jurisdiction where they relocate.
Higher tax rates collect more per dollar taxed. However, the base reduction due to avoidance, migration, or simply lower aggregate supply per unit worker means that there will be fewer dollars to be taxed. So whether tax revenues increase or decrease depends on whether the reduction in the tax base is large enough to offset the tax rate increase.
The anecdotal evidence suggests that the sensitivity of the states’ revenue collection to tax rate changes is much greater than the proponents of tax rate increases claim or believe. In Oklahoma, Republican Governor Frank Keating and then-Democrat Brad Henry cut the income tax rates to 5.25% from 7%, and revenues kept rising. Maryland’s Governor Martin O’Malley raised taxes in 2007, saying that he could balance the budget by taxing high-income people. His strategy did not work very well. The number of millionaires in the state fell sharply. Some of this was due to the recession, but some of it was also due to migration out of the state. Then, to close the budget gap, the governor proposed more taxes, this time on the middle class.
In general, states with some of the highest income tax rates—Maryland and Illinois—have had the toughest time staying out of the red. In contrast, states with no personal income tax—New Hampshire, Tennessee, and Florida—manage to balance their budgets.
The States’ Competitive Environment
The relative performance and the changing fortunes of the high-tax and low-tax states does not bode well for the supporters of tax increases. The issue is how significant the impact of tax rate changes is on the tax base (labor supply per worker), tax minimization and avoidance (by altering the timing of income realization), conversion (from one form of income into another), and relocation of factors (out of the tax jurisdiction) or businesses to lower tax states (domestic corporate inversions). The sensitivity of the tax base to tax rate changes may be greater than estimates made by simply using the labor supply elasticities or some other narrowly defined measure. Those estimates are ignoring the outsourcing and evasion effects on the tax base.
Time and distance also enter into the relocation decision. Take the case of a potential migrant. The larger the migration gains, the more likely the factors of production will migrate. The longer the factors’ horizon, the easier it will be to amortize the cost of migration. This argument suggests that the supply elasticities increase with time. The further the factors have to move, all else the same, the higher the transportation costs, the less likely a factor is to move to that location. The insight here is that while most people consider neighboring states to be their direct competitors, the fact remains that all other locations across the world are alternatives that any mobile factor may or should consider when contemplating a move out of state. It is a mistake to focus on the local economy as if it were a closed economy. Hence we need to develop a framework that considers all these possibilities where all localities are in competition.
One important implication of this is that the immobile factor bears the full burden of economic policy, both the good and the bad. When good things happen in a state and transportation costs are reduced, the after-tax returns of land, the fixed or immobile factor increase disproportionately. Similarly, when the transportation costs increase, land will also bear a disproportionate impact.
The States’ Income Tax Rates as a Proxy for Their Competitive Environment
We argue that trade and factor mobility result in the equalization of the gross of tax factor returns across state boundaries. Hence a tax increase in one state results in a lower after-tax rate of return in that state. However, that alone is not enough to determine whether the factor will move across state borders. Our framework suggests a simple answer: as the gross of tax returns are the same, all one needs to know is the differences in tax rates between the state in question and the rest of the world. Therefore, by understanding and anticipating changes of the transportation costs, that is, the differences in tax rates across state boundaries, one may be able to anticipate the changes in the differences in expected returns and correlation between the rates of return of the immobile factors across the different state borders. It is these differences in correlation and expected returns that give rise to the states’ relative economic performance.
Using the top personal income tax rates for each of the states in 2017 and 2008, we separated the states into one of four groups: no state income tax rates, high state income tax rates, rising state income tax rates, and other or “average” tax rates. Using the data for each of the states reported in Table 6.1, we grouped the net migration information into one of the several groups.
Table 6.1
| State | 2017 | 2008 | |
|---|---|---|---|
| Top income tax rates | Top income tax rates | Right to Work | |
| Alabama | 5.00% | 5.00% | 1953 |
| Alaska | 0.00% | 0.00% | |
| Arizona | 4.54% | 4.54% | 1946 |
| Arkansas | 6.90% | 7.00% | 1944 |
| California | 13.30% | 10.30% | |
| Colorado | 4.63% of federal | 4.63% of federal | |
| Connecticut | 6.99% | 5.00% | |
| Delaware | 6.60% | 5.95% | |
| District of Columbia | 8.95% | 8.50% | |
| Florida | 0 | 0 | 1944 |
| Georgia | 6.00% | 6.00% | 1947 |
| Hawaii | 8.25% | 8.25% | |
| Idaho | 7.40% | 7.80% | 1985 |
| Illinois | 3.75% of federal | 3% of federal | |
| Indiana | 3.23% of federal | 3.4% of federal | 2012 |
| Iowa | 8.98% | 8.98% | 1947 |
| Kansas | 4.60% | 6.45% | 1958 |
| Kentucky | 6.00% | 6.00% | 2017 |
| Louisiana | 6.00% | 6.00% | 1976 |
| Maine | 10.15% | 8.50% | |
| Maryland | 5.75% | 5.75% | |
| Massachusetts | 5.60% | 12.00% | |
| Michigan | 4.25% of federal AGI | 4.35% of federal AGI | 2013 |
| Minnesota | 9.85% | 7.85% | |
| Missouri | 6.00% | 6.00% | |
| Mississippi | 5.00% | 5.00% | 1954 |
| Montana | 6.90% | 6.90% | |
| Nebraska | 6.84% | 6.84% | 1946 |
| Nevada | 0 | 0 | 1952 |
| New Hampshire | 5.00% | 5.00% | |
| New Jersey | 8.97% | 8.97% | |
| New Mexico | 4.90% | 5.30% | |
| New York | 8.82% | 6.85% | |
| North Carolina | 5.499% | 8.000% | 1947 |
| North Dakota | 2.90% | 5.54% | 1948 |
| Ohio | 4.997% | 6.555% | |
| Oklahoma | 5.00% | 5.65% | 2001 |
| Oregon | 9.90% | 9.00% | |
| Pennsylvania | 3.07% | 3.07% | |
| Rhode Island | 5.99% | 9.90% | |
| South Carolina | 7.00% | 7.00% | 1954 |
| South Dakota | 0.00% | 0.00% | |
| Tennessee | 5.00% | 6.00% | 1947 |
| Texas | 0.00% | 0.00% | |
| Utah | 5.00% | 5.00% | 1955 |
| Vermont | 8.95% | 9.50% | 1947 |
| Virginia | 5.75% | 5.75% | |
| Washington | 0.00% | 0.00% | |
| West Virginia | 6.50% | 6.50% | 2016 |
| Wisconsin | 7.65% | 6.75% | 2015 |
| Wyoming | 0.00% | 0.00% | 1963 |
Source: Tax Foundation and the National Right-to-Work Committee.
The listing for each of the tax groups is as follows:
- • States with no state income tax rates: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
- • States with high state personal income tax rates: California and Connecticut, the District of Columbia, Hawaii, Illinois, Idaho, Iowa, Maine, Minnesota, New Jersey, New York, Oregon, South Carolina, and Vermont.
- • States with the low personal income tax rates: Alabama, Arizona, Mississippi, New Hampshire, New Mexico, North Dakota, Oklahoma, Pennsylvania, Tennessee, and Utah.
- • States with increase in the top tax rates: California, Connecticut, Delaware, District of Columbia, Illinois, Maine, Minnesota, New York, Oregon, and Wisconsin.
- • States with a decrease in the top personal income tax rates: Idaho, Kansas, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, Rhode Island, Tennessee, and Vermont.
- • The other or “average” states: Arkansas, Colorado, Georgia, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Missouri, Montana, Nebraska, North Carolina, Ohio, Oklahoma, Rhode Island, Virginia, and West Virginia.
There are a couple of points that need to be made regarding our classification. First, notice the overlap between the high tax rate states and the states with rising rates during the period. Second, the grouping is based on events from 2008 through 2017. Thus, it includes the aftermath of the financial crisis.
The Evidence: The Changing Competitive Environment
Fortunately, there is a way that allows us to test the basic hypothesis that tax rates do matter and that migration is one way to arbitrage the differences in the after-tax rates of return. The Internal Revenue Service (IRS) publishes information on annual state-to-state migration. Although the data is readily available, it is presented in a cumbersome way and it requires a bit of work to manipulate the information. Then there is the issue that the migration is based on returns filed and, as such, it may not capture some of the migration at the lower end of the income scale or people who do not file a return. Using the IRS data, we have summarized the migration inflows, outflows, and nonmigration statistics of the states grouped by the previously mentioned tax level classification. As we are looking at the total inflow and outflow by state, the grouping will include some double counting. That is there may be some migration from one state to another in the same grouping and while technically we should remove it, which is not possible, using the broad data used to construct Table 6.2.
Table 6.2
| States income tax rates classification | Nonmigrants | Inflows | Outflows | Net Inflows | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | |
| High tax rates states | 265,047,198 | 575,732,909 | 69,016.09 | 5,883,209 | 10,335,157 | 54,279.59 | 6,583,482 | 11,881,296 | 59,266.39 | −700,273 | −1,546,139 | −4986.80 |
| Middle tax rates states | 266,478,783 | 575,681,282 | 60,301.08 | 7,356,005 | 13,917,055 | 47,936.07 | 7,695,438 | 14,464,480 | 49,849.83 | −339,433 | −547,425 | −1,913.76 |
| Low tax rates states | 107,793,819 | 236,636,834 | 57,032.06 | 3,010,989 | 5,852,434 | 47,849.31 | 3,170,276 | 6,109,980 | 46,197.62 | −159,287 | −257,546 | 1651.69 |
| No income tax states | 129,052,291 | 280,378,754 | 60,006.63 | 4,306,928 | 8,220,598 | 57,562.94 | 3,879,809 | 7,294,044 | 46,899.77 | 427,119 | 926,554 | 10,663.17 |
| All states | 768,372,091 | 1,668,429,779 | 62,799.23 | 20,557,131 | 38,325,244 | 51,755.73 | 21,329,005 | 39,749,800 | 51,676.90 | −771,874 | −1,424,556 | 78.83 |
The level of state income tax rates: the information presented in Table 6.2 is quite intriguing and supportive of our underlying assumption. The last row of the table reports the aggregate data for the United States. Notice that the average adjusted gross income (AGI) per return is $51,755.73 for the inflows and $51676.9 for the outflows from the states. The net difference between the two is $78.83, an insignificant amount. This information may lead some to suggest that in the aggregate there is no net gain from migration from one place to another. Yet as one looks to the different groups, the story is quite different. The first thing to notice is the relationship between the net inflows and the tax classification. The data shows the largest outflows for the states with the highest tax rates. The outflow is larger in both absolute terms, as well as a percent of the nonmigrant population. As we move down the tax groups from the highest toward the average and low tax states, the outflow diminishes and turns into a net inflow for the states with no income tax rates. The highest tax rate states are losing population at the fastest rate, while the no income tax states are gaining. The data suggests a clear correlation between the states tax rates and the net migration across state lines.
Another interesting piece of information is presented in the last column of Table 6.2. It shows the difference between the average AGI per return between the inflows to that of the outflows experienced by the groups of states. For the states with the highest tax rates, the difference is −$4986.80. Yet as one moves down the column toward the states with lower tax rates, the negative differential narrows and turns positive for the group of lower tax rates, as well as those with no income tax. These results show that for the higher tax rate states the income of the inflows or immigrants is lower than that of the outflow or the people leaving the state, while the reverse is true for the lower tax rate states.
Given the progressivity of the tax code, combined with a progressive taxation in some states, it follows that the higher income taxpayers will be the ones with the largest potential gains from leaving the high tax area. Under a highly progressive structure, there may not be a meaningful tax arbitrage opportunity for the lower income taxpayers. More important, if the high tax rates are the result of profligate spending, whether in large benefits to public employees or expansive, and in some cases mean-tested, social programs, these policies may attract lower income taxpayers who could take advantage of these mean-tested programs. The end result may be an outflow of taxpayers with a high taxable income combined with an inflow of taxpayers of lower taxable income. Some may call that a tax-driven “brain drain.”
The changes in state income tax rates reported in Table 6.3 tell the same qualitative story. The outflow is greater in both absolute, as well as in percentage term of the state’s populations for those states experiencing an increase in the state income tax rates. Again, as before, the income of those leaving the rising tax rate states is higher than those coming into the state. In contrast, for those the states with declining tax rates, the income is approximately the same, while the net flow is very close to a wash. This data suggests that the outflow from the rising rate states is more than likely to go not necessarily to the states with declining tax rates, but to those with the lowest tax rates.
Table 6.3
| Nonmigrants | Inflows | Outflows | Net inflows | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | |
| States with rising tax rates | 232,581,084 | 504,458,452 | 68,888.14 | 4,731,844 | 8,135,998 | 54,183.53 | 5,397,210 | 9,655,252 | 60,119.28 | −665,366 | −1,519,254 | −5,935.75 |
| States with falling tax rates | 99,993,695 | 234,352,149 | 55,758.72 | 2,884,756 | 6,075,056 | 46,712.25 | 2,946,227 | 6,163,984 | 46,350.94 | −61,471 | −88,928 | 361.30 |
The Right to Work principle affirms the right of every American to work for a living without being compelled to belong to a union. A Right to Work law guarantees that no person can be compelled, as a condition of employment, to join or not to join, nor to pay dues to a labor union. Section 14(b) of the Taft-Hartley Act affirms the right of states to enact Right to Work laws. Some studies have documented the fact that Right to Work states have greater economic vitality; official Department of Labor statistics show, with faster growth in manufacturing and nonagricultural jobs, lower unemployment rates and fewer work stoppages. Under these conditions, one would expect a net inflow of workers into the Right to Work states. The net migration patterns into the states with and without Right to Work legislation can be found in Table 6.4. The results reported in the last three columns tell a familiar story. The Right to Work states are gaining populations while the non-Right to Work states are losing population. While the income of the inflows into the non-Right to Work is a bit smaller than that of the outflow, that differential reverses sign and is much more pronounced for the Right to Work states. The inflows have a higher income to the tune of $2395.378. Hence not only are the Right to Work states gaining taxpayers, the ones they are gaining have a higher income than the ones they are losing. Brain drain anyone?
Table 6.4
| Nonmigrants | Inflows | Outflows | Net inflows | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI Per Return | |
| Not right-to-Work | 588,176,827 | 1,264,383,357 | 65,211.4 | 14,458,987 | 26,260,381 | 54,221.4 | 15,420,868 | 28,048,500 | 54,804.3 | −961,881 | −1,788,119 | −582.86 |
| Right-to-Work | 180,195,264 | 404,046,422 | 54,925.8 | 6,098,144 | 12,064,863 | 45,909.5 | 5,908,137 | 11,701,300 | 43,514.1 | 190,007 | 363,563 | 2,395.38 |
If one takes the Right to Work laws as a proxy for government intervention, regulations, and other rigidities, the data show that states that are less regulated and more sympathetic to free enterprise (i.e., the Right to Work states), gained population and increased their tax base. The opposite holds true for the states with no Right to Work laws. The one issue that we have yet to focus is whether there is any interaction between the states’ tax rate policies and the Right to Work in determining and affecting a state economic environment.
The Interaction Among States’ Migration, State Income Tax Rates, and Right to Work
Information regarding the interaction between the migration patterns, the state’s income tax rates, and whether a state is a Right to Work state is reported in Table 6.5. The top panel reports information on the states classified as high tax rate states. Notice that this group is then subdivided into Right to Work, rising tax rates, average tax rates, and falling tax rates. The relevant information for purposes of the current discussion is reported in the last column of the table. Upon inspection of the data a clear pattern emerges. Within the high tax rate states, the following groups of states for whom the net inflows or net immigration show a positive number. That is the incoming people as a group experience a net gain and thus show a positive number; see the last column of Table 6.5. The states with population and income gains are either states located in: Right to Work states or states with falling tax rates and/or “average” tax rates. Notice also that the high tax rates states lost population to all the groups except for the Right to Work states with “average” income tax rates.
Table 6.5
| Nonmigrants | Inflows | Outflows | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| No. of States | Returns | Households | AGI per return | Returns | Households | AGI per return | Returns | Households | AGI per return | |
| High tax rates | 14 | 296,786,958 | 649,000,562 | 67,560.93 | 5,883,209 | 10,335,157 | 54,279.59 | 6,583,482 | 11,881,296 | 59,266.39 |
| Right to Work | 4 | 94,594,361 | 200,955,394 | 67,799.43 | 1,475,563 | 2,455,806 | 57,718.52 | 1,813,595 | 3,160,480 | 65,018.83 |
| Right to Work and falling tax rates | 2 | 3,3764,781 | 76,625,251 | 54,914.28 | 207,292 | 407,182 | 46,288.48 | 214,422 | 409,392 | 42,334.82 |
| Rising tax rates | 8 | 214,627,195 | 466,277,767 | 69,661.37 | 4,401,268 | 7,528,618 | 54,530.78 | 4,983,411 | 8,915,958 | 60,853.46 |
| “Average” tax rates | 4 | 48,394,982 | 106,097,544 | 67,069.12 | 1,274,649 | 2,399,357 | 54,711.81 | 1,385,649 | 2,555,946 | 56,178.63 |
| “Average” tax rates and Right-to-Work | 2 | 21,430,655 | 48,223,724 | 54,271.01 | 636,710 | 1,240,945 | 48,911.01 | 542,811 | 1,028,586 | 41,974.15 |
| “Average” tax rates and Not Right to Work | 2 | 26,964,327 | 57,873,820 | 77,240.78 | 637,939 | 1,158,412 | 60,501.43 | 842,838 | 1,527,360 | 65,326.71 |
| Falling tax rates | 2 | 33,764,781 | 76,625,251 | 54,914.28 | 207,292 | 407,182 | 46,288.48 | 214,422 | 409,392 | 42,334.82 |
| Falling rates and Right to Work | 2 | 33,764,781 | 76,625,251 | 54,914.28 | 207,292 | 407,182 | 46,288.48 | 214,422 | 409,392 | 42,334.82 |
| “Average” tax rates | 20 | 249,507,691 | 538,075,925 | 60,525.45 | 7,519,605 | 14,178,602 | 48,363.80 | 7,828,425 | 14,694,047 | 49,734.62 |
| Rising tax rates | 2 | 17,953,889 | 38,180,685 | 59,644.70 | 330,576 | 607,380 | 49,560.19 | 413,799 | 739,294 | 51,277.42 |
| No tax rate change | 13 | 176,704,206 | 385,778,036 | 59,395.20 | 4,910,694 | 9,386,687 | 46,889.42 | 5,089,826 | 9,692,682 | 49,094.16 |
| No tax rate change and Right to Work | 4 | 64,379,032 | 145,280,565 | 54,703.45 | 1,917,459 | 3,743,967 | 44,397.42 | 1,850,417 | 3,645,737 | 43,863.70 |
| No tax rate change and not Right to Work | 9 | 112,325,174 | 241,957,405 | 62,264.68 | 3,156,835 | 5,904,267 | 49,476.14 | 3,372,396 | 6,276,512 | 51,726.47 |
| Falling tax rates | 5 | 54,849,596 | 112,657,270 | 64,085.50 | 2,114,735 | 3,922,988 | 50,112.65 | 2,191,813 | 4,032,504 | 51,335.11 |
| Falling tax rates and Right to Work | 2 | 3,640,114 | 7,368,183 | 62,206.17 | 1,080,154 | 2,132,873 | 47,915.90 | 999,989 | 1,989,715 | 45,394.29 |
| Falling tax rates and Not Right to Work | 3 | 51,209,482 | 105,289,087 | 64,219.09 | 1,034,581 | 1,790,115 | 52,406.17 | 1,191,824 | 2,042,789 | 56,319.70 |
| Low tax rates | 10 | 93,025,151 | 200,974,538 | 57,580.30 | 3,010,989 | 5,852,434 | 47,849.31 | 3,170,276 | 6,109,980 | 46,197.62 |
| Falling tax rates | 4 | 32,609,537 | 72,240,314 | 51,229.55 | 998,345 | 1,994,291 | 44,145.77 | 954,565 | 1,837,614 | 45,046.61 |
| Falling tax rates and Right to Work | 3 | 20,916,843 | 46,179,472 | 53,379.88 | 375,509 | 760,740 | 41,570.15 | 336,915 | 668,426 | 44,050.70 |
| Falling tax rates and Not Right to Work | 1 | 4,768,505 | 10,577,202 | 60,461.77 | 176,584 | 386,278 | 49,298.55 | 202,823 | 454,708 | 44,573.24 |
| No tax rate change | 6 | 60,415,614 | 128,734,224 | 61,008.13 | 2,012,644 | 3,858,143 | 49,686.40 | 2,215,711 | 4,272,366 | 46,693.49 |
| Right to Work | 7 | 50,152,112 | 11,1750,942 | 54,698.91 | 2,053,073 | 4,120,876 | 45,823.85 | 2,097,464 | 4,216,023 | 43,105.85 |
| Right to Work and No tax rate change | 3 | 27,661,560 | 61,536,498 | 51,534.79 | 835,954 | 1,670,399 | 44161.64 | 812,470 | 16,07,044 | 43,493.13 |
| Right to Work and Falling tax rates | 4 | 22,490,552 | 50,214,444 | 58,590.53 | 1,217,119 | 2,450,477 | 46,965.51 | 1,284,994 | 2,608,979 | 42,860.98 |
| No income tax | 7 | 129,052,291 | 280,378,754 | 60,006.63 | 4,143,328 | 7,959,051 | 57,166.79 | 3,746,822 | 7,064,477 | 47,035.77 |
| Right to Work | 2 | 8,612,255 | 18,558,577 | 59,358.10 | 312,518 | 629,715 | 40,829.11 | 318,809 | 643,795 | 43,590.14 |
| Not Right to Work | 5 | 120,440,036 | 261,820,177 | 60,053.00 | 3,830,810 | 7,329,336 | 58,499.62 | 3,428,013 | 6,420,682 | 47,356.21 |
The second panel reports the data for the “average” tax rate states. Again, a pattern emerges. The states with no significant tax rates and/or falling tax rates that also happen to be Right to Work are the only group of states showing a net gain from migration as well as a positive or net inflow of people. Notice also that on average the magnitude of the migration gains is smaller for the “average” income tax rate states than for the high income tax rate states.
The third panel shows that for the low tax rate states the groups experiencing a net outflow also experience an income gain. This fits our view that the people will migrate to improve their income levels even if they are in a low tax rate state. The biggest income gains is experienced by the groups of states that have a falling tax rate and are Right to Work states.
The fourth panel shows the states with no income tax rates; again the data shows that these groups of states show a net inflow of people and these groups of states also show the largest gains in income. The one anomaly here is that the Right to Work states show an unexpected result: a net outflow and a net income loss. But this makes some sense. People will move to areas where there are more opportunities. You would expect the lower income people the ones likely to gain an increase in income. One possibility that we have not discussed up to this point is how the social safety net may affect the migration level of the lower income groups. The differential in social safety net benefits may be an important factor for the lower income groups.
The data in the panels show that the income difference between the inflows and outflows are the largest for the most extreme tax rate changes. The gains are the largest for the no income tax rate states while the losses are the largest for the high-income tax rate states. Another result suggested by the data is that the interaction between the Right to Work and tax rates seems to break down for states with no income tax rate states. If as we argue that the Right to Work may be a proxy for the regulatory and overall environment, one can also argue that the no income tax rate state may also reflect similar environments. Hence, we would expect the Right to Work to be more important the higher the tax rates.
Brain Drain?
The findings reported in the previous section and the overall migration away from the high tax states to the other states is in line with the competitive environment framework that we have outlined. One concern is that the migration patterns are such that the people leaving the high tax states tend to have higher income than the people moving into the state thereby raising the possibility of a brain drain effect taking place in these high tax rate states economies.
To investigate this possibility, we chose a high tax state that is dear to our hearts, California, and examined the emigration and immigration patterns to and from high and low tax rate states and Right to Work states. Once we show that the patterns are consistent with the results already reported, we focus on the migration patterns with the neighboring/bordering states.
The results reported in Table 6.6 shows that California is only gaining people from states with high and rising or average tax rates, as well as from states with average and rising tax rates. More importantly, the people moving in from those states have a higher income than those moving out to those states. In this case, the brain drain is working in California’s favor. But sadly there are not that many states that have as high or higher tax rates than the state of California. For the remaining group of states, California is losing population to these states, in particular the Right to Work states or states with no income tax rates. The data shows that the people moving to these states have a higher income than those coming in from these states, a result that supports the brain drain hypothesis.
Table 6.6
| Immigration | Outmigration | Net inflows | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Returns | Households | AGI per household | Returns | Household | AGI per household | Returns | Households | AGI per households | ||
| Immigration | 1,581,844 | 2,805,818 | 54,791.58 | 1,657,989 | 3,101,575 | 57,616.64 | −76,145 | −295,757 | −2,825.06 | |
| High tax rates | ||||||||||
| Rising rates | 108,493 | 176,931 | 67,798.04 | 83,341 | 140,770 | 58,227.81 | 25,152 | 36,161 | 9,570.23 | |
| Average rates | 126,278 | 212,389 | 65,352.16 | 107,113 | 186,144 | 64,477.59 | 19,165 | 26,245 | 874.57 | |
| Falling rates | 52,989 | 99,146 | 48,817.10 | 53,800 | 105,017 | 49,269.50 | −811 | −5,871 | −452.41 | |
| Average tax rates | ||||||||||
| Rising rates | 146,937 | 221,325 | 77,207.59 | 117,136 | 177,176 | 71,613.10 | 29,801 | 44,149 | 5,594.49 | |
| Average rates | 312,070 | 563,603 | 51,714.69 | 323,549 | 621,294 | 55,148.54 | −11,479 | −57,691 | −3,433.85 | |
| Falling rates | 44,621 | 72,807 | 50,911.64 | 37,564 | 67,068 | 51,076.91 | 7,057 | 5,739 | −165.27 | |
| Low tax rates | ||||||||||
| Rising rates | ||||||||||
| Average rates | 94,055 | 16,2078 | 51,383.73 | 93,920 | 179,836 | 54,668.72 | 135 | −17,758 | −3,284.99 | |
| Falling rates | 49,648 | 89,958 | 43,906.95 | 52,958 | 99,806 | 41,771.28 | −3,310 | −9,848 | 2,135.67 | |
| No income tax | 378,267 | 703,309 | 53,884.39 | 450,248 | 885,974 | 60,309.37 | −71,981 | −182,665 | −6,424.98 | |
| Right to Work | 234,342 | 443,764 | 43,789.42 | 266,724 | 534,098 | 48,316.32 | −32,382 | −90,334 | −4,526.89 | |
| Other states | 1,079,016 | 1,857,782 | 60,317.62 | 1,052,905 | 1,928,987 | 60,949.37 | 26,111 | −71,205 | −631.74 | |
| Arizona | 111,731 | 215,104 | 44,370.59 | 126,098 | 241,154 | 51,178.21 | −12,353 | −26,050 | −6,807.62 | |
| Nevada | 96849 | 183,937 | 38,387.15 | 88,178 | 239,428 | 60,921.42 | −29,249 | −55,491 | −22,534.27 | |
| Oregon | 59,906 | 105,231 | 44,252.83 | 83,341 | 157,908 | 50,287.85 | −28,272 | −52,677 | −6,035.01 | |
The data on the migration patterns with the neighboring states is also quite interesting and consistent with the results already reported. But one result stands out; the gains from moving to Arizona and/or Oregon are roughly the same, slightly better than $6000. However, the gains from moving to Nevada at $22,534.27 are almost four times larger than those of moving to Oregon and or Arizona. Recall that Oregon and Arizona were both designated as high tax rate states while Nevada has no state income tax rate. It is important to note that the people incoming from Nevada have an average income of $38,387.15 while those moving out have an income of $60,921.42. This number raises the issue as to why are these lower income people coming here from Nevada.
Notice that there is a net outflow to each of the neighboring states. It seems that California is like an exploding supernova sending jobs all over the United States’ universe and, in particular, its neighbors. If this is true, the neighboring states should erect statues to the governors of California. The state’s bad fiscal policies have caused a net emigration out of California to the benefit of the neighboring states.
The differences in taxation across the states explain the patterns of emigration as well as the AGI of the migrants to its neighboring states. Our basic hypothesis is simple: in the absence of any tax effect or any other impediment, we would expect that the migration out of California into neighboring states to be distributed in direct proportion to the relative sizes of the neighboring economies. For example, as Arizona accounts for 48.69% of the nonmigrant population of the region during the time period, all else the same, we would expect the state to capture 45.82% of the migration. Yet Arizona only accounts for 19.41% of the net flows. In contrast, Nevada with only 21.66% of the nonmigrant population accounts for 41.34% of the net migration flows.
Now tax differences and other transportation costs would affect the emigration pattern out of California. As Nevada is classified as a no income tax state, Arizona and Oregon as high rate states, the tax arbitrage hypothesis suggests that Nevada should gain a more than proportionate share of the emigration out of California. Nevada accounts for 21.66% of the neighbors’ nonmigrant population and yet it captures 41.34% of the net outflows from California to its neighbors.
So far we have been able to provide a tax-based explanation for the emigration out of California. However, the converse does not hold water. Looking at the tax rate data presented in Table 6.7, it is apparent that, on average, people would not move to California from Nevada for tax reasons. They may move from Oregon, the high tax state. The tax story would suggest that as far as immigration into California goes, Oregon should be an outperformer and Nevada, the no tax state, should be an underperformer. Yet as we look at the bottom half of Table 6.6, we find that this is not the case.
Table 6.7
| Income bracket | California | Arizona | Nevada | Oregon |
|---|---|---|---|---|
| $0 | 1.00% | 2.59% | 0.00% | 5% |
| $6,700 | 1.00% | 2.59% | 0.00% | 7% |
| $16,030 | 2.00% | 2.50% | 0.00% | 7% |
| $16,900 | 2.00% | 2.50% | 0.00% | 9% |
| $20,357 | 2.00% | 2.88% | 0.00% | 9% |
| $38,002 | 4.00% | 2.88% | 0.00% | 9% |
| $50,890 | 4.00% | 3.36% | 0.00% | 9% |
| $59,978 | 6.00% | 3.36% | 0.00% | 9% |
| $83,258 | 8.00% | 3.36% | 0.00% | 9% |
| $101,779 | 8.00% | 4.24% | 0.00% | 9% |
| $105,224 | 9.30% | 4.24% | 0.00% | 9% |
| $250,000 | 9.30% | 4.24% | 0.00% | 9.90% |
| $305,336 | 9.30% | 4.54% | 0.00% | 9.90% |
| $537,500 | 10.30% | 4.54% | 0.00% | 9.90% |
| $644,998 | 11.30% | 4.54% | 0.00% | 9.90% |
| $1,074,996 | 12.30% | 4.54% | 0.00% | 9.90% |
| $1,074,996 | 13.30% | 4.54% | 0.00% | 9.90% |
We have already hinted at the rationale for the possible migration patterns. The reason why many of these states have high tax rates is that they have a government that has enacted a multitude of social and other public spending programs. However, one of the requirements for enjoyment of the benefits is need. Hence to the extent that the public services are means tested, they will attract migrants from states with no such programs. Hence if the tax rate is a proxy for the spending levels, the progressivity of the state tax code and strict means testing is all we need to add to the mix. Then we can easily argue that the migration from lowest tax neighbor, Nevada, to California will be in excess of the states’ share, while the opposite will hold for the highest neighboring state, Oregon. The income data for the people coming into California at the bottom of Table 6.6 shows that this is the case.
The data clearly support our views that the high tax rates will induce the higher income taxpayers to emigrate and the provision of means tested public services will induce the immigration of lower income taxpayers. The net effect of these policies is a net outflow, as well as a “brain drain” that results in a net reduction in tax revenues per dollar worth of income. In addition, the expansion of public services not only attracts the taxpayers that will pass the means test (i.e., lower income taxpayers), but it will also result in an increase in public spending. The progressivity reduces the base for two reasons: there will be fewer people and they will have a lower income. Under a progressive tax code this will have a disproportionate effect on revenues. The end result is higher tax rates, lower revenues per capita, and higher spending per capita. The combination leads to a brain drain and that is not a good thing for the state’s finances. However, if our views are correct, the problem is reversible and its solution is an obvious one.
Summary
The states’ experiences enhance the supply-siders’ arguments as to why tax rate changes can have a significant impact on the tax base. Proponents of tax rate increases concede, in principle, the qualitative arguments that we are making. They just do not agree with the magnitude of the effects in question. Essentially what these economists are saying is that they don’t believe that these people will respond to the disincentives. If they do, the government should be ready to step up its enforcement to make sure it collects. But the one area that enforcement cannot help is to force people to work, hire workers, or invest.
On the issue of personal and corporate income taxation, there is a considerable disagreement as to what the impact of the tax rates on the economy and the tax base will be. Needless to say, proponents of the tax increases argue that the substitution effects are small or negligible, and will have no significant effect on the economy’s growth rate and/or tax revenues in the short or long run. We disagree. Our view is that to the extent these moves make the capital markets more efficient, the economy will benefit and so will the long run growth rate. The higher after-tax rates of return will increase the overall supply of labor and capital to the economy, thereby increasing the level of output and quite possibly the growth rate. What happens to tax revenue collections depends on the overall response. However, the story here suggests that the longer the horizon, the greater the flexibility of the economy to adjust and thus the larger the impact of the tax rate changes will be on the tax base.
The one major criticism that we have regarding the supply-side effects of the tax rates is that the critics focus mainly on the aggregate supply from a closed economy perspective. As we have already mentioned, this debate is about the magnitude of the response of the factors within the economy. We have made our views known in the previous paragraph. The critics believe that the supply response will be modest at best, where as we think it is much larger. We also think they are ignoring one very important effect that significantly underestimates the supply response. They have much to learn from the states’ experiences.
So, the big issue is whether the tax increase will slow down the pace of economic activity and thus, in the long run, reduce the tax base. To this they conclude that to reduce tax avoidance opportunities, tax rates on capital gains and dividends should be increased along with the basic rate. Closing loopholes and stepping up enforcement would further limit tax avoidance and evasion. However, that will not produce the desired results in the long run and quite possibly the short run too.
To make our point we need to make a parallel. Imagine equilibrium in an integrated economy, say the United States, consisting of a union of 50 states. Each of the states can be thought of an open economy where factors of production are free to move. The data shows that states with rising tax rates tend to suffer outmigration of both people and capital, and, as a result, a reduction in the tax base, while states with lower tax rates gain population, as well as experiencing a capital inflow and a tax base increase.
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