The Effects of Tax Reductions In Arizona

February 18, 2013

The Effects of Tax Reductions In Arizona:
Significantly Reduced Government Revenue and No Apparent Impact on Economic Growth

Tom R. Rex
Fellow, Grand Canyon Institute

Executive Summary

Reductions in effective tax rates under certain conditions can result in gains in economic activity and increased government revenue. In practice, however, many supporters of “supply-side” economics ignore or misrepresent the “under certain conditions” clause and erroneously argue that all or most tax reductions will have a net beneficial impact.

Several limitations apply to supply-side economics, especially at a sub-national level:

  • Most prominently, the “Laffer Curve” indicates that the benefits will occur only if the tax reduction is made to a tax rate that is higher than optimal. Reductions to lower-than-optimal tax rates will reduce government revenue.
  • The relationship between taxes and economic growth and government revenue is much stronger for business taxes than for individual taxes.
  • The reduction in one tax may not have much effect if the overall tax burden remains higher than optimal.
  • State and local government taxes are a relatively small expense to businesses, and only the minority of businesses engaged in traded-sector activities can boost a region’s economic growth. Thus, only a small supply-side effect should be expected even if higher-than-optimal state and local government taxes are reduced to the optimal point.
  • Even if all of the other conditions are met, if a state already is at full employment and has low commercial real estate vacancy rates when the tax reduction goes into effect, a net benefit to government finance will not be realized. In this case, labor will need to be imported to accommodate the faster economic growth, meaning that government expenditures must rise to serve the new residents.

In Arizona, the Legislature has repeatedly lowered state government taxes over the last two decades, usually with the justification that the reductions will be good for the economy and that the initial loss of revenue will quickly be made up by an increase in economic activity. However, Arizona has not been in a position to receive much in the way of supply-side benefits:

  • Even in the early 1990s when the tax reductions began, the overall state and local government tax burden was not higher than average.
  • Individual taxes have been disproportionately reduced. Even today, the business tax burden is average compared to the national norm while the individual tax burden is very low, relative both to other states and to Arizona’s historical norm.
  • Most tax reductions have been passed in the midst of an economic expansion. Moreover, Arizona has not had an ongoing issue with underutilized resources (labor and physical space). Therefore, any increase in economic activity would necessitate an increase in government expenditures.

Thus, the tax reductions in Arizona should have had little effect on economic growth and should have reduced government revenue.

The empirical evidence in Arizona matches this conceptual conclusion. A correlation analysis indicates that the tax reductions have followed cyclical upswings in the economy that have created temporary revenue surpluses that allowed the tax reductions to occur while initially balancing the budget. This is seen in Figure E-1. Significant tax reductions occurred in each fiscal year from 1995 through 2001; the economy recovered from the recession in 1994 and was expanding rapidly by 1995. Large tax reductions also occurred in fiscal years 2007 and 2008; the economy had recovered from recession with strong growth in 2005 and 2006.

In the longer term, no positive economic response to the tax reductions can be perceived. Figure E-2 shows average annual growth in Arizona relative to the national average in each of the last five economic cycles for three economic measures: a measure of aggregate growth (employment), a measure of prosperity (per capita earnings), and a measure of productivity (per employee earnings). If the tax reductions boosted economic performance, the effect should begin to be seen in the 1991-to-2001 economic cycle, with a greater effect measured in the 2001-to-2010 cycle. Instead, of the last five economic cycles, employment growth was third highest in the 1991-to-2001 cycle and lowest in the 2001-to-2010 cycle. Prosperity and productivity gains were highest by a small margin during the 1991-to-2001 cycle, but losses during the 2001-to-2010 cycle were typical of earlier cycles.

If economic growth does not accelerate to offset tax reductions, then government revenue relative to the size of the economy has to fall. This is shown clearly in Figure E-3, with sharp drops in actual revenue since the mid-1990s, when tax reductions began to go into effect. Had no tax code changes been made since 1992, revenues would have been substantially higher and similar to the historical norm.