The Economic Trauma of High Taxes

Occasionally an article comes along that is so good I agree with essentially everything in it. Two good economists, Arthur Laffer and Stephen Moore wrote a piece in the Wall Street Journal titled "Soak the Rich, Lose the Rich".

States are facing nearly $100 billion in budget deficits this year. They are required to balance their budgets. In the past, state governments have relied more on spending cut-backs. But now, they are trying to pursue the new paradigm: tax the rich, the top 1% -- 2% (or 5% in some cases) of earners in each state.

It will not work. One of the first laws of economics is extremely simple: people respond to incentives.

In their study Laffer and Moore show that Americans are more sensitive to higher taxes than ever before.
Tax differentials between low and high tax states is widening, meaning, for example, that a move from California to Nevada is increasingly more profitable. They found that between 1998--2007 1,100 people per day moved from the 9 highest income-tax states such as California and New York to the 9 tax haven states with no income tax. Also, incredibly, the no-income tax states created 89% more jobs and had 32% faster personal income growth than their high tax counterparts.

This study and many others provide powerful evidence that high state and local taxes repel jobs and businesses. The authors found a study that looked at 3 tax-the-rich states that increased taxes between 2000 and 2005 (Connecticut, New York, and New Jersey). All were rewarded by a significant reduction in the number of rich filers. "Amazingly, these 3 states ranked 46th, 49th, and 50th among all states in percentage increase in wealthy tax filers in the years after they tried to soak the rich."

Laffer and Moore then pointed out that Governor Rick Perry told them, "Our state is competing with Germany, France, Japan and China for business. We'd better have a pro-growth tax system or those American jobs will be out-sourced." They conclude that Texas has the jobs and prosperity model right. Texas created more new jobs in 2008 than all other 49 states combined!

My last thought is that the Texas message needs to be spread across America. Instead the Obama Nation is imposing greater bureaucratic costs on business, while contemplating its own tax-the-rich schemes. This can't be good for Texas or, indeed, the other 49 states.

Some Threats to the Economic Recovery

 

There is some light at the end of the proverbial tunnel on the economy. Some economic measures are showing modest improvements while others are still decreasing, but at a lessened rate. Forecasters are becoming more confident that the recession will end in the second half of this year followed by at least a modest recovery in 2010. Unemployment will continue to rise and may stay stubbornly high in the first half of 2010 (maybe around 10%). This forecast is consistent with Fed thinking as expressed by Fed Chairman, Ben Bernanke, on several occasions.

I believe this scenario is all but assured. Monetary and fiscal policies are more aggressive than in any period of U.S. history. Assuming there are no more hidden financial icebergs out there, this historic stimulus will jump-start the economy.

Monetary policy has lowered the overnight Federal Funds rate to essentially 0%. The Fed has pumped so many reserves into the system (leading to excess money creation) that the Fed's own balance sheet has more than doubled, and is still growing

Fiscal policy (government tax and spending policies) is also unusually aggressive. Last year's deficit was $458 billion. The projection so far this year is for a deficit of $1.8 trillion.

The problem with this much stimulus is the potential deleterious side effects starting in 2010 (hopefully not this year). Because of huge deficits and money creation we probably face high interest rates and inflation not too far down the road.

The challenge for policy-makers will be to unwind the stimulus so that the expected recovery will lead to a sustained economic recovery that does not peter-out into another recession, unusually soon after this one ends. I will be monitoring this over the next several years.