Recently, I had an opportunity to hear Art Laffer speak. Laffer is an economist, who in 1974 sketched on a napkin what came to be known as the Laffer Curve, which shows the relationship between tax rates and the resulting tax revenue generated. His intent was to maximize government revenues, over the long term, by finding the best tax rate that would do so.
His recent research has shifted from the national tax level to the state tax level. Analysis of the long-term impact of the level of state tax resulted in very dramatic findings and an important lesson for the state of North Carolina.
In 1960, 18 states had no income tax. Today, seven states in the United States do not tax income: Tennessee, Florida, Texas, Nevada, Wyoming, Washington and Alaska. Eleven states have established an income tax since 1960. Connecticut in 1991 was the last. The other 10 states were New Jersey, Ohio, Rhode Island, Pennsylvania, Maine, Illinois, Nebraska, Michigan, Indiana and West Virginia.
To cut to the chase, as a collective, guess which states have experienced the most population growth, the highest increases in K-12 education, the highest increases in public health and hospital employees, the greatest reductions in poverty rate, and the greatest increases in the state highway system? Unbelievably, the seven states with no income tax. Together the 11 states that added a state income tax all rank lower in these areas than they did before they instituted the income tax. Most people would guess that the states with low tax rates would have population growth, but more tax revenue, less poverty, and more public services. Interestingly, when the states first proposed to their citizens that they add an income tax, they always contended that the income tax would allow for greater public services. That contention has turned out to be dramatically wrong.
What does this mean for North Carolina? The states that have reduced their income tax rates, individual and corporate, have generally improved their long-term tax revenues and their public services compared with states that have maintained or increased their tax rates. It doesn’t seem to make sense. However, this is exactly why we conduct research, to see if our intuitions match the real world.
North Carolina has reduced the personal income tax rate from 7.75 percent to 5.25 percent and the corporate rate from 6.9 percent to 2.5 percent. You can find articles on the internet critical of these cuts, but the only real downside is that it’s difficult to know the impact in the very short term. There may be a year or two where revenues fall below projections, but that’s only because people don’t act on major decisions immediately. The decrease in corporate rate to 2.5 percent doesn’t cause a California business to move to North Carolina immediately. A cut to 5.25 percent in the personal tax rate doesn’t cause a retiree to move from New Jersey to North Carolina immediately. Laffer’s research shows that over the long term, the state will be better off.
The examples of New Jersey is particularly instructive. In 1965 New Jersey did not have a sales tax or an income tax. That’s hard to imagine for anyone who is younger than 50. It was one of the most desirable places for people to move. Its financial situation was excellent. Then in 1966 it added a sales tax and in 1976 an income tax. Today it has some of the highest state taxes in the nation. It has massive out-migration and horrible finances.
The “sweet spot” on the Laffer Curve is where state revenue is maximized over the long term. North Carolina has been getting closer lately, allowing, for example, the largest percentage increase in America for teacher salaries in the past five years or so. North Carolina’s tax rates, and its future, are moving in the right direction.