The right way to cut taxes
If your goal is to foster economic growth and job creation, there’s a right way and a wrong way to cut taxes on business. Fortunately, Pat McCrory and the General Assembly made the right choice.
The wrong way is to offer tax credits or other targeted incentives to companies based on where they locate or how they spend their revenue. In order for such incentives to create net economic value, the public officials who craft them would have to possess superior knowledge to that of private entrepreneurs, investors and managers.
This is what Nobel-winning economist Friedrich Hayek and his collaborator W.W. Bartley called the “Fatal Conceit” in a 1988 book of the same name. Central planning doesn’t fail because government officials are dumb or have bad intentions. Central planning fails because no single person or group could possibly possess all of the constantly emerging and changing pieces of information necessary to make welfare-enhancing decisions.
Markets are far from perfect. In fact, perfection is impossible for human beings. Still, the reason the market process works better than central planning is that even as some market actors make bad decisions, others make good ones. That confines the damage done by the bad decisions and gives those in error a strong incentive to learn from their mistakes. If central planners make bad decisions, however, the consequences are far broader, and because they don’t incur personal losses commensurate with their error, they are more likely to repeat it rather than learn from it.
That’s the theory. What about the practice?
Since 1992, there have been some 200 peer-reviewed studies published in academic or professional journals about the potential economic effects of state and local tax policy. For overall tax burdens, 63 percent of the studies found negative associations with economic measures such as GDP, personal income, employment, or investment. The share of negative findings rises to two-thirds for corporate or business tax burdens and nearly three-quarters for marginal tax rates. In other words, all other things being equal, reducing tax rates on personal and business income is likely to have economic benefits for a state or locality.
But targeted tax incentives fare far worse in the research literature than broad-based tax reduction. Only 25 percent of scholarly studies link targeted incentives to improvements in economic performance. In most cases, states or localities that offer incentives do not experience any noticeable change in their growth rates of output, income, employment, or investment.
How can this be? The central-planning fallacy is one explanation. If governments reduce the effective tax burden on some firms, locations, or investment decisions, that creates a relatively higher tax burden on others. The resulting inefficiencies appear to offset whatever economic benefits may flow from granting incentives. Essentially, government ends up “betting” on the wrong horse.
Another likely explanation has to do with uncertainty. A change in tax policy is unlikely to affect the decisions of entrepreneurs, investors, and executives unless they are reasonably confident it will stay in place for many years. It may well be that economic actors feel more confident about broad-based tax cuts than they do about targeted incentives, given that the latter are often controversial, complex, and enacted with expiration dates.
In their 2013 tax package, Gov. McCrory and the legislature chose to focus on rate reduction rather than extending or expanding tax incentives. Several controversial tax breaks, such as a subsidy for film production, are now scheduled to expire over the next two years. North Carolina’s 6.9 percent rate on corporate income will fall to 5 percent, and perhaps to as low as 3 percent in four years if revenue-growth projections are met. The state’s personal-income tax, which now tops out at 7.75 percent, will convert to a Flat Tax of 5.75 percent, thus making North Carolina a more attractive place to start or invest in new enterprises.
Eliminating special breaks and lowering marginal tax rates for everyone constitute sound tax reform by any reasonable definition. It’s also good for business.
Hood is president of the John Locke Foundation and author of “Our Best Foot Forward.”