An Economist’s Perspective on HB 3405 and HB 2649By Randall J. Pozdena, PhDPresident, QuantEcon Inc.June 9, 2009

Randall PozdenaThe opinions expressed herein are those of the author and
should not be attributed to any other individual or to any other organization
with which the author is affiliated.

The State of Oregon faces State budget deficits due to the sharp decline in employment and economic activity in the state. In an attempt to fend off this fiscal problem, the Oregon House just passed, and the Oregon Senate will decide shortly, on two major tax measures:

HB 3405 would increase tax rates on corporate profits, from 6.6 to 7.9 percent for two years, dropping to 7.6 percent thereafter.
HB 2649 would increase, for three years, personal income and capital gains tax rates from the current 9 percent to 10.8 percent and 11 percent for those earning more than $125,000 and $250,000, respectively. A 9.9 percent rate would be imposed thereafter.

The long-run fiscal health of the State depends, of course, not only a system of taxation but also encouragement and preservation of a robust economy. However, fiscal policy often proceeds with a singular focus on the revenue aspects of the policy. In this sense, many lawmakers appear to regard the effects of increases in tax rates very differently from most economists:

Lawmakers take a static, accounting view of the effects of tax rate hikes. They believe that the taxed economic factors (labor or capital) will react very little to the tax rate, yielding higher revenues. They also tend to take the view that those with higher incomes “deserve” to be taxed more aggressively.
Economists take a more dynamic view. They consider the effects of the tax rates on the behavior of individuals and businesses, and the resulting consequences for the economy in both the short- and the long-run. They also observe that those with higher incomes are responsible for most investment and job creation.

The empirical evidence assembled by economists is overwhelming as regards the adverse effects of increased marginal tax rates on personal or corporate income. Such increases impair virtually every behavior that is important to the maintenance and growth of the economy and the incomes and jobs enjoyed by its citizens. Rate hikes impair labor supply, entrepreneurship, and the willingness of businesses and individuals to invest, provide jobs, and locate in the state.

Just as importantly, the very policies intended to increase revenues actually may reduce them.
The Scholarly Evidence
Economists have been concerned about the collateral effects of tax policy for decades. These findings are from recent, authoritative studies of corporate income taxation:

Organization for Economic Cooperation and Development (2008)

• Corporate taxes are found to be most harmful for growth, followed by personal income taxes, and then consumption taxes.
• Investment is adversely affected by corporate taxation.
• The adverse effect of corporate taxes is strongest on industries that are older and more profitable, because they tend to be more exposed to taxation.
• Increasing the corporate tax rate may be particularly harmful for productivity growth of the most dynamic and innovative firms. This is because such firms rely heavily on retained earnings to finance their growth.

National Bureau of Economic Research (2008)

• Researchers from Harvard University and The World Bank looked at 85 nations’ taxation of similar sectors of their economies. They found higher corporate income tax rates discouraged entrepreneurship, foreign direct investment and economic growth.

Lee and Gordon (2004)

• These University of San Diego professors found a strong, negative relationship between corporate taxation and economic growth. Each 10 percent increase in corporate tax rates appears to lead to 1 to 2 percent decreases in the rate of economic growth.

These are findings from recent, authoritative studies of personal income taxation:

Gruber and Saez (2002)

• Increases in income tax rates by 10 percent reduce taxable income by 5.7 percent for taxpayers with incomes over $100,000.
• The decline in taxable incomes for those under $100,000 is only one-third that amount.
• These effects occur partly because the well-to-do have more options for how and where they work and report their income. (See the migration studies, below.)

Schacter and Althaus (1989)

• State and local income taxes have adverse effects on migrants.
• A 10 percent increase in the rate of taxation reduces in-migration by 20 percent, and increases out-migration by 9 percent.

Hsing (1998)

• US households migrate to an area with [among other factors] a lower tax burden, more job growth, and higher wage rates.

Feld and Kirchgässner (2001) and Schmidheiny (2006)

• High earners locate to communities in which the average effective tax rates on high incomes are relatively low.
• In reaction to high tax rates, rich households are significantly more likely to move to low-tax communities than are poor households.
• These are studies performed in Switzerland, where unique cantonal and community variations in tax policy provide an ideal environment for studying tax migration.
Effects on Public Revenues
Although tax revenues may rise transiently with rate increases, as the behavioral reactions (of work, entrepreneurship, investment and migration) play out, revenues typically fall in the longer run.

One does not have to rely on scholarly statistical analyses alone to look for these effects:

• Herbert Hoover raised the high-end income tax rate from 12 to 63 percent the first year of the Great Depression. Revenues from the affected taxpayers fell 80 percent.
• Conversely, when Coolidge cut tax rates from 73 to 21 percent in 1926, revenues had increased 61 percent.
• When JFK cut the top rate from 91 recent to 70 percent in 1965, revenues grew by 62 percent.
• The Reagan tax rate cuts in the early 80s increased revenues 99 percent.
• The Bush tax cuts produced a 20 percent increase in revenue between 2004 and 2006, after inflation.

These results, predicted by the so-called Laffer Curve, occur when the highest marginal tax rates are already high. Considering that, under announced Obama administration tax policies, the combined Oregon and US marginal tax rates on income may be 60 percent even without HB 2649, it seems highly likely that Oregon revenues ultimately will decline with the proposed increases.
Should High Earners Be Taxed More Aggressively?
The rate schedule introduced by HB 2649 progressively penalizes higher income households. High profile executive compensation debates and other press foci have re-ignited the class warfare to which high earners long have been subject. This is somewhat ironic, for several reasons:

• First, according to data from the Organization for Economic Cooperation and Development, the US already has the highest effective taxation of the well-to-do. American households in the top 10 percent by income pay the largest share of their incomes in tax of all of the 24 richest OECD member nations. Specifically, this 10 percent pays over 45 percent of all income taxes, versus earning 33 percent of all income–this yields a ratio of tax to income share of 1.35. This is almost 50 percent more progressive than Switzerland, at the opposite end of the scale, and more progressive than Sweden, Britain, the Netherlands, etc. Indeed, by virtually any measure of tax equality, the US has the most progressive effective personal income tax structure in the civilized world.
• Second, high-income households bear a disproportionate share of the financial investment risk in the economy, according to the 2007 Federal Reserve Survey of Consumer Finances (SCF). The highest income-decile households invest 14 times that of the median household, even though their income is only 4.3 times that of the median household.
• Third, high-income households are disproportionately entrepreneurial, according to the SCF. Households with a business owner as head of household have average incomes more than twice that of the average household.

Hence, the tax proposals before the legislature, in effect, seek to differentially burden households that are already disproportionately paying taxes, taking risks, creating their own and others’ jobs and trying to run businesses.
The proposed tax initiatives have the potential to seriously damage the Oregon economy, by retarding work, investment, entrepreneurship and business activity. The focus of the taxation on high-income individuals and corporations is particularly worrisome, given the tendency of both classes of taxpayer to be regionally mobile. The end result may be to provide only modest succor to those concerned about the budget deficit, but persistent damage to the economy. ?

Randall Pozdena is a consulting economist who received his BA with Honors in Economics from Dartmouth College, and his PhD from the University of California, Berkeley. He also is a member of the CFA Institute. He is a former professor of economics and finance, former research vice president for the Federal Reserve Bank of San Francisco, and senior economist at the Stanford Research Institute. He has been a practicing consultant in Portland for 18 years, and has served on number gubernatorial, academic, and non-profit boards, investment committees and commissions. He is also an Academic Advisor to Cascade Policy Institute.

©2009. The right to reproduce this document with its content unchanged is granted and attribution given the author.

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