Greater Opportunity Through Innovative Change


"Economists and policymakers have long questioned the effect of state and local taxes on economic development. According to Schmenner (1), economists have long argued that taxes had little impact on business location decisions, while development practitioners and elected officials ignored this advice and aggressively pursued development by using tax incentives. More recent research using improved data and methodologies has begun to show that taxes can make a difference, and the emerging consensus among economists now says that taxes do matter."

Joseph M. Phillips and Ernest P. Goss, "The Effect of State and Local Taxes on Economic Development: A Meta-Analysis," Southern Economic Journal, October 1995, pp. 320-333

Critics of the idea that tax rates are a factor affecting economic development frequently allege there is little or no supporting research for such a claim. Individuals who maintain tax rates matter and argue for their reduction, it is alleged, are motivated by greed and materialism and succeed by virtue of fate or luck.(2) The critics ignore or overlook a growing body of literature in peer-reviewed journals, and reviews, that find tax rates are a factor or one of many considered by entrepreneurs.

The idea that tax rates matter is most closely associated with supply-side economics and the work of Dr. Arthur B. Laffer and Nobel Laureate Dr. Robert A. Mundell.(3) But one does not have to be a supply-sider or accept the idea that government revenues increase when rates are cut to recognize that taxes affect economic activity. Supply-siders have not conducted many of the research essays cited in the literature that conclude business activity is responsive to federal, state and local rates.

Once Upon A Time Economists Believed Tax Rates Did Not Matter

The old view cited by Phillips and Goss was perhaps best summarized by Univ. of Illinois economics professor John F. Due in 1961 in The National Tax Journal:

"For decades one of the most controversial issues in the field of state-local finance has been that of the effects of tax differentials on location of economic activity, particularly of industry. No argument has been so consistently and universally used against new state taxes or increases in rates, especially those affecting business, than the "drive industry out" thesis. On the reverse side, states frequently have used claims of low taxes as a lure to business, and in the south many local governments have sought to lure industry by property tax concessions."

Due concluded "statistical analysis and study of location factors are by no means conclusive" but "suggest very strongly that the tax effects cannot be of major importance." He also found the "tax climate factor, as one element in the general business reputation or climate" of a state, "without doubt influences some location decision-making, by causing firms to exclude certain states or urban areas from consideration."(4)

Emergence Of Supply-Side Economics

Supply-side economics emerged in the late 1970s as a countervailing idea to the view tax rates do not matter. Laffer (1981) provided an overview of supply-side theory in Financial Analysts Journal:

"Since the appearance of the Keynesian theory in 1936, virtually all American economists have been distinctly oriented toward aggregate demand as the most appropriate form of economic analysis. However, almost since its inception, the Keynesian income-expenditure analysis has faced opposition from another demand-oriented philosophy: monetarism. Classical economics returned to preeminence with the Kennedy administration. An essential premise of classical economic analysis is the belief that people will alter their behavior when economic incentives are changed."

Laffer concluded:

1) Changes in tax rates affect output in a direct fashion.

2) Changes in tax rates affect employment directly.

3) The constellation of tax rates and how they are collected is as important as the rate.

4) Lowering tax rates on any one factor will lower total revenues by less than the initial tax bases times the change in rate.(5)

Moser (1983), in the Northeast Louisiana Business Review, noted supply-side economics focused on tax rates in the long run:

"Supply-side economics, popularized by the 1980 presidential election campaign, has become an apparent element in President Reagan's economic recovery program. Reagan's proposals involve:1. a reduction of marginal tax rates, (and) 2. a reduction in the growth rate of government spending."

"Basically," Moser observed, Mr. Reagan's supply-side proposals were consistent, in most respects, with pre-Keynesian Classical economics. "(S)upply-side economics, like Classical economics, isa theory of the long run, and thus time is needed for the changes to work. The question remains as to how much time must people wait before alternative policies are sought."(6)

McKinnon (1981) wrote in Arkansas Business and Economic Review:

"Supply-side economics appears to be a new approach, but it is actually well-developed in classical economic theory. The current move away from demand-oriented Keynesian policies represents a fundamental change in national goals from emphasis on economic equity and stabilization to economic efficiency and growth. Correct policies may depend on which goal we rae more concerned with at the time."(7)

Proponents of supply-side economics point to U.S. economic growth following the Reagan tax cuts as validating the idea that rates matter. There are numerous essays in the literature that dispute this claim. One attempt to analyze the impact of tax cuts under presidents Reagan and Kennedy is by Canto, Jones and Webb (1986) in The Journal of Business & Economic Statistics.(8)

Southern Economic Journal

The Southern Economic Journal, (Southern Economics Association), has published various essays on tax rates in the past quarter-century. An early piece by Romans and Subvahmanyam (1979) found:

"Conflicting sets of evidence exist with respect to the effects of state and local taxes on industry location and regional economic growth in the United States. Survey results of business firms indicate that 'high taxes' consistently rank close to or at the top of any list of determinants of industry location."

Romans and Subvahmanyam wrote about an issue that had been ignored by other economists: the degree of progression in the tax structure and its effect on personal income growth. They found:

"(T)he evidence indicates that it might well behoove state and local governments to consider the effects of egalitarian fiscal policies on their economies. The level of personal tax does not appear to affect the economic growth rate in either direction and the level of business taxes is positively correlated with growth. But the degree of progression in the personal tax structure and the proportion of tax revenues flowing into transfer payments, i.e., the redistribution aspects of taxes, are negatively and significantly correlated with growth in state personal income."(9)

Canto and Webb (1987) examined the fiscal policies of all 50 states, including Arkansas, and the impact of relative tax burden on economic performance. In their introduction they write, "The relative performance of different state economies has been a matter of much interest to both policymakers and the public in general."

They concluded:

"In thirty eight of the states examined the relative tax burden was negative and significant. These results suggest that relative tax burdens distort the factors of production, work-leisure choice, as well as, such other factors as location. Alternatively stated, the results indicate that state tax policy influences the state's income level ..."

Arkansas was among the 38 states found to have a negative and significant coefficient.(10)

Bartik (1989) focused on small business start-ups and found: "Taxes. The panel data results strongly indicate that higher property taxes negatively affect small business starts ... The panel results also indicate that higher personal income taxes, higher general sales taxes, and higher sales taxes on equipment have negative effects on starts, although the coefficients ... are statistically insignificant ... The particularly strong negative affect of property taxes may occur because property taxes are paid regardless of profits. Many small businesses are not profitable in their first few years, so high property taxes would be much more relevant than profits-based taxes." (11)

Phillips and Goss (1995) surveyed the literature and found a wide range of elasticity estimates among economists from (positive) 0.24 to (negative) 4.43. Nearly 70 estimates are published.(12)

Elasticity measures the response to a change in policy or a variable. To those interested in the affect of tax rates on economic activity the elasticity is one of if not the most important factor.

Journal Of Economic Inquiry

Benson and Johnson (1986) suggested "that taxes negatively affect economic activity" but found "states have power within a narrow range. The findings of a distributed-lag effect suggests states can vary rates somewhat without immediately experiencing massive capital influences or decreases in formation rates ... Accordingly, politicians who are elected for terms running from two to four years will find themselves making fiscal decisions whose major consequences will not be evident until after the nearest election." They conclude, "Previous empirical findings suggesting that state and local taxes have little impact on economic activity may have enhanced the degree of ignorance or incorrectly guided the decisions of politicians."(13)

Koester and Kormendi (1989) reviewed data from 63 countries to "examine the impact of average and marginal tax rates on the level and growth of economic activity." They concluded, "(I)ncreases in marginal tax rates have negative effects on the level of economic activity. This evidence supports the hypothesis that reduction in the "progressivity" of tax rates induce a parallel shift upward in the "growth path."

Prior research, the authors note, did not address the effects on tax rates on "the level of economic activity." "The combined effect," they concluded, "...can be summarized as follows: Holding average tax rates constant, higher (lower) marginal tax rates generally are associated with downward (upward) parallel shifts in the whole growth path."(14)

Padovano and Galli (2001) examined tax rates and growth in Europe. They found, "Within a sample of homogenous economies and after improving the estimates of the effective marginal tax rates and the specification of the model, we have been able to isolate the impact of marginal tax rates on economic growth. Our analysis of a cross-section time-series panel of 23 OECD countries for 1950s-1980s decades show that high marginal tax rates and tax progressivity are negatively correlated with long-run economic growth."(15)

Journal Of Urban Economics

Other essays in the literature focus on the impact of tax rates on capital flight from urban to suburban areas. Another question addressed in the journal is whether manufacturing firms are responsive to tax rates when siting a plant. An early survey of the literature is provided by Oakland (1978), who observed, "My search of the literature has failed to uncover any solid evidence for or against the proposition that intraurban location decisions of business firms are significantly affected by fiscal considerations."

"Part of the reason for this," Oakland wrote, "is the paucity of empirical work on the question. Another is that the work that has been done has completely neglected the supply side of the equation."(16)

Papers were subsequently published in the journal on the topic.

Charney (1983) concluded, "The model and empirical analysis of this study focus on the determinants of site selection within a metropolitan area and the findings clearly indicate that local tax rates are among the significant location factors for relocating manufacturers." The results, Charney wrote, raises "issues that must be theoretically and empirically addressed before the overall impact of tax differentials on manufacturing activity can be addressed." One issue raised by Charney is whether the location decisions of manufacturers new to an area are similar to choices made by established firms.(17)

McGuire (1985) researched siting decisions in Minnesota and found, "Employing a far richer data set than previous studies, at least with respect to the dependent variable, firms locations, the question as to whether tax rate differentials matter to firms was answered with a qualified yes. Tax rates, McGuire wrote, "probably do matter but to what extent is unclear and I think would vary from metro area to metro area."(18)


Interest in the subject of tax rates can be observed at the highest levels of the economics profession. Dr. Martin Feldstein, president of the National Bureau of Economic Research (NBER), has himself researched the issue. Feldstein (1995) examined "a Treasury Department panel of more than 4,000 taxpayers to estimate the sensitivity of taxable income to changes in tax rates on the basis of a comparison of the tax returns of the same individual taxpayers before and after the 1986 tax reform." The 1986 act combined sharp reductions in high marginal tax rates with base-broadening changes in tax rules. The paper concluded, "The evidence shows an elasticity of taxable income with respect to the marginal net-of-tax rate that is at least one and could be substantially higher."

Feldstein found "a substantial response of taxable income to changes in marginal tax rates" in the data. "If the long run response to a change in marginal tax rates is greater than the short-run response (e.g., because it invokes changes in occupation, location, education, etc.), this analysis of only two years; experience after the 1986 tax rate changes may underestimate the long-run sensitivity of taxable income to changes in tax rates."(19)

A shortcoming of this survey is that it is introductory and far from comprehensive. There are, literally, hundreds of articles in the peer-reviewed literature since supply-side economics emerged a quarter-century ago. It is equally likely hundreds of new essays will appear in the decades ahead.(20)


(1) Schmenner, Roger W., Making Business Location Decisions (Englewood Cliffs, N.J.: Prentice-Hall), 1982.

(2) On the various arguments advanced by the critics against business enterprise and in support of greater government intervention in the economy see Rothbard, Murray N., Power and Market (Kansas City: Sheed, Andrews & McMeel, Inc.), 2nd edition, 1977, 203-255.

(3) Mundell was the 1999 Nobel Economics Laureate. See Prasch, Robert E., "The Economic Contributions Of Robert A. Mundell," Review of Political Economy (London), January 2001, 41-58

(4) Due, John F., "Studies of State-Local Tax Influences On Location Of Industry," National Tax Journal, June 1961

(5) Laffer, Arthur B., "Supply-Side Economics," Financial Analysts Journal, September-October 1981, 29-44

(6) Moser, Ernest R., "Supply-Side Economics Revisited," N.E. Louisiana Business Review, Spring-Summer 1983, 29-34

(7) McKinnon, Thomas R., "Supply Side Economics and Practical Policy: Some Comments," Arkansas Business and Economic Review, Spring 1981, 33

(8) Canto, Victor, Douglas Jones and Robert I. Webb, "The Revenue Effects Of The Kennedy & Reagan Tax Cuts: Some Time Series Estimates," Journal of Business & Economic Statistics, July 1986, 281-88

(9) Romans, Thomas and Ganti Subvahmanyam, "State and Local Taxes, Transfers and Regional Economic Growth," Southern Economic Journal, October 1979, 435-44

(10) Canto, Victor A. and Robert I. Webb, "The Effect of State Fiscal Policy on State Relative Economic Performance," Southern Economic Journal, July 1987, 186-202

(11) Bartik, Timothy J., "Small Business Start-Ups in the United States: Estimates of the Effects of Characteristics of States," Southern Economic Journal, April 1989, 1004-1018

(12) Phillips, Joseph M. and Ernest P. Goss, "The Effect of State and Local Taxes on Economic Development: A Meta-Analysis," Southern Economic Journal, October 1995, 320-333

(13) Benson, Bruce L. and Ronald N. Johnson, "The Lagged Impact of State and Local Taxes on Economic Activity and Political Behavior," Economic Inquiry, July 1986, 389-401

(14) Koester, Reinhard B. and Roger C. Kormendi, "Taxation, Aggregate Activity, and Economic Growth: Cross-Country Evidence on Some Supply Side Hypotheses," Economic Inquiry, July 1989, 367-386

(15) Padovano, Fabio and Emma Galli, "Tax Rates & Economic Growth In The OECD Countries (1950-1990)," Economic Inquiry, January 2001, 44-57

(16) Oakland, W.H., "Local Taxes and Intra-urban Industrial Location: A Survey," in Metropolitan Finance and Growth Management Policies (Madison: Univ. of Wisconsin Press), 1978

(17) Charney, Alberta H., "Intraurban Manufacturing Location Decisions & Local Tax Differentials," Journal Of Urban Economics, 1983, 184-205

(18) McGuire, Therese J., "Are Local Property Taxes Important In The Intrametropolitan Location Decisions of Firms? An Empirical Analysis Of The Minneapolis-St. Paul Metropolitan Area," Journal Of Urban Economics, 1985, 226-34

(19) Feldstein, Martin, "The Effect Of Marginal Tax Rates on Taxable Income: A Panel Study of The 1986 Tax Reform Act," Journal of Political Economy, 1995, 551-572

(20) The NBER has published research on the issue of tax rates in recent years. One paper concluded, "The greater the decrease in the sole proprietor's marginal tax rate between 1985 and 1988, the greater the increase in the size of his or her business." Carroll, Robert, Douglas Holtz-Eakin, Mark Rider and Harvey Rosen, "High Income Taxes Inhibit The Growth Of Small Firms" (Cambridge: NBER Working Paper No. 7980)