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Laffer’s Flawed Analysis on State Taxes

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If you plotted a chart showing that every single day, a rooster crows at dawn and then the sun comes up, would you have proven that the rooster caused the sunrise?  Of course not.  Unfortunately, some of the “analysis” purportedly showing that state taxes are bad for a state’s economy is similarly lacking in rigor — and can be terribly misleading.

David J. Shakow, professor emeritus at the University of Pennsylvania Law School, took a close look at one such study, which Arthur Laffer presented in the Wall Street Journal in October.  He found that Laffer not only made the rookie mistake of confounding correlation and causation but relied in part on questionable data.

Laffer, of course, is an icon of anti-tax economics.  Best known for the widely discredited “Laffer Curve” (which claimed that cutting taxes would increase revenue), he is frequently invoked by anti-government elected officials to justify policies that undermine the ability of states and localities to pay for services.

Laffer’s study argued that creating a state income tax has “devastating” consequences for a state’s economy.  He claimed, for instance, that in each of the 11 states that imposed the tax in the past 50 years, personal income per capita is lower now, relative to the U.S. average, than it was in the year before the tax began.

Yet, as Shakow explains, the income data Laffer used for the “before” part of this comparison — the year prior to enactment of the tax — are “not consistent with the data from the most likely public source of this data, the Bureau of Economic Analysis.”  Laffer did use BEA data for the “after” part of the comparison (and everywhere else in his study).  In short, his study isn’t the apples-to-apples comparison it claims to be.

When Shakow did a true apples-to-apples comparison using BEA data throughout, he found that seven of the 11 tax-imposing states had increases in per capita income relative to the U.S. average.  As for the four remaining states (Ohio, Illinois, Michigan, and Indiana), “The economies of those Midwestern industrial states are in such serious trouble that it seems unlikely they would have done much better if they had not introduced an income tax,” he notes.

Even if Laffer were right about personal income dropping in states with income taxes, he provided no evidence that the income tax was the cause.

When Shakow examined another of Laffer’s claims — that the tax-imposing states subsequently had lower economic growth — he found it equally lacking in providing support for causation.  Laffer ignored the possibility that other economic factors, such as changes to the U.S. manufacturing sector that affected some states more than others, could be at play.

“[T]he issue of causation is much more complicated than Laffer suggests,” Shakow cautioned.  “The danger is that one slice of the data may be misleading if it is not considered thoughtfully.”

Flawed analyses like Laffer’s could make it harder for states to raise the revenues they need to help families hit by the recession and to make investments needed to promote long-term prosperity.  The recession has caused a collapse in state revenues like none before.  It’s too big a problem to solve by cutting services alone.  A balanced approach that includes revenues is needed to make sure states don’t cause themselves long-term economic harm.