December 2004 Editorial

Revenue Curves

Stop me if you’ve heard this one before, and I bet you have: NCCBI goes up to a legislative leader and says, “North Carolina’s taxes are too high. They should be reduced.” And the legislative leader replies, “Okay, but if we cut taxes by, say, $100 million, we will have to cut spending by $100 million. What do you want us to cut?”

If you’re waiting for the punch line, there isn’t one because most legislators have a dead-pan understanding of taxes. They think in straight lines and mathematical formulas. If tax rates go up by 5 percent, tax revenue will go up by 5 percent. If tax rates do down 10 percent, revenue will go down 10 percent.

We’ve never bought that argument because, as business people, we know that the economy doesn’t move in straight lines or follow mathematical formulas. It moves, it slides, it bulges here and shrinks there in response to many stimuli, including taxes. It doesn’t seem likely that a 10 percent increase in the sales tax, for example, will generate a 10 percent increase in tax revenue. The product will cost more, which will depress demand.  Conversely, a 10 percent reduction in the sales tax will stimulate demand and lessen the impact of the lower rate.

The noted economist Arthur Laffer, who was Ronald Reagan’s economic guru, first had this insight back in the early 1980s and described this inverse relationship between tax rates and tax revenue with his now-famous curve. In the 1990s, economist Robert P. Inman of the Wharton School took the idea down to the local level when he accurately predicted that Philadelphia would only worsen its budget deficit with another tax hike.

Finally, an economist has used North Carolina to test Laffer’s and Inman’s theories. The work by Reynolds Distinguished Professor Michael L. Walden of N.C. State, entitled “Dynamic Revenue Curves for North Carolina Taxes,” was published recently in the scholarly journal Public Budgeting and Finance.

After examining mountains of data, Walden found evidence confirming the predicted effects of the Laffer curve. His models concluded that in North Carolina, a 5 percent increase in sales taxes actually increases revenues by between 2.8 and 3.8 percent, whereas a 5 percent cut in sales taxes reduces revenues by between 3.1 to 3.9 percent. Walden found similar but less dramatic results when he crunched the numbers for individual income taxes and gas taxes. He couldn’t demonstrate the same result for corporate income taxes due to their fungible nature and differences in effective tax rates among our neighboring states.

In a letter to us explaining his research, Walden cuts to the chase: “Is there a link between tax rates and economic growth and jobs? My research says yes. A reduction of 1 percentage point in the individual income tax rate (with any reduced spending coming from programs other than education, highways and public safety) would increase personal income in the state by $5.1 billion. Assuming approximately $50,000 of income generates one job, this is equivalent to around 100,000 new jobs.”

And that’s no laughing matter.

-- Steve Tuttle