By: Jacob Goss and Chang Liu
Across the United States, states rely on taxes to fund most of their government expenditures. The tax rates vary across states, but, in general, all states rely mainly on three categories of taxes: sales, corporate and individual income. States rely on these taxes at varying rates. For example, Texas doesn’t collect individual income tax, while Washington doesn’t collect corporate taxes, and Delaware doesn’t have a sales tax, but altogether these three broad categories generally hold true across all fifty states. These taxes generate the majority of a state’s revenue, as income, corporate, and sales taxes each accounted for 35%, 5%, and 47% of states’ total tax revenue in 2012, according to the calculations in Fajgelbaum et al. (2018). And these revenues accounted for 4% of total U.S. GDP that year.
In Wisconsin, there is interest in seeing how the state compares to the national averages, and lawmakers are considering how changing the state’s tax system could affect its economic outlook. As shown in the table below, the state bears an interesting resemblance to the national averages. Wisconsin has a higher income tax rate than the national average, while the sales tax rates lies slightly below. Its tax revenues make up a higher share of GDP, and it has a lower unemployment rate, with a higher growth rate of GDP and lower per capita personal income growth.
In our paper “The Impacts of State Tax Structure: A Panel Analysis”, we investigate the impact of a state’s tax structure on its economy. We use a panel of all fifty U.S. states, and linear regressions to determine the relationship between tax rates and several key economic factors. In particular, we measure the state aggregate economy through state GDP, personal income through per capita real personal income, the labor market through the unemployment rate, and state tax collections through tax revenue and its volatility.
First, we analyze the impact of taxes on state GDP and personal income. Corporate taxes have a statistically significant negative impact on both GDP and personal income, while income taxes affect only personal income, and sales taxes effect neither. However, corporate taxes only have a small economic effect: a 1% increase in the corporate tax rate will lower GDP and personal income growth by only 0.01%. Individual income taxes have a much stronger effect, as raising the income tax by 1% will lower personal income growth by 0.93%. This relationship has strong economic implications, as it shows that raising personal income tax rates can be devastating to personal income growth, while corporate and sales tax rate changes have little or no effect.
To find the effects of different taxes on state government tax revenue, we run two separate regressions: one with tax revenue per unit of GDP, and the other with log tax revenue as the dependent variable. The former provides a more comparable statistic of tax collection across states (controlling for size of the economy), while the second allows the results to be interpreted as the percentage change in total tax revenue given a 1% change in any tax rate. This directly demonstrates how varying the tax structure affects tax revenue levels, a much more policy-relevant result.
We find that corporate and sales taxes have no significant impact on tax revenues, while income taxes have a positive effect on the tax revenue/GDP ratio and a negative effect on the tax revenue levels, especially in the short run. In particular, we find that raising the income tax rate permanently by 1% would initially lower tax revenue by 1% — 4%, followed by increases in future tax revenues. These results indicate that in the short run the negative impacts of raising the income tax rate on GDP and personal income dominate its positive effect on tax revenue per unit of output, leading to a negative effect on total tax revenue.
On top of this, we look at the relationships between tax structure and tax revenue volatility. We find that corporate and sales taxes have a significant positive impact on volatility, while the income tax does not. This suggests that, to maintain a stable tax base, states should rely more on income taxes and less on other sources of income, as corporate income and sales revenue are more volatile sources of state tax revenue.
For unemployment, we find none of the three forms of taxes have a significant impact at the state level. These results hold when adding robustness checks, like the tax rates from previous periods, and no relationship between state taxes and unemployment rate ever emerge. This study shows that tax rates are not statistically linked to unemployment.
Taken together, our results tell a compelling story. Increases in income taxes lower personal income growth and contemporaneous tax revenues, but income tax revenues might provide a stable tax base. Corporate and sales taxes, on the other hand, do not directly harm personal income or tax revenue, but they do give a significantly volatile tax base. This suggests that states may be able to rely on cutting income taxes to effectively generate GDP growth, and in order to maintain a stable tax base they should avoid relying solely on corporate and sales taxes.
Looking back at Wisconsin, the results suggest that the state can make meaningful economic changes through tax reform. Lowering the income tax rate should stimulate the economy, especially sparking the growth of per capita income, while not compromising tax revenues. If there were lost revenue from the tax reductions, an increase in the sales tax may offset the loss without harming the economy (although our results suggest sales taxes themselves do not significantly impact tax revenue), but at the cost of more revenue volatility. Corporate tax changes might not be as effective, especially given that the Wisconsin corporate tax rate is well above the national average.