Gov. Mark Dayton wisely urged Minnesotans to use facts in the budget debate in a speech to the Chamber of Commerce. Despite this sage advice, he continued to rely on a flawed analysis as an important rationale for his budget’s higher taxes.

“If the lowest taxes equaled the highest job growth and the highest per capita income, public policy would be clear and simple,” Dayton told the Chamber. “In fact, however, the opposite is true. If you look at the last chart, two pages of your handout, people living in the states with the lowest taxes generally have among the lowest per capita incomes. And those states have inferior job growth,” he stated.

Gov. Dayton’s data analysis has multiple statistical mistakes. One critical error is selection bias. He looks at a small subsample of the available evidence that was carefully cherry-picked, instead of drawing a conclusion from all of the available evidence.

Dayton showed data from only six states in one table and from only eight states in a second table before drawing the specious conclusion that these cherry-picked numbers prove that lower taxes equal lower job growth and lower per capita income.

New Hampshire, for instance, was clearly picked for one table to “prove” that New Hampshire’s low taxes lead to New Hampshire being 46th in job growth in 2012, while New Hampshire’s high per capita income failed to appear in the other table. Similarly, Dayton’s tables suggest that North Dakota’s job growth comes from its high tax collections, instead of the Bakken oil boom that has led to both North Dakota’s job growth and a gusher of energy-related tax revenue.

Dayton’s analysis also suffers from a tiny sample, a lack of statistical hypothesis testing, and the omission of any control variables. These serious statistical flaws mean that Dayton’s inference that higher taxes equal higher incomes and job growth is not supported by his methodology.

Most peer-reviewed research examining the aggregate effect of state taxes finds “a negative relationship between taxation and growth,” while a few papers “do not detect any significant negative impact of taxes on growth” according to a careful literature review by economists Ergete Ferede and Bev Dahlby in last September’s National Tax Journal. This literature review does not find a robust positive relationship between aggregate state taxes and income growth.

Research on the aggregate effects of taxes is complicated by several technical issues of data quality. Aggregate measures of taxes mix more- and less-distortionary types of taxes. Aggregation also conflates productive public expenditures with wasteful public expenditures.

Even careful analysis of the aggregate effects of typical state tax and spending patterns doesn’t provide the best guidance about the economic consequences of specific increases in taxes and spending.

A better way to understand the effects of higher taxes and spending is to consider each tax hike and spending program on a case-by-case basis.

Each dollar of government spending costs the private sector both the dollar taken from people in the private sector plus the economic damage from all the ways taxes distort decision-making.

People change their behavior in response to changes in taxes. Higher income tax rates are a disincentive to work, work overtime, or work multiple jobs. Higher income tax rates penalize education and on-the-job-training by lowering the after-tax rewards for investment in productive human capital.

At low tax rates, this economic damage from taxes is small. But at higher tax rates, these negative effects of taxes are larger.

The tax bills in St. Paul would increase effective marginal income tax rates above 50 percent for some primary earners and above 60 percent for affected secondary earners. In other words, these taxpayers would gain less than the government from additional hard work to earn another dollar of pre-tax wages.

At the proposed federal plus Minnesota income-tax rates, each extra dollar of government spending is likely to cost the private sector around $1.25 to $3. I applied standard economic formulas and the proposed tax rates to a range of estimated behavioral responses from other economists’ research to produce this imprecise estimate.

The logical case for higher taxes and spending requires explaining why the private sector should shrink by more than a dollar for each additional dollar spent by the public sector.

Gov. Dayton should lead elected officials from both parties to eschew flawed analysis in favor of careful enumeration and consideration of the real costs of additional taxes and the benefits of each spending program based on the best possible analysis.

John Spry of St. Paul is an associate professor in the Department of Finance at the University of St. Thomas. He’s on Twitter at @JohnASpry .

House_Incidence_Analysis_2013 (5-11-12)

Senate_Incidence_Analysis_2013 (5-11-13)

Gov_Supplemental_Incidence_Analysis (5-11-13)

Let’s look at the numbers of how layers of taxes add up to effective marginal income tax rates over 60%:

Federal income tax rate             39.6%            (top tax bracket)

Federal FICA                            15.3%             (combined FICA tax rate up to $113,700 of each individual’s earnings)

Minnesota income tax               12.49%           (Revenue Estimate of a 8.49% tax rate + 4.0% surtax for the 2013 and 2014 tax years)

The combined effective marginal tax rate on secondary earners would almost never be equal to the simple sum of 39.6% + 15.3% + 12.49% = 67.39%.

This is because these hard-working taxpayers would better of deducting their Minnesota state income tax as itemizers on their federal taxes and because some of the FICA contributions may also be tax deductible.  However, even considering deductibility, the effective marginal tax rate would still be over 60%.

The type of taxpayer who would face effective marginal tax rates over 60% would be the secondary earner, filing jointly with their spouse who earned sufficient income to put the couple in the top federal tax rate, but as an individual makes under the FICA limit of $113,700.  For example a teacher, nurse, or home day-care provider filing jointly with a surgeon or successful owner of a business could have individual income below the $113,70 FICA limit, but enough joint income to be in the highest federal and Minnesota tax brackets.

Of course, the combination of several layers of taxes and phase-outs of government subsidies also produces extremely high effective marginal tax rates that can approach and exceed 100%!

Finally, Professor Steven Landsburg at the University of Rochester reminds us that “You Too Could Face 95% Taxation” from multiple layers of taxation on working now to spend when you are older.  (Source: Steven E. Landsburg, ‘‘You Too Could Face 95% Taxation,’’ The Wall Street Journal, March 15, 2011, p. A 22.)

Let’s look at the numbers of how layers of taxes add up to effective marginal income tax rates over 60%:

Federal income tax rate             39.6%            (top tax bracket)

Federal FICA                            15.3%             (combined FICA tax rate up to $113,700 of each individual’s earnings)

Minnesota income tax               12.65%           (Revenue Estimate of a 9.85% tax rate + 2.8% surtax for the 2013 and 2014 tax years)

The combined effective marginal tax rate on secondary earners would almost never be equal to the simple sum of 39.6% + 15.3% + 12.65% = 67.55%.

This is because these hard-working taxpayers would better of deducting their Minnesota state income tax as itemizers on their federal taxes and because some of the FICA contributions may also be tax deductible.  However, even considering federal deductibility, the effective marginal tax rate would still be over 60%.

The type of taxpayer who would face effective marginal tax rates over 60% would be the secondary earner, filing jointly with their spouse who earned sufficient income to put the couple in the top federal tax rate, but as an individual makes under the FICA limit of $113,700.  For example a teacher, nurse, or home day-care provider filing jointly with a surgeon or successful owner of a business could have individual income below the $113,70 FICA limit, but enough joint income to be in the highest federal and Minnesota tax brackets.

Of course, the combination of several layers of taxes and phase-outs of government subsidies also produces extremely high effective marginal tax rates that can approach and exceed 100%!

Finally, Professor Steven Landsburg at the University of Rochester reminds us that “You Too Could Face 95% Taxation” from multiple layers of taxation on working now to spend when you are older.  (Source: Steven E. Landsburg, ‘‘You Too Could Face 95% Taxation,’’ The Wall Street Journal, March 15, 2011, p. A 22.)

Dear Chairwoman Ortman and Members of the Committee,

I have been asked to provide some information about the economics of revenue estimates for your consideration by members of the Legislature.  My testimony and all errors are my own.

As Yogi Berra might have said, “forecasting is difficult, especially when it involves the future.”  Yet forecasting the gross and net receipts and change in state revenue from the proposed changes in lawful (charitable) gambling is especially difficult.  It is so difficult that no economist can claim accuracy in forecasting lawful gambling revenue from the gambling behavior of Minnesota consumers encountering new forms of gambling.

Forecasting sales of any new product launch accurately for decades is an impossible challenge.  In this case, it would require knowing how consumers will respond to the novel forms of gambling versus existing gambling.  It also requires knowing how paper lawful gambling receipts and lottery sales will fall due to the newly introduced forms of gambling.

The multiple Revenue Analyses for HF 1486/SF 702 and HF 2810/SF2391 show the difficulty of this estimation because of their wildly different guesses.  In several of the early iterations of Revenue Analyses, the Gambling Control Board said:

This estimate assumes that 50% of paper pull-tabs and tip boards would be eliminated in FY 2012, 75% in FY 2013, and by FY 2014 95% of paper pull-tabs and tip boards would be eliminated.

Then beginning in December 4, 2011 the Gambling Control Board said:

The introduction of electronic pull-tabs and electronic linked bingo will reduce the amount of paper pull-tabs sold by 20%.

There is obviously a large difference in revenue between the Gambling Control Board’s estimate that 95% of paper pull-tabs and tip boards would be eliminated and its estimate that 20% would be eliminated.  One thing we know for sure is that not all of the Gambling Control Board estimates can be close to being correct.

It is hard to understand how the Gambling Control Board estimated that the new forms of gambling would reduce paper lawful gambling but not have any negative effects on lottery sales and state revenue from the lottery.  Perhaps they just didn’t consider effects on the lottery in their estimation process.  This is a significant omission.

I am not able to vouch for the estimates provided to you from the Gambling Control Board.  Those Gambling Control Board estimates are highly uncertain.

In addition, reporters Elizabeth Dunbar, Marlys Harris, and Don Davis quoted me about the uncertainty surrounding forecasting revenue from novel forms of gambling.

Here are some highlights of Viard’s economic analysis of state sales taxes:

The sales tax exemption for consumer services has drawn scathing criticism from tax policy experts, who have uniformly condemned it as a source of economic inefficiency, complexity, and other problems.  The near unanimity on this issue resembles the consensus, documented in my article last June, condemning sales taxation of business purchases. Although it is both unnecessary and impractical to list all of the voices on this issue, I cite a few sources.

Hellerstein, Stark, Swain, and Youngman said:

Whatever the historical explanation for the limitation of the sales tax to sales of tangible personal property, it certainly does not lie in the dictates of sound fiscal or economic policy.  Indeed, tax economists long have deplored the exclusion of consumer services other than health and, in some cases, utility services from state taxation…

The most glaring flaw of the exemption of consumer services is that it causes resources to be inefficiently allocated, with too many resources allocated to consumer services and too few to consumer goods…

The economic case for neutral taxation of services is equally compelling, whether the economy is weak or strong…

Efficiency and simplicity both call for the transformation of state and local sales taxes into broad-based consumption taxes, with neutral treatment of the consumption of goods and the consumption of services.

Economists and public policy analysts generally think of the sales tax as a consumption tax. As such, it should be levied only on sales to consumers, and not on sales between businesses. Taxing intermediate purchases – including capital equipment, office supplies, and building materials – will cause tax pyramiding as one business passes the tax cost along to the next. Ultimately, this creates an additional (and hidden) tax burden on consumers who purchase the final goods and products, as noted in a 2009 presentation to lawmakers:

Pyramiding occurs when a tax applies at multiple levels of business production and distribution. The result of this typically would be to pass the tax along in higher prices at the next level of production (e.g., a manufacturer  who sells to a wholesaler). The tax burden “pyramids” or cascades at each level, so that the total burden on the consumer is higher than the statutory or nominal rate. Pyramiding favors vertically integrated or larger businesses. These businesses can minimize the multiple levels of tax by performing functions – that would be taxable if purchased from a third party – with employees.  Pyramiding also undercuts statutory exemptions (e.g., the sales tax paid by grocers gets passed along in higher grocery prices, despite the exemption for food products) that are intended to reduce regressivity or exempt necessities.

Viard’s article, Sales Taxation of Business Purchases: A Tax Policy Distortion, is required reading for any serious student of state tax policy.

Here are some highlights of Viard’s careful analysis and rejection of sales tax on intermediate business purchases:

actual state and local sales taxes diverge dramatically from the popular and textbook vision of the tax. One major flaw is the exclusion of a wide range of consumer services from taxation, which renders the consumer tax base much narrower than the textbook description suggests. The other crucial flaw, which is the focus of this article, is the imposition of tax on a wide range of business purchases; taxes on those purchases account for roughly 40 percent of nationwide sales tax revenue. The taxation of business purchases impedes economic efficiency and hides the true tax burden from the public…

A wide range of authors have discussed the economic distortions arising from taxation of business purchases. The following sources of inefficiency have been noted:
• The taxation of capital goods imposes a penalty on saving and investment, replicating the key flaw of income taxation. A recent Cato Institute report finds that state sales taxes, along with asset-based taxes on property, add about 7 percentage points to the effective corporate income tax rate in the United States.
• The choice between production processes is distorted, because firms have an incentive to use inputs and capital goods that are exempt from sales tax in place of those that are subject to sales tax.
• Firms have an incentive to vertically integrate, because production within a single firm is not subject to the tax imposed on sales between firms.
• The tax on inputs pyramids into the price of the final goods in an uneven manner, causing effective tax rates to vary across goods subject to the same statutory tax rate, which can distort consumers’ choices between different goods.

Evidence from statistical studies and simulations of economic models suggests that that the taxation of business purchases significantly impedes economic efficiency…

In 2002 Charles E. McLure Jr. identified the taxation of business purchases as one of many ‘‘nutty’’ features of state and local tax systems. Hellerstein et al. list the taxation of business purchases as a ‘‘structural flaw’’ of state sales taxes. State Tax Notes contributing editor David Brunori noted the ‘‘near unanimity among public finance scholars’’ against the practice and nominated it as one contender for the most egregious flaw of state tax systems…

Despite their image as consumption taxes, state and local retail sales taxes are actually imposed on a large volume of business purchases, resulting in significant economic inefficiency. Whether reform is pursued within the sales tax context or outside it, a reduction in the taxation of business purchases should be a high priority in efforts to improve state and local tax systems.

Source: Tax Policy Center http://www.taxpolicycenter.org/numbers/displayatab.cfm?Docid=3756&DocTypeID=2

Hat tip: http://gregmankiw.blogspot.com/2013/01/tax-progressivity-update.html

St. Paul Pioneer Press (MN) – Sunday, October 21, 2012

Jobs are the leading concern of voters as the election nears. People want to get the economy moving again. So why are some of Minnesota’s leading lawmakers sponsoring bills to create a “jobs tax” on Minnesota payrolls?

“Jobs tax” is the term Rep. Ann Lenczewski, DFL-Bloomington, uses to describe a poorly written corporate income tax code that penalizes the expansion of payrolls in Minnesota.

State corporate income taxes are based on the share of a firm’s payroll, property and sales that are located within the state.

Bills by DFL leaders Rep. Paul Thissen and Sen. Tom Bakk would base a third of the state corporate tax on the size of firms’ Minnesota-based payroll.

Corporations creating more jobs in Minnesota would get a larger tax bill as punishment for their expended payrolls. Minnesota would have the worst corporate tax environment in the industrialized world under the DFL leaders’ proposal.

These bills lack economic or common sense.

When you tax something you get less of it.

Taxing firms based on their Minnesota payroll sends a powerful message that Minnesota doesn’t want job-creating investments. Accounting firms will warn their clients against growing jobs in Minnesota.

The effect of the DFL leaders’ tax bill would be significantly higher taxes on Minnesota-based firms, like General Mills, and lower tax bills for their out-of-state competitors, like Michigan-based Kellogg’s, because of the larger Minnesota payroll of our homegrown companies.

Democratic economists agree with the common-sense notion that taxing Minnesota payrolls is harmful to our state economy.

Taxing the payrolls of corporations in Minnesota would reduce employment in Minnesota, according to research published in the peer-reviewed Journal of Public Economics by Professors Austan Goolsbee and Edward Maydew. Goolsbee was chairman of President Obama’s Council of Economic Advisors.

The proposed tax hike on Minnesota payrolls would cost Minnesota around 70,000 permanent jobs in the long run, according to the Goolsbee and Maydew estimates.

They also warn policymakers to consider the lost individual income tax revenue from lower Minnesota payrolls when evaluating a corporate tax increase.

Former Rep. Julie Bunn, DFL-Lake Elmo, a former Macalester College economist, sponsored legislation to end this tax on Minnesota job creation. She says ending the corporate tax formula that penalizes Minnesota-based payrolls will “make Minnesota more competitive relative to other states.”

In-state payrolls are reduced by taxes on in-state payrolls, according to data from individual businesses analyzed by non-partisan economists Kelly Edmiston of the Kansas City Federal Reserve and Javier Arze del Granado of the International Monetary Fund in the peer-reviewed journal Public Finance Review.

Thissen says he wants to tax “rich corporate interests” instead of ordinary Minnesotans. He may believe that government can collect taxes from the legal fiction of corporations without ever having to impose a tax burden on ordinary people. Nevertheless, experience and evidence reject this.

Professor James Hines of the University of Michigan and Kansas City Federal Reserve economist Alison Felix observe, “It has long been understood that it is nonsensical to say that businesses bear tax burdens.” Instead, real people bear the entire tax burden.

The Minnesota Tax Incidence Study says the corporate income tax is a regressive tax. A regressive tax hits the poor and the middle class harder than the rich. The DFL leaders’ tax bill disproportionately increases taxes on lower-income workers.

If we really want job growth, we should move from taxing jobs, investment and saving toward taxing consumption.

The 21st Century Tax Reform Commission proposed replacing the corporate income tax with broader consumption taxes to modernize our tax code. Political leaders should take another look at its evidence-based recommendations if they want to maximize Minnesota’s job growth potential.

John Spry is an associate professor in the Opus College of Business at the University of St. Thomas and was a member of the 21st Century Tax Reform Commission.