By Michael Hicks | Ball State University
The chances are that folks learn most of what they know about economics in their late teens or 20s, in a high school or college class. It is also often the case that the person teaching that class learned most of their economics 30 or 40 years before that. So, it may easily come to pass that an adult nearing age 60 is attached to economic ideas that are really 75 years old. I am not the first to observe this. John Maynard Keynes noted that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”
Of course, there are abundant lessons to be had in the economic ideas of old. A person today could get on quite well in most professions knowing nothing more than economists knew about the world in 1946. Indeed, Keynes died in April of that year, and his influence lingers still today. But, as a profession, economists have come to learn more about the world in the past 75 years than in the 75 centuries before it. Some of those things have usefulness today.
Forty years ago, when I was a budding undergraduate economist, the policy world was eagerly tackling high tax rates. An advisor to Ronald Reagan, Art Laffer, received a great deal of attention explaining the benefits of reducing the 70% tax rate on high-income earners. His views gained plenty of following in the policy world. There was good reason for that. It seems pretty clear that a 70% marginal tax rate removes the incentive for much productive work.
What became known as the Laffer curve, asserted that government revenues could increase following a tax cut. In some cases, that is surely true. So, Mr. Reagan signed legislation that cut taxes on the very rich from 70% to 50% to 37%. However, that tax cut didn’t pay for itself, even in the 1980s.
At the same time, an important economic growth model developed in the 1950s enjoyed widespread acclaim. It predicted that poor nations would grow faster than rich nations. The reason for this is that places where capital investment is scarce would offer higher rates of return to businesses who invested there. So, poor places would naturally attract more capital and grow faster, while rich places would slow. The two would converge over time.
All this means that if you were an undergraduate student in the late 1970s–80s, you were taught that low tax rates and capital investment were the key to growth and prosperity. While the Laffer curve was never mainstream economics, it was common in policy circles. The capital-led growth model received a Nobel Prize in 1987.
Fast forward 40 to 45 years, and those once fresh-faced college kids are now governors, serve in legislatures and run local economic development policies all over the country. But, the lessons absorbed in the late 1970s–80s seems not to have been updated. That’s too bad, because economists made important new discoveries on both taxes and capital investment.
The Laffer curve died a pretty quick death. The failure of the Reagan tax cuts to pay for themselves killed it. But, a variant held on to public imagination — the notion that while tax cuts might not pay for themselves among existing businesses, they might cause families and businesses to relocate to a city. That would cause tax revenues to rise.
That idea too was quickly debunked in dozens of studies from economists of all stripes. But, one really interesting fact surrounding the question emerged. It turns out, people and businesses didn’t move to the low-tax cities and states. They were actually flocking to high-tax cities and states. Over the past three decades, that trend has accelerated. Today, almost all population and employment growth occur in places with higher taxes. That is a puzzle that is partially solved by research on the failings of the capital-growth models from the 1950s.
By the 1980s, the predictions of poor countries growing faster than rich counties failed to materialize. This attracted a great deal of research, which settled on an answer that today is obvious. It’s not capital that causes economic growth, but human capital. Workers and their education, skills, drive and capacity to adapt are the causal factors in economic growth.
This finding changed development policy in the third world, and helped fuel more poverty reduction in the past 30 years than the 30 centuries that preceded it. More importantly, it also explains why people, and especially businesses, might move to high-tax places.
Generally, places with higher taxes spend more on education, which has a positive, albeit loose, effect on school performance. Better schools mean more kids finishing high school and heading to college or strong post-secondary training. Higher taxes often mean better healthcare services, so more productive workers. Often it means communities with more livable neighborhoods, less crime, better sidewalks and well-maintained parks. So, for businesses and households, the anguish of higher taxes is moderated by the better public services that accompany it.
The lesson in all this is that policymakers who 40 years ago were told that capital and low taxes drove prosperity, might wish to revisit what they know about the matter. Modern economic research reveals a far more complete picture. To summarize it, families search for value, not cost, in the places they choose to live. They do this when they buy a car, a TV or their dinner, it stands to reason they do so in the place they live.
Businesses are even more attentive to value, moving businesses to where they are most productive, rather than where they are cheapest. But, we don’t need economic research to reveal this. If families and businesses ignored value for ‘cheap,’ then Indiana and Mississippi would be economic powerhouses, and Massachusetts and Washington would be vast economic wastelands.
The obsessive focus on lower tax rates infantilizes the decisions of families and businesses. Unless your vision is to make your city or state the ‘discount store’ of communities, it is time to focus on value, not cost. If not, you risk being the intellectual devotee of some long-discredited economist, or worse, steering your community away from prosperity.
Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University.