John Hood: The right way to cut taxes

Sep. 23, 2013 @ 04:53 PM

RALEIGH — If your goal is to foster economic growth and job creation, there’s a right way and a wrong way to cut taxes on business. Fortunately, Pat McCrory and the General Assembly made the right choice.
The wrong way is to offer tax credits or other targeted incentives to companies based on where they locate or how they spend their revenue. In order for such incentives to create net economic value, the public officials who craft them would have to possess superior knowledge to that of private entrepreneurs, investors and managers.
But they don’t. Central planning fails not because government officials are dumb or have bad intentions but because no single person or group could possibly possess all of the constantly emerging and changing pieces of information necessary to make welfare-enhancing decisions.
Markets are far from perfect. In fact, perfection is impossible for human beings. Still, the reason the market process works better than central planning is that even as some market actors make bad decisions, others make good ones. That confines the damage done by the bad decisions and gives those in error a strong incentive to learn from their mistakes.
That’s the theory. What about the practice?
Since 1992, there have been some 200 peer-reviewed studies about the economic effects of state and local taxes. For overall tax burdens, 63 percent of the studies found negative associations with job creation, output, or some other measure of economic performance. The share of negative findings rises to two-thirds for corporate or business tax burdens and nearly three-quarters for marginal tax rates. In other words, all other things being equal, reducing tax rates on personal and business income is likely to have economic benefits.
But targeted tax incentives fare far worse than broad-based tax reduction. Only 25 percent of scholarly studies link targeted incentives to improvements in economic performance. In most cases, states or localities that offer incentives do not experience any noticeable change in their growth rates.
How can this be? The central-planning fallacy is one explanation. If governments reduce the effective tax burden on some firms, locations, or investment decisions, that creates a relatively higher tax burden on others. The resulting inefficiencies appear to offset whatever economic benefits may flow from granting incentives. Essentially, government ends up “betting” on the wrong horse.
In their 2013 tax package, Gov. McCrory and the Legislature chose to focus on rate reduction rather than extending or expanding tax incentives. North Carolina’s current 6.9 percent rate on corporate income will fall to 5 percent, and perhaps to as low as 3 percent in four years if revenue-growth projections are met. The state’s personal-income tax, which now tops out at 7.75 percent, will convert to a Flat Tax of 5.75 percent, thus making North Carolina a more attractive place to start or invest in new enterprises.
Eliminating special breaks and lowering marginal tax rates for everyone constitute sound tax reform by any reasonable definition. It’s also good for business.

John Hood is president of the John Locke Foundation and publisher of Representations of fact and opinions are solely those of the author.