July 09, 2008 News & Features » Cover Story


Love, Happiness and Higher Taxes 

It's nearly universal public policy: Lowering taxes makes the economy stronger. But what if the opposite were true? .

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As legacies go, shepherding through the state's largest tax hike since former Gov. Mills Godwin's sales tax has its drawbacks. Especially for upper-echelon politicians with sights set on the White House or say, the U.S. Senate.

Yet Gov. Mark Warner faced a different predicament in 2005 as he entered the victory-lap stage of his four-year term in the executive mansion. He left office with the highest approval ratings of any Virginia governor in recent memory: 76 percent.

That statistic comes with bragging rights. After all, Warner had done the unthinkable: He convinced anti-tax Republicans in both chambers of the General Assembly that the only way to fix the state's dire financial straits was to strap on a $1.5 billion tax increase. This in a state so fixated on taxes that Warner's predecessor, Republican James Gilmore, ran and got elected primarily on a single campaign promise -- to eliminate the car tax.

Of course, you won't find any mention of the historic tax jolt in Warner's bid for the U.S. Senate. That's Gilmore's message in his bid for the same seat. Every chance he gets, Gilmore talks about the tax-and-spend Warner's broken promises -- he'd vowed during his gubernatorial campaign not to raise taxes.

But he did. And now Warner's chief tool for cleaning up the state's financial morass and achieving near rock-star status as governor, which led to a very brief but serious presidential bid, somehow has become ammunition for his chief antagonist. Such is the disdain for the government kitty. To tax or not to tax. The debate will be on full display as the two former governors and their polarity square off for the U.S. Senate. Warner promises to clean up the fiscal mess in Washington the same way he straightened out Virginia's books (thanks, in part, to the tax hike). Gilmore promises to make cutting federal taxes his top priority.

Regardless of where one falls in the political spectrum, it's a widely held belief that easing the tax burden on people and businesses is the best way to grow the economy, spur private investment, increase productivity and create jobs. In macroeconomic textbooks, the idea's often taught without debate, asserted as a policy-making rule of thumb.

It's the reason Warner, despite all of his success doing much the opposite, won't dare run his campaign with a promise to raise taxes. It's the reason Gilmore can make banning federal tax increases his top priority even though his no-car-tax pledge is largely responsible for the giant budget shortfall his administration left in 2002.

But what if the opposite were equally true? What if higher taxes had a positive effect on the economy, on private investment, on productivity and job creation?

It's not so far-fetched. In fact, the idea that higher taxes may be good for us has been around since the birth of the country. But ever since former President Ronald Reagan made "trickle-down economics" the GOP's fiscal mantra, tax increases have largely equated to political death, disappearing from the policy lexicon of even the most left-leaning liberals.

But the case for higher taxes, however politically unpalatable, is a powerful one. The Warner administration may be a case in point.
In the months before he left office, Warner told Style Weekly: "The thing that constantly amazes me about the opposition is: If you look at the lowest tax states in the country, they are not the states with the fastest-growing economy, they are not the states with the best schools. They are not the states that have the most jobs or the lowest unemployment rate.

"I think one of the reasons why Virginians generally think we're moving in the right direction," he said, "is because they've been sold a 'you can have it all for nothing' approach. And they saw where it landed us. It landed us on the verge of bankruptcy."

Warner, naturally, wouldn't take his argument to its natural conclusion. Essentially, his success challenges the very foundation of the fiscal, anti-tax conservative base, which rose to the forefront in the Reagan years. The underpinnings of Reaganomics and the trickle-down theory holds that tax cuts -- particularly for the rich -- stimulate private investment at the top, which trickles down to the lower income brackets and benefits the entire economy. It's ingrained in the long-held economic theory that the rising tide lifts all boats: Higher taxes leads to government-deficit spending, which raises private interest rates and equates to less money for consumers to spend on retail goods and services and for businesses to spend on private investment and job creation.

While there are many variations of economic theory, in politics, the simplistic version is this: Lowering taxes translates into more money for consumers and entrepreneurs, who in turn send those dollars rippling throughout the economy.

One needn't look any further than the recent debate on Capitol Square over fixing the state's transportation crisis. While there are differing views on which fees and taxes to raise to generate money for much-needed road improvements, generally the politics can be split into two camps. There are those who oppose raising taxes at all cost -- the idea that the money is already there if we rein in existing government waste. On the other side are people who see a tax hike as the only logical choice.

The anti-tax folks, of course, won out. But there's still no money for road improvements. No one advocates ignoring the state's road crisis, particularly in places such as Hampton Roads and Northern Virginia, where idling through gas that costs $4 a gallon is hitting pocketbooks like never before.

All of this begs the question: What's better for the economy? No money to make road improvements and ease traffic constraints in exchange for keeping taxes low in the short term, or a hike in gas taxes today in exchange for better commutes tomorrow?

One can argue that raising taxes now is a bad idea -- it can reduce consumer spending in a spiraling economy. And few argue against the stimulating effects of periodic tax breaks and tax refund checks.

But raising taxes doesn't have to come at the exclusion of tax holidays. After all, how much impact would a penny per gallon tax hike really have on consumers? When Hurricane Katrina struck three years ago, many people predicted that rising gas prices would toss the economy into a recession. That was when gas was breaching $2 a gallon. In 2008, now pushing $4 a gallon (some 200 cents per gallon later) Virginians are only just beginning to alter their driving habits. Is a penny per gallon really not worth it?

William M. Shobe, director of business and economics research at the Weldon Cooper Center for Public Service at the University of Virginia, says such questions rarely penetrate the tax debate.

"Transportation is an input to production just like nails and concrete and labor, so every business needs transportation. Some need it more than others," Shobe says. "So the question is, 'Where do we stand? Where do we stand in this trade-off between the quality [of public services] and the level of taxation?'"

Almost everyone at the Statehouse agrees that Virginia faces a crisis regarding transportation dollars. But even those who propose gas tax increases -- from half a cent to a full penny per gallon -- cloak the pitch in desperation. It's not an option to consider unless we're facing an end-of-the-world scenario.

The no-tax-is-good-for-business philosophy is so pervasive that most macroeconomic textbooks even fail to challenge the assertion, says Arthur H. Goldsmith, an economics professor at Washington and Lee University. What if government spending on public infrastructure such as roads and schools had an equally stimulating effect on the economy? In a research paper published in the spring edition of the Journal of Economic Education, Goldsmith argues precisely this point.

"Borrowing to finance government consumption does crowd out private investment and thereby has the capacity to harm long-run productivity and output," he writes. "However, government investment spending by enhancing public capital improves productivity directly and may promote private investment, by enlarging profit expectations, further promoting productivity growth."

In other words, government spending on infrastructure, such as roads, actually helps make businesses more efficient, and therefore more profitable. So much so that "long-run growth fostered by government investment spending may exceed the detrimental effect on productivity associated with crowding out," Goldsmith writes.

Translation: The economic benefit of government spending on things like roads appears to outweigh the economic benefits of tax cutting.
Goldsmith isn't the first to challenge the notion that businesses always prefer lower taxes. In 2004, Robert Lynch, associate professor and chairman of the department of economics at Washington College, argued in a paper for the Economic Policy Institute, "Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development," that the average business tax burden is so small -- state and local taxes account for less than 1 percent of business costs -- that even eliminating taxes altogether would have little material effect on spending.
He argues that tax cuts, in fact, can result in higher costs to industry and businesses: "In the absence of adequate taxation, the provision of 'public' services becomes an internal cost to firms. Moreover, the costs of providing these 'public' services privately, in the relatively small amounts needed by individual firms, may be much higher than the costs of providing them collectively to all firms by the government.

"For example, it may be cheaper for a city to provide police protection to all firms located within its borders than it would be for each firm to pay for its own security force."

This might help explain why the Virginia Chamber of Commerce was out front pushing to solve the state's transportation crisis and, as strange as it may seem for the lobbying arm of local businesses, preaching the virtues of "new revenue" (an increase in fees or taxes). Imagine, businesses pushing for higher taxes.

This doesn't exactly surprise Greg Wingfield, president and chief executive of the Greater Richmond Partnership, the region's dominant economic-development agency. He says public services are equally if not more important to companies when they are deciding on a new location, for example. When making a pitch to lure, say, an automobile manufacturer into the state, Wingfield says it's important to show that Virginia has a stable tax structure and hasn't "tried to balance the budget on the backs of business." But typically the tax structure isn't the chief concern or selling point. Things like schools, roads and other public services are usually more important. And great schools and great road systems aren't achieved by chopping taxes.

"We are in the middle of the pack in terms of the income tax. ...We are not the lowest-tax state in the country," he says. "But I can argue if you look at the Mississippis, the Alabamas and the Louisianas, they have the lowest taxes in the country. But do they have the best economies in the country? The answer is no."

The state with the highest tax burden is Connecticut, according to the Tax Foundation in Washington, D.C., with New Jersey at No. 2, New York at No. 3 and California at No. 4. Virginia falls a bit higher than middle of the pack, at No. 12, but the least burdensome tax states are Alaska, No. 50; Mississippi, No. 49; Montana, No. 48; and West Virginia, No. 47.

The relatively recent phenomenon of states luring new businesses by offering generous tax breaks and incentives -- in order to compete with other states that also increasingly offer tax breaks and incentives -- can, if taken too far, hurt existing businesses.

"If you forgive a tax, you have to make it up somewhere else," Wingfield says, arguing that if you lure an automobile manufacturer to, say, Hanover County with five-year break on the machinery and tools tax, it "usually falls on the existing business base [to compensate] because the new company is going to be using water, it's going to be using sewer. I think we're letting the rhetoric take over the debate."

That doesn't mean the state shouldn't be offering tax breaks or working to reduce taxes, nor does it mean that government spending shouldn't be reined in and raked for inefficiencies. The push and pull over taxes that takes place in the political arena is an important check and balance. A blatant no-new-taxes stance, however, can be just as harmful to the economy as free-for-all tax increases, Goldsmith argues.

"Taxes on consumers hurt consumption, right? Taxes on savings, taxes on profit make business ventures, make businesses less desirable. But you have to account for the fact that tax revenue is then spent on something," Goldsmith says. "If we spent that money on boogie boards and ice-cream cones, then it probably on net would have a detrimental effect. But if we spent it on things that had an effect on work-force ability, activities, then you are going to likely have at the end of the day...a positive impact."

The economic literature is filled with similar insights. In a paper surveying the prominent research on taxation and economic development published in the New England Economic Review in 1997, economist Michael Wasylenko found that "taxes do not appear to have a substantial effect on economic activity among states."

The reason: With exception of the few states that deviate from the pack, like New York and California, the vast majority have adopted similar tax structures, making it largely a moot point. That's not exactly what state policy makers want to hear, however.

"States appear to overestimate the degree to which taxes affect economic outcomes and hence are not very receptive to the finding that taxes have little effect," Wasylenko writes, "nor to the explanation that, from a national perspective, firm location and economic activity are zero-sum games for states."

Politically, higher taxes aren't likely to come into vogue anytime soon. And certainly the state of the economy plays a bigger role in the public's willingness to accept tax increases than, say, a transportation crisis and a recession fueled by rising gas prices.

"The difference between Kaine and Warner: Kaine's proposal is coming at a very lean time," says Larry J. Sabato, the longtime political science professor at U.Va. "If people are fat and times are good, you can push a tax increase. I would have said the same thing in the 1960s when Mills Godwin passed the largest increase in taxes in Virginia's history." (The former governor implemented the sales tax to fund the state's community college system.)

Which version the public will buy in November will offer a crucial test. Gilmore bets his no-car-tax pledge still resonates. Warner bets Virginians will remember how he cleaned up Gilmore's mess and put the state's finances back in order. But you won't find anyone on either side blaming the state's financial problems on tax cuts. And we're a long way from politicians campaigning for tax increases.
Goldsmith says this fear of taxes is preventing any reasonable discussion about government spending.

"To me we are wasting our energy on the wrong questions," he says. "It strikes me as naive. We are borrowing and spending $100 million a month to support our activities in Iraq and Afghanistan. Is that spending promoting productivity and economic growth?"

The better question, Goldsmith says, is whether the state is allocating its taxes, or even raising taxes, to pay for public infrastructure that is productivity-based -- things like roads, bridges and other infrastructure that make it easier for industry to operate in Virginia. If improved roads in Hampton Roads reduce travel time for a trucking company, they increase productivity, which leads to increased profits and job creation.

"I think we are having the wrong conversation in this country -- should we be spending more or less?" Goldsmith asks. "We can't have a conversation about public-private partnership...when we spend all of our time on the notion of, 'Is any government spending good or bad?'" S


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