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Large personal income tax cuts are at the heart of the economic reforms proposed by the Economic Revitalization Task Force (ERTF). The ERTF has proposed cutting the top state income tax rate from 10% to 7% in 1999 and to 6% in 2001. Rates for lower income tax brackets would be cut proportionately. By slashing income tax rates, ERTF aims to make Hawai'i a more attractive place to locate new businesses, to undertake new investment, and to create new jobs. But are income tax cuts capable of achieving these goals? Or is ERTF placing too much faith in the power of income tax cuts to stimulate the economy? What can the people of Hawai'i reasonably expect from income tax cuts? Reviewing what economists know about the impact of income tax cuts on state economies, we consider whether the standard analysis also applies to the specific circumstances of Hawai'i.
How Large will the Stimulus be?
Will lower tax rates help to attract new business, investment, or jobs to Hawai'i? Recent studies of tax cuts in other states yield mixed results. Michael Wasylenko, an economist at Syracuse University, has surveyed the major empirical studies of personal income tax cuts at the state level (New England Economic Review, March/April 1997). He finds conflicting evidence regarding the efficacy of income tax cuts. Several studies find evidence that income tax cuts stimulate income or job growth, while other studies do not. In the studies showing positive effects, Wasylenko reports that a 10% cut in tax collections produces between 1% and 6% more economic activity, with an average impact of perhaps 3%.
One reason that the net effect of tax cuts is small is that most states have similar tax systems. Without large differences in state tax systems, business will make location and expansion decisions based on other important factors, such as the cost and availability of labor, public utilities, transportation, and the quality of public services such as education.
Hawai'i's income tax system is, however, significantly different from the other 44 states with personal income taxes. Hawai'i's personal income tax rates were among the highest in the USA in 1997. Only two states, North Dakota (12%) and Montana (11%), had higher rates. And Hawai'i's top rate of 10% kicks in at very low income levels, just $20,500 for a single taxpayer and $41,000 for a married couple. California, a state with a per capita income ($38,812 in 1996) close to Hawaii's per capita income ($41,772), has a 9.3% top income tax rate. However, that rate applies only to income above $223,390 for a single taxpayer and $446,780 for married taxpayers.
Because the top income tax rate in Hawai'i (10%) is far above the median rate for all states with income taxes (7% in 1996), reducing Hawai'i's top rate to 6% could significantly improve the state's competitive position for retaining existing firms and attracting new ones. Perhaps as important as the direct cost reductions would be the strong signal sent that Hawai'i's tax climate is becoming less draconian. This may be particularly important to firms with highly skilled workers earning incomes in the highest tax bracket. Software developers, biotechnology engineers, and financial managers are examples. Cuts in Hawai'i's income tax rates have the potential, therefore, to help slow the brain drain to the mainland of young, highly educated sons and daughters of Hawai'i.
The Costs of Tax Cuts
The benefits from income tax cuts must be weighed against their costs. The income tax cuts will entail a loss of revenues to the state. The Hawai'i State Constitution, like most other state constitutions, mandates that the Hawai'i's operating budget be balanced. This means that lower income tax revenues must be exactly balanced by reductions in state spending. These cuts in state services will affect decisions by businesses to locate in Hawai'i or to expand their operations here. Statistical studies as well as surveys of businesspeople show that public education, transportation infrastructure, and public safety are important determinants of economic activity. Thus, the overall effect of income tax cuts clearly depends on the value of state services that must be reduced because of the lower state revenues. This, in turn, depends on how much lower Hawai'i state revenues will be as a result of the income tax cuts.
The Hawai'i State Department of Taxation has estimated that ERTF income tax rate cuts will reduce Hawai'i income tax revenues from $996 million to $676 million in 1999 and 2000 and to $576 million in 2001. Even with proposed increases in the General Excise Tax, state revenue losses are expected to amount to $100 million in 1999 and 2000 and $200 million in 2001. The state's estimates of revenue losses are almost certainly too high for several reasons. First, if the lower tax rates stimulate more economic activity, then additional taxes will be paid on the income generated from those activities. Second, lower tax rates reduce the incentives for people to cheat on their taxes or to hide their income in legal tax shelters. Illegal tax evasion and legal tax avoidance yield lower tax savings when rates are low, so that fewer taxpayers can be expected to engage in these activities. These revenue gains will limit the net revenue losses from the tax cuts.
While ERTF's proposed income taxes cuts may not cause a one-for-one decline in state revenues, they will almost certainly generate lower revenues and therefore require reductions in state spending. To what extent these spending cuts harm state residents or the business climate depends on the specific cuts. Some state spending is surely wasteful and could be profitably eliminated. Here the ERTF is notably silent. Without specific reductions on the table, it is impossible to know whether low or high value services will be cutback. The ERTF's ambiguity about spending cuts means that until a package of proposed spending cuts is announced, the desirability of the income tax cuts cannot be properly evaluated.
In addition, the proposed
rate cuts
are not quite as large as they seem. Hawai'i state income taxes are
deductible
on federal returns for taxpayers who itemize. For these people,
reductions in
state taxes will be partially offset by higher federal tax liabilities.
For
example, a Hawai'i taxpayer in the highest federal bracket (39.6%) who
saves
$100 in Hawaii state income taxes will owe $39.60 in additional federal
income
taxes. Thus, the state government loses $100 in revenue and state
spending,
the taxpayer gains $60.40, and the federal government receives taxes
worth $39.60
that used to stay in Hawai'i. The Washington-based Center on Budget and
Fiscal
Priorities has estimated that $60 to $100 million will be exported to
the federal
government because of the Hawaii income tax cuts This estimate is
probably too
large because it does not take into account the large proportion of
taxpayers
(54.5%) who do not itemize on their federal tax return.
The Short and the Long Run
Wasylenko's survey of empirical studies of tax cuts found that they had a small but positive effect on economic activity. Yet like many other macroeconomic policies, income tax cuts may have very different short-run and long-run effects. In the short-run, balanced budget tax cuts require reductions in government spending. This may lead to employment losses in state government and in firms that sell goods and services to the State. While the cut in government spending will be partially offset by increases in spending by taxpayers enjoying higher after-tax incomes, the income tax cuts could produce a further short-run increase in unemployment and a decline in the growth of real income and overall economic activity. Once labor markets make the painful adjustments necessary to absorb the displaced private and government workers, then the long-run positive effect of the income tax cut will take effect. Such adjustments could take two to three years, a long time in the current depressed Hawai'i economy.
We conclude that while large income tax cuts could generate negative short-term effects on economic activity, by themselves they are likely to generate only small-to-moderate positive effects on the Hawai'i state economy in the long run. The empirical studies of tax cuts in other states provides us with a clear warning: while tax cuts are an important part of an economic reform package in Hawai'i, we cannot rely on them to bear the burden of generating future economic growth. Hawai'i's prospects will always be heavily influenced by economic conditions on the mainland and in Japan. And perhaps most important to future growth prospects are critical microeconomic reforms in Hawai'i that would improve Hawaii's economic climate.
