Minnesota’s Budget Deficit: Research shows that high tax rates restrain economic growth

On Tuesday, Minnesota Management and Budget forecast a surplus of $641 million for the FY 2020-21, which ends next June, but a deficit of $1.273 billion for FY 2022-23. This next biennium will be the main focus of the upcoming 2021 legislative session. As we explained on Monday when we launched our new paper Minnesota’s Budget Deficit: Why we should make spending cuts and not raise taxes, the state constitution requires a balanced budget each biennium. Lawmakers in St. Paul must ask themselves the question: how will we close this deficit? They will have three options: higher tax rates, lower spending, or some combination of both.

High tax rates restrain economic growth

As we noted yesterday:

The dollar amount of tax revenue seems far more likely to be a function of the size of the state’s economy than of its tax rates. This means that if you want more money to fund government services, you should look to increase the state’s GDP rather than hike its tax rates.

In fact, for public finances, a tax hike is actually bad news. The balance of empirical research on the effects of state tax rates on economic growth is clear: high tax rates and tax hikes slow economic growth.

In a review of the literature measuring the impact of taxes on economic growth, economist William McBride concluded:

…that there are not a lot of dissenting opinions coming from peer-reviewed academic journals. More and more, the consensus among experts is that taxes on corporate and personal income are particularly harmful to economic growth, with consumption and property taxes less so. This is because economic growth ultimately comes from production, innovation, and risk-taking.

Of the 26 papers reviewed by McBride, 23 – 88 percent – find a negative impact of higher tax rates on economic growth. The other three papers find no effect. Not one paper finds a positive effect. Of the six studies looking at state tax rates specifically, every one found a negative impact of high taxes on economic growth.

More recent research corroborates this conclusion. Of twelve papers looking at the impact of taxes on economic growth published since 2012, seven find negative effects, the other five find ‘mixed’ or ‘unclear’ effects, and none finds a positive effect.

Furthermore, research suggests that the negative effects on economic growth from increased taxes are more pronounced when, as in Minnesota’s case, taxes are already high. In a paper titled ‘Non-linear Effects of Taxation on Growth‘, economists Nir Jaimovich and Sergio Rebelo find that:

“Low or moderate tax rates have a very small impact on long-run growth rates. But as tax rates rise, their negative impact on growth rises dramatically.”

As we noted on Tuesday, Minnesota already has some of the highest tax rates in the United States. So, not only would tax hikes be bad news for public finances, they would be especially bad news in Minnesota.

John Phelan and Martha Njolomole are economists at the Center of the American Experiment.