Winter 1997
by Robert Tannenwald and Alicia Sasser

States, when reforming their tax systems, are giving more consideration to economic competitiveness. In the wake of the 1990-1991 recession, the New England states are especially eager to expand employment and protect against economic downturns. And they are cutting taxes on business to further this end.

A popular trend in state tax reform is to lighten the burden on "exporters" -- companies that sell mainly to out-of-state customers. Massachusetts, for example, now taxes a smaller portion of their income. Ittaxes corporate income according to the percentage of sales made to in-state customers, rather than the traditional three-factor formula based on a blended percentage of in-state payroll, property, and sales. Massachusetts enacted this "single-factor apportionment" in recognition of the fact that the new tax rules provided incentives for exporters to remain, and expand, within the state.

Cutting taxes on some or all businesses may stimulate economic development. But these cuts cannot be considered in isolation. Because tax cuts lower revenues, states may have to raise other taxes (on individuals or on other businesses)or cut spending. Either option can impair economic development.

In recent years, states have been more inclined than they have in the past to cut spending in response to shrinking revenues, and to restrain spending growth as revenues have recovered. In the recession of the early 1990s, when revenues fell dramatically throughout New England, the largest cuts often came in higher education. And rather than cut their own budgets further, state legislators often chose to give less "local aid" to cities and towns,where the cuts had similar effects. Raising local taxes was difficult, especially in poorer communities, so cuts in local aid tended to result in cuts in spending. As the largest budget item, education often bore the brunt. At both the state and local levels, revenue cuts thus often led to reductions in education spending.

In as much as business tax cuts reduce state revenue,they reduce money available for education and local aid.While a markedly improved economy has allowed Massachusetts to grant business tax relief and raise spending on higher education and local aid, circumstances will not always be so favorable. Thus, it might be better to view business tax cuts not only as a stimulus to economic development, but also as a shift in development strategy. The policy potentially shifts investment from the public to the private sector, and from human to business capital formation.

When states cut business taxes as part of an economic development strategy, they should also consider the implications -- for economic development -- of the resulting spending cuts (or tax increases). When businesses decide where to locate or expand, they certainly consider a state's tax climate. But they also consider the quality of public services and availability of an educated work force, one of New England's greatest assets.

Business tax cuts might well be the best way to stimulate economic development. But policy makers should come to this conclusion with open eyes.
-- Robert Tannenwald and Alicia Sasser, senior economist and budget analyst at the Boston Fed.