Published Oct 27, 2010

So, I’ve been looking into all of our candidates, and the positions generally cleave down a simple line. Sure, there are differences on a variety of important issues and many, many details, but one key factor stands out: do we need tax cuts to help business or not? If you believe that the answer is yes, then you’re almost required to vote for one candidate; if you believe taxes aren’t a major issue, then it’s likely that the candidate on the other side is more appealing.Now, there’s a lot of rhetoric on either side of the issue. I’m going to try to bypass a lot of the economic theory disagreements and start from a basic question: are our taxes on business high or not? (tl;dr: no, in fact high taxes are good for California.)My approach to this question is going to be a little weird: I’m going to proceed from the insight that, in the past, California was a highly-competitive state. Companies chose to locate here, we were a center of innovation, we had the best universities in the world, and our economy was larger than most countries’. Starting with aerospace in the 1950s, through semiconductors in the ’70s, computers in the ’80s, biotechnology in the ’90s, and the Internet in the ’00s, we’ve been leading members of the economy not just of the United States but of the whole world.Clearly, back in some good old days, things were going well. We made the right moves to incubate all of these industries and take a leading role in their growth. In fact, it seems reasonable to me to assert that whatever we were doing back then was a best practice that we should seek to emulate, unless we can come up with a specific reason not to.So, are our taxes higher now than they were then? If so, logic might suggest that we should cut them. If not, logic might suggest that our problems stem from areas other than taxes.

Are Our Taxes High?

I chose to measure taxes on business as a % of state GDP. This has the advantage of putting the amount of money collected in context, while still being pretty easy to understand. (My tax numbers come from the US Census Bureau, and go back to 1963.)So, here’s California’s state taxes:
The green line is California. The magenta line is the average of all states. The pink line is the long-term average of the magenta line, with the dashed pink lines showing 1 standard deviation above and below that line. Here we can see that California seems to have somewhat higher taxes, although, taking the long-term average of the California tax vs. that long-term average of all states’ taxes, California’s taxes are only about 4% higher. (That’s not 4% of GDP, that’s 4% of the total tax level, or about 0.2% of GDP. The scale of the chart to the left exaggerates the difference.) (Oh, and what’s a standard deviation? Well, 60-some percent of the points you have in most any set of data will fit within one standard deviation of the average. Standard deviation’s an attempt to say whether or not a data point is average. A point within two standard deviations is, statistically, probably average. A point within one standard deviation is, statistically, probably really really average. So, everything within those dotted lines is probably pretty much the same.)Now, as I said above, I want to compare to past, successful times in California, not to practices in other states that may or may not work. So, I re-graphed California’s tax levels as the difference between that year’s tax level and the long-term average tax level.
The blue line is obviously the tax level. For context, I’ve got dotted lines at one standard deviation above and one standard deviation below. As you can see, most every year of taxes is within one standard deviation, or, as they say in the math business, “the same.” (In fact, if I’d put in two standard deviations, only the top and bottom peaks in that line would actually fall outside that level — again, from a mathematical point of view, the tax level has remained about the same.) However, the upward trend is undeniable. Compared to past California taxes, we’re about the same but increasing.

But Wait…

So I wanted to compare California to past glory days: that demands a standard for glory. I’m defining glory as “being the best damn state in the Union.” In economic terms, I want to see when California’s share of the US GDP was maximized. So, let’s overlay that on the graph we just saw (State GDP numbers from the BEA):
The new red line is that standard for glory; again, I have dashed lines at one standard deviation out. As with the tax line above, I’m showing the difference from the long-run average share of US GDP; when the line is above 0, California’s doing better than average, when it’s below, worse. Here we see something funny: the state’s share of US GDP seems to have an upward trend, just as the share of taxes has an upward trend… that is, higher taxes don’t seem to hold back the state’s awesomeness.This eyeball result surprised me a little, so I double-checked it. Turns out the math proves that impression out. The r-squared of these results, a statistical measure of how highly related the two numbers are, is 0.53 on a scale of 0 (not at all) to 1 (completely) — that’s not tremendously high, but it is noticeable. Even more, the direction of that correlation is positive — that is, for each increase in tax, you get a commensurate increase in share of US GDP.Another way of saying that is: California seems to be most successful when taxes are high.

Are Some Taxes High?

OK, but we hear a lot about capital gains taxes and about death taxes and things like that. Is it possible that the problem isn’t the overall business tax level, but on specific components of the tax that businesspeople would be exposed to. My data set breaks down taxes by type, so, let’s take a look:
This graph just shows the breakdown of total taxes by tax type. At the top, in brown, is the “death tax” — as we can see, not much. The yellow Select Sales Tax is sales taxes on specific items, mostly gas and sin taxes. At the bottom is the light blue property tax, not a big part of overall taxes for businesses even before Prop 13. Unfortunately, two big tax components are subsumed in other, larger components, and I don’t have the data to break them out:
  • Gross Receipts tax is part of General Sales Tax. This tax is significant just because California subjects many small businesses to this tax, while other states don’t. I may or may not deal with that in another blog entry, but it’s interesting to know.
  • Capital Gains Tax and Personal Income Tax are both in the blue of Individual Income Tax.
Anyway, as we can see, there’s been a long-term trend to collect fewer regressive sales taxes, and an increase in collection of the Income Tax group of items. Since I don’t have the breakdown, I can’t tell you if this means new income taxes, or just that capital gains have become large thanks to a booming economy and a vigorous investment capital market.

But, Once Again, Wait…

However, we can ask, just like we did for the overall tax levels: do these tax components lead to awesomeness or not? After all, we could find ourselves in a situation in which some taxes were higher than they should be, and others lower, and thus taxes need to re-balanced within an overall tax level, for maximum efficiency.So, I did the same thing as the above: I looked at the correlation between each individual tax level and that year’s CA share of US GDP:
Obviously, that’s Greek to 90% of my readers. Let’s just say that this shows a strong correlation. (Severance tax is at 0 because it’s so low in CA to be measured here.) This further suggests that lower taxes lead to a higher share of US GDP. Except, upon further thought, looking at current-year correlations doesn’t make sense: after all, higher current-year taxes should lead to lower current-year investment which leads to lower future growth and thus lower future share of US GDP, not lower current share of US GDP. So, I re-ran the correlation, seeing how one year’s taxes affected the next year’s share of US GDP:
OK, again we have a pretty good predictor, except you’ll see that the column under Coefficients has changed sign from negative to positive. That’s pretty important, because the coefficient tells us the direction of the relationship. In the first correlation, we see negative coefficients; that means, for each one percent increase in taxes, you see that level of decrease in share of GDP. But, looking at future returns — as I understand the argument for lower taxes suggests we should — we see that a one percent increase in taxes leads to the coefficient’s level of increase in share of GDP. That is, higher taxes lead to higher future GDP.Just to double-check, I used share of US GDP four years in the future, instead of just 1 year:
The result is: about the same; higher taxes lead to higher future share of GDP. It’s notable that every single kind of tax has a positive coefficient — there doesn’t even seem to be one that pulls down future share of GDP. In fact — fun fact here — the negative Intercept coefficient suggests that, if we set taxes to 0, we’d get negative growth over the long term.

So, What’s The Skinny On Taxes?

Given the data here, it’s reasonable to interpret things thusly:
  1. California’s strength is in industries that are complicated and involve a lot of intellectual property development (see: aerospace, semiconductors, computers, biotech, internet, as described above)
  2. It takes substantial cash investments to develop this IP
  3. Therefore, California does well when it taxes highly enough to be able to make these investments
  4. Further, despite the state’s current parlous, um, state, California has invested its tax collections well enough in the past that these taxes have enabled business growth, not business closure
  5. And, thus, logically, we shouldn’t cut taxes, but instead need to get our spending house in order, to ensure that we continue to make these smart investments and enable future business growth in the way that we’ve enabled past business growth
So, does this mean that I’m for higher taxes across-the-board? No. But, I will say, that California’s strength depends on the government taxing and investing for long-term growth, not on the government getting out of the way.There may be other states where things should be libertarian, or just lower tax to stimulate some kinds of business growth; that doesn’t seem to be the way in which California has been competitive in the past. And, since we’ve been exceptionally competitive, shouldn’t we follow our own example first, before we try to be some other state? It’s logical enough that there should be some long-term successful strategy in which some states have higher taxes and invest those taxes in complex, investment-heavy businesses, while other states have low taxes and therefore attract the kinds of businesses that appreciate low-tax, low-investment environments. Let’s have our strategy. That’s how all businesses, and most stand-out states and nations, succeed.