As a result of the national economic slowdown since 2001, most U.S. states currently face severe budget shortfalls, and state legislators are considering myriad ways to alleviate the fiscal imbalances. The obvious solutions must involve either slashing state government spending or raising various state taxes. What needs to be carefully considered in these deliberations is that these fiscal contractions may have profound immediate and permanent consequences on economic growth. Also, the choice of policy may set the state on different short-run and long-run growth paths, thus policy makers would benefit from an analysis that examines the consequences of policy shifts on state economic growth.
Ascertaining determinants of long-run growth is of global as well as national interest, because analyzing reasons for economic growth within a country is a necessary prerequisite for tackling the problem of convergence in per capita incomes between different countries. Yet simply determining whether sustained economic growth is occurring within different areas of a country is a difficult task. Many economists, including Barro and Sala-i-Martin (1995) and Carlino and Mills (1993), have investigated if different regions of a country follow similar growth trajectories or in fact have their growth paths predominantly determined by initial conditions. The cases of Italy, with its consistently richer northern and poorer southern regions, and Canada, with its corresponding richer western and poorer maritime provinces, demonstrate that regional income convergence is not ensured for all countries, even developed ones. These cases also pose hard questions for policy makers, because these poorer regions have for decades been aided substantially by national governments in an effort to harmonize incomes across the countries, yet have not always achieved the desired goals.
Though there may be many possible reasons for disparate growth rates within a country, one conjecture involves differing state or regional tax rates. State fiscal policies may have profound effects on a state's economy. Papke (1991) examines the effects that state and local tax differentials have on business location decisions and finds that high state tax rates reduce the creation of new firms across most industries. As far as taxes comprising the bulk of a state's revenue base, higher income tax rates may also hinder economic growth by eroding incentives to work, save, and invest. Higher corporate taxes may cause either the migration of businesses to other states or an increase in the number of business failures. Higher sales tax rates may prompt purchases of goods and services in other states or through the Internet and mail-order catalogs, and higher property tax rates may keep households from purchasing (rather than renting) homes.
The theoretical literature on the relation between fiscal policy and economic growth is mixed. On the one hand, most economists agree that higher tax rates initially lead to lower levels of economic output, and thus lower transitional growth rates. However, there exist several different views about long-run growth effects, with some authors claiming that fiscal policies have no long-run growth effects, whereas others assert that higher tax rates lead to permanently reduced rates of growth. The latter view at first seems intuitive. States or regions with higher tax rates tend to drive away businesses and/or households, which ceteris paribus cause growth to suffer. However, on further reflection, an increase in tax rates may not always lead to diminished state or regional growth, nor are higher tax rates always unpopular. In 2002, voters in Massachusetts rejected a proposed ballot measure that would abolish the state's personal income tax. These voters agreed to pay higher taxes in exchange for improved public programs that included educational and environmental improvements. Thus if increasing state tax rates also causes public expenditures as a share of state income to increase, with a corresponding increase in tangible public spending that benefits households and/or businesses, then the possibility exists that a state's economy will experience at least short-run growth. …