The Bell Policy Center

Research Advocacy Opportunity Oct 21, 2011

Proposition 103 supports education while protecting economic growth

By Alec Arellano and Rich Jones

Executive summary
Proposition 103 on Novembers ballot will raise about $500 million annually for education over the next five years. It does this by increasing Colorados income tax rate from 4.63% to 5% and the state sales tax rate from 2.9% to 3%. These are the rates that existed throughout the 1990s a period of strong economic growth in Colorado. These revenues will be used to counteract deep cuts to education spending enacted in recent years and to help protect against further cuts. Opponents have argued that the increases in tax rates will slow economic growth, resulting in slower job growth than is currently projected. A thorough review of the research on economic development shows that while taxes matter, other factors, including the cost and quality of labor, quality of public services, proximity to markets and access to suppliers, are more important. Over the long term, investments in education that result in a better-educated and higher-skilled workforce will make

Colorado more attractive to businesses and help drive our economic growth. Economic analyses show that while tax increases are likely to slow job growth, increases in state spending tend to increase job growth. In fact, several studies suggest that the increased number of jobs related to additional state spending would exceed the losses due to tax increases. At a minimum, it is likely that these effects will cancel each other out. The decline in job growth driven by tax increases will likely offset the increase in job growth created through additional education spending. However, continued cuts in education spending will cost us jobs and, over the long run, will likely hurt the quality of our workforce, making Colorado less attractive to businesses and individuals looking to relocate. Passing Proposition 103 is good for Colorados students, their families and schools. It helps protect against future cuts in education spending, adds to our long-term economic competitiveness and does so without harming our economy. It is the right thing to do.

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Proposition 103 supports education while protecting economic growth

Introduction
On Nov. 1, Coloradans will vote on Proposition 103, a ballot initiative that would raise approximately $2.9 billion over five years to fund K-12 and higher education. The revenue would be generated by raising the income tax rate from 4.63% to 5%, and raising the state sales tax rate from 2.9% to 3%. These are the rates that existed in 1999, and both increases would be temporary, ending after five years.1 Advocates of the initiative argue it will help counteract deep cuts to the states education spending enacted over the past three years and help forestall future cuts. Proposition 103s sponsor, state Sen. Rollie Heath, argues that the initiative has huge potential to help schools.2 Colorados budget for fiscal year 2011-12 cuts education spending by $227.5 million over the fiscal year 2010-2011 budget, for an average reduction of $344 per student.3 According to the Colorado School Finance Project, Colorado spent $2,408 less per pupil in kindergarten through 12th grade than the national average of $10,586 in 2009-10, the most recent year for which data are available.4 Proposition 103 will help keep Colorado from falling further behind.5 Heath also argues that the initiative is needed to maintain an educated workforce that will help Colorado stay economically competitive with other states. Opponents of Proposition 103 call it a jobs killer and argue the initiative would deal a crushing blow to Colorados struggling economy as it recovers from the recession. In support of this claim, they cite a study carried out by Eric Fruits, an Oregon-based economic consultant, for the Common Sense Policy Roundtable, a Colorado-based research organization.6 Fruits study uses an econometric model to predict slower job growth in Colorado relative to a baseline forecast for the next five years if voters approve Proposition 103. He uses data from the Legislative Council staff to project that Colorado will add 320,000 jobs from 2012 to 2017 without Proposition 103. If Proposition 103 passes, his model predicts the Colorado economy will add 289,000 jobs, or 30,500 fewer jobs than his baseline forecast. In addition, Barry Poulson, senior fellow in fiscal policy at the Independence Institute, and John D. Merrifield, professor of economics at the University of Texas, authored a study using a model developed by Poulson to estimate the effects of Proposition 103 on economic growth and jobs in Colorado. They estimate that if Proposition 103 passes, Colorados economy will create 7,400 to 11,600 fewer jobs than it otherwise would over the period 2012 through 2016.7 This paper reviews the analysis contained in the opponents two papers, summarizes some of the academic literature relating to taxes and economic growth and presents data on the effects of tax increases recently enacted by other states. Finally, it describes the effect that Proposition 103 will have on economic growth and jobs in Colorado.

Fruits and Poulson studies

Both Fruits and Poulson cite a number of academic studies that examine the relationship between state and local tax rates and economic growth and employment levels. Fruits goes into much greater detail in reviewing the results of this literature and concludes that it shows two things: 1) Higher marginal tax rates are associated with reduced employment growth. 2) Higher marginal tax rates will have a negative effect on net in-migration trends, meaning fewer people will move to Colorado. Poulson essentially concurs with these findings, stating that taxpayers tend to migrate to states with lower taxes and that businesses respond to higher taxes by investing and relocating in states with lower taxes. Both rely on these findings in constructing the models they use to estimate the effects of Proposition 103 on economic growth and jobs. Neither paper provides sufficient detail to determine exactly how their models work, the factors used in the models or the relationships between the different factors that were used to generate their findings. Therefore, we cannot replicate their analysis, thoroughly examine the relative importance of different factors or check to see if spending on public services is accounted for in their analyses. However, other academic studies that examine how taxes and spending on public services such as education affect economic development lead us to conclude that their findings are exaggerated at best, if not completely off base.

Research on the effects of taxes, government spending on economic growth

Most of the academic studies of business location decisions find that state and local taxes are not the primary factor in deciding where businesses locate. Rather, factors such as the cost and quality of labor, quality of public services, proximity to markets and access to suppliers are more important. Because the effect of taxes on business location decisions is small, costs such as wages and other compensation can potentially overshadow the differences in taxes between states and localities.8 Taxes play a role, however, and research on the effects of state taxes on economic growth tends to focus

Proposition 103 supports education while protecting economic growth

on how tax cuts and other incentives affect economic growth. The effects of tax increases, while receiving less attention in the literature, are largely the mirror image of the tax-cut analysis. In any case, the research does not offer the clear consensus on the negative effects of tax increases that Fruits claims it does. Two of the major summaries of the research cited by Fruits (Bartik, 1991 and Wasylenko, 1997) find that taxes do have a small effect on the location of firms within a region. Generally, this effect is greatest when a states overall tax burden differs significantly from other states in the region. However, many of the studies included in these summaries do not account for differences among states and localities in the level of public services. They assume the amount of public services remains constant even though tax revenues are cut.9 In fact, an analysis of more than 100 academic studies on this topic finds that spending on public services has a positive effective on economic growth. It cites studies that found increases in spending for education and infrastructure, in particular, were most consistently correlated with economic growth. Other research also found public spending on services is linked to economic growth.10 A review of the academic literature on economic development showed that in 27 out of 43 studies, public spending was found to have a positive effect on economic growth. Spending on transportation had the clearest positive impact, but education spending also had a positive effect.11 Economists express the relationship between taxes and government spending on the number of jobs created in terms of elasticity. In other words, they examine how an increase in one factor, such as taxes, would affect another factor, such as jobs. If an increase in one results in an increase in another, it is expressed as a positive elasticity. If an increase in one results in a decrease in the other, it is expressed as negative elasticity. The magnitude of the effect is represented by a number. An elasticity of 1 indicates that a 1 percent increase in one factor will result in an increase of 1 percent in the other. Taxes are estimated to have a median long-run elasticity of negative 0.2 percent.12 This means that over 20 years, a 1 percent increase in taxes would result in 0.2 percent fewer jobs, if everything else was equal. On the other hand, the effects of government spending on economic growth are estimated to have an elasticity that ranges between positive 0.02 and positive 0.65.13 The data did not allow the author to compute a median elasticity for government spending. Again, this means that a 1 percent increase in government spending would result in between 0.02 percent and 0.65 percent more jobs, if everything else was equal. Another way to look at this question is to examine the multiplier effects that government tax and spending policies have on Colorados economy. Fruits and Poulson argue that the $500 million per year that Proposition 103 would raise in taxes will come out of the private sector, thus reducing spending and savings; this reduction in spending will reduce economic output. However, it is not clear whether they accounted for the fact that, absent the increased revenue generated by Proposition 103, it is possible that state and local governments will continue to cut education spending further, thus dampening economic activity. Nor is it certain whether they accounted for the fact that revenues raised by Proposition 103 will be allocated to school districts, colleges and universities and used to pay teachers, bus drivers and other workers and to purchase supplies from private vendors. These funds will circulate through the economy and increase output as employees spend their earnings on goods and services and the vendors use their revenues to pay workers, buy supplies and otherwise invest in their businesses. A recent study of the effects of mid-year state budget cuts found that $1.00 in mid-year budget cuts reduces state income in that year by around $1.70 and that $25,000 in cuts results in the loss of a job. Almost all of the jobs that would be lost are in the private sector, according to this analysis.14 To the extent that the revenue from Proposition 103 would be used to counteract cuts in education spending, it would add to total state personal income and employment. For example, if the $227 million in education cuts enacted in fiscal year 2011-12 are avoided, we estimate it will preserve about 9,000 jobs, many of which are in the private sector. It will also avoid the loss of $395 million in total state personal income. If Proposition 103 fails and state and local governments continue to cut education spending, every $1 in spending cuts to education would result in a $1.70 decrease in state personal income as teachers and other workers are laid off and contracts with private vendors are cancelled. The drag on Colorados economy from further cuts to education if Proposition 103 fails would be greater than the combined effects of an increase in taxes coupled with increased spending on education. Over the long term, however, investments in education should pay off, as businesses consistently say that the quality of a states workforce is an important factor in their location decisions. In fact, the Metro Denver Chamber of Commerces Economic Development Corporation promotes Colorado as the ideal climate for growing talented workers.15 Colorado ranks fifth in CNBCs 2011 list of the top states for doing business and Education is one of the deciding criteria for this ranking.16 General Electrics Prime Star Solar cited the quality of our workforce as one of the major reasons it

Proposition 103 supports education while protecting economic growth

chose to expand in Colorado.17 The current status of Colorados education system, though, gives cause for concern. In spite of its high ranking overall, the state ranks 30th in the education subcategory on the CNBC list. Whats more, Colorados per-pupil spending is $2,408 below the national average, and the state ranks 50th in a comparison of teacher salaries as a percentage of pay in comparable professions.18 While we cannot tell with precision whether the elasticity of taxes or the elasticity of government spending on job growth is stronger, it is clear that increased spending on education under Proposition 103 will have a positive effect on economic growth and the number of jobs in Colorado. It would likely offset any decline in job growth due to the effects of increased taxes and could result in a net increase in jobs due to the economic effects of increased spending on education. Over the long term, however, a well-educated workforce will be an important factor in making Colorado attractive to businesses and in promoting economic growth. Table 1

Average job and GDP growth (1987-1998)

Colorado Job growth GDP growth 3% 7.3%

U.S. 1.9% 5.8%

Source: Bureau of Economic Analysis

decisions to migrate, particularly for retirees.20

Colorados tax structure in comparison with that of other states

Although numerous studies suggest that a states level of taxation is not a primary factor in business location decisions or in the migration decisions of individuals, it is valuable to clarify how Colorados tax structure compares with those of other states. According to a 2010 report by the Colorado Legislative Council, Colorados combined state and local taxes of $95.53 per $1,000 of personal income were the seventh-lowest in the nation. In terms of state tax collections alone, Colorado ranks second-lowest. These rankings have remained largely stable over the last decade.21 Moreover, a comparison with other states in the west gives an indication of Colorados tax competitiveness. Among the 12 states in the western United States, Colorado ranks seventh-lowest for individual income taxes and ninth-lowest for corporate income taxes relative to personal income. Colorados overall combined state and local tax ranking is the second-lowest of these 12 states.22 If we consider tax rates as a factor influencing a states attractiveness to business and high-income individuals, it is clear that Colorado is already ahead of nearly all of its competitors in this region. Even with the temporary and relatively small tax increases proposed in Proposition 103, Colorado will remain one of the lowest tax states in the region and the nation. If passed, Proposition 103 will raise the states income tax rate from 4.63 percent to 5 percent, which is the rate that prevailed in Colorado from 1987 to 1998. Data from the Bureau of Economic Analysis shows that during this period, Colorados average rate of growth for both jobs and gross state product was higher than the national average for these indicators (Table 1). In fact, from 1991 to 2000 Colorado had the third-highest growth in gross state product in the nation and fourthlargest growth in employment.23 These data indicate that this level of income tax did not restrain economic growth.

Research on the effects of tax increases on migration

The other argument that Fruits makes that if passed, Proposition 103s tax increase will cause fewer people to move to Colorado and prompt some highincome earners to move away is not supported by the academic research. Recent research finds that increases in state tax rates do not prompt people to migrate. A study by two Stanford University sociologists found that New Jerseys 2.6 percent increase in its top income tax rate for those earning above $500,000 in 2004 did not cause these filers to leave the state. While the net outmigration of those with incomes exceeding $500,000 increased, so did the out-migration of those earning between $200,000 and $500,000. These people were not subject to the tax increase, and yet they left the state by about the same rate as those who had to pay it. The authors concluded the effect of the new tax bracket is negligible and did not appreciably increase the outmigration of wealthy residents. These findings mesh well with existing research that shows that the migration response to marginal tax policy changes is generally quite small, they said.19 Furthermore, a report by the Center for Budget and Policy Priorities that reviewed the academic literature on migration found that few Americans change their state of residence over the course of their lifetime, and those that do are drawn by cheaper housing and other cost-of-living expenses, rather than state tax rates. There is also evidence that other factors, such as the weather, are important considerations that affect

Proposition 103 supports education while protecting economic growth

Chart 1

Average monthly job growth (February 2010-August 2011)

Oregon 0.083% Washington 0.078% Idaho 0.088% 0.071% Nevada California

0.08% .06 .04 .02 0 -.02

of growth (Chart 1). Nevada, the only state of the five with negative monthly job growth during this period, extended through 2013 an existing sales tax rate that was set to decline by 0.35 in 2011.26 However, this extension was accompanied by massive cuts to public spending. Nevada was also hit especially hard by the collapse of the housing bubble.27 According to the September 2011 Oregon Economic and Revenue Forecast, Oregons 4.2 percent growth in the past year is better than all western states and the U.S. average. Oregons year-over-year increase ranks fifth-best nationally.28 Clearly, the comparison of Oregons growth with that of its neighboring states does not support the argument that increases in state taxes will automatically have a negative affect a states economic growth.

-0.022% Source: U.S. Bureau of Labor Statistics

Based on these analyses, we conclude that Proposition 103 will have a negligible effect on people moving into or out of Colorado. When coupled with our states natural beauty and high quality of life, Colorado is likely to remain attractive to businesses and others looking to migrate.

Conclusion
Proposition 103 will raise much-needed revenue for education by returning income and sales tax rates to levels in place throughout the 1990s a period when Colorado experienced strong economic growth and created jobs faster than all but three other states. Economic analyses of the effects of state taxes and spending on economic growth show that while tax increases are likely to slow job growth, increases in state spending tend to increase job growth. At a minimum, it is likely that they would cancel each other out, with the decline in job growth due to increased taxes being offset by the increase in job growth created through increased education spending. However, several studies suggest that increases in the number of jobs related to additional spending would exceed the losses due to tax increases. In any case, continued cuts in education spending will cost us jobs and, over the longrun, will likely hurt the quality of our workforce, making Colorado less attractive to businesses and individuals looking to relocate. Passing Proposition 103 is good for Colorados students, their families and schools. It helps protect against future cuts in education spending, adds to our long-term economic competitiveness and does so without harming our economy. It is the right thing to do.

Tax policy history in other states

A recent report from the National Conference of State Legislatures shows that, in the last 20 years, many states have increased taxes during and immediately after recessions to deal with declining yearend budget balances.24 Additionally, a report by the Center on Budget and Policy Priorities found states that enacted significant tax increases after the 2001 recession saw growth rates that closely matched the national average. By contrast, states that did not raise taxes, or cut them significantly, saw slower growth than average.25 In January 2010, Oregon increased income tax rates by approximately 2 percent for filers in the top tax bracket. A comparison of data from the Bureau of Labor Statistics for Oregon and its neighboring states shows that, in the year and half since this rate change, Oregons average monthly rate of job growth was greater than it was in the previous two recession years and greater than the rates for California, Nevada and Washington. It is only marginally less than Idahos rate

End notes
1

million is available to school districts beginning in early 2012 which will reduce the amount of overall cuts.
4

Colorado Legislative Council. 2011 State Ballot Information Booklet, Sept. 9, 2011. Hardin, C. (2011). Proposition 103: Loot Dreams. Colorado Springs Independent. Mitchell, N. (2011). Roller-coaster revenue ride. Education News Colorado. Because revenue estimates came in higher in June 2011 than originally anticipated, another $67.5

Colorado School Finance Project, Profile Data: 2011 Highlights, Summer 2011 Oldham, J. Colorado Voters May Raise Taxes by $3 Billion After Caps Sap School Funds. Bloomberg. Fruits, E. (2011). The Effects on Employment and Migration. Common Sense Policy Roundtable.

Proposition 103 supports education while protecting economic growth

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Poulson, B and John Merrifield, Proposition 103: What is the cost to Colorado Taxpayers?, Independence Institute. Fisher, P. & Ditsler, E. (2003). Taxes and State Economic Growth: The Myths and the Reality. The Iowa Policy Project. Fisher, P. & Ditsler, E. (2003) and Lynch, R. (2004). Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development. Economic Policy Institute. Lynch, R, 2004, p 43 Fisher, Ronald, The effects of state and local public services on economic development. New England Economic Review, March/April, 1997. Wasylenko, Michael, Taxation and economic development: The state of economic literature, New England Economic Review, March/April, 1997. Fisher, Ronald, March/April 1997. Clemens, J and Stephen Miran, The effects of state budget cuts on employment and income, Harvard University, May 10, 2010. Metro Denver Economic Development Corp. The Ideal Climate for Growing Talented Workers, 2011. CNBC, Americas Top States for Business 2011, June 28, 2011. Jaffe, M (2011), GE could double the size of its solar panel plant in Aurora, Denver Post, October 14, 2011. Education Week (2010). Quality Counts 2010 and Colorado

School Finance Project, Summer 2011.

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Young, C. & Varner, C. (2011). Millionaire Migration and State Taxation of Top Incomes: Evidence from a Natural Experiment. National Tax Journal. Tannenwald, R., Shure, J. & Johnson, N. (2011). Tax Flight is a Myth: Higher State Taxes Bring More Revenue, Not More Migration. Center on Budget and Policy Priorities. Kirk, R. (2010). How Colorado Compares in State and Local Taxes. Colorado Legislative Council. Kirk, R. (2010). Hedges, C, (2003), Ten Years of TABOR, The Bell Policy Center. Snell, R. (2011). Taxes on the Horizon? National Conference of State Legislatures. Johnson, N., Nicholas, A. & Pennington, S. (2009). Tax Measures Help Balance State Budgets: A Common and Reasonable Response to Shortfalls. Center on Budget and Policy Priorities. Nevada Department of Taxation (2011). Tax Rate Changes. Dostal, E. (2011). Biggest spending cuts, tax increases in Nevada history wont close budget gap, Assembly speaker says. Las Vegas Sun. Oregon Office of Economic Analysis, Oregon Revenue and Economic Forecast (2011). Economic growth is based on the growth in the states coincident index, which measures nonfarm employment, the unemployment rate, and real wage and salary disbursements.

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