AR-House Dist. 41: Garnering Dissent, Pt. 1 of 2

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While I have written at some length about the flaws inherent in a proposal to remove Arkansas’s capital gains tax, that post was written in the more general context of a blanket removal of all capital gains tax, regardless of when the asset was acquired.  Because Representative Ed Garner’s recently filed HB 1002 (2011) only address new capital investments and therefore carries a slightly different price tag, and because Garner proffered specific reasons for why he thought this was a good idea, I wanted to address the new bill directly.

I. Introduction

Based on Garner’s statements, it seems that the rationale behind his proposal is twofold: it will remove any competitive disadvantage Arkansas has vis-a-vis surrounding states, and it will create private sector jobs.  As he told Jason Tolbert:

Something that I’ve looked at for years is the non-competitive nature of Arkansas’s tax code [when compared] with surrounding states when it comes to attracting new industry and retaining capital investment in the state to grow private sector jobs.  And, from day one, since I entered the Legislature, the information that we have as far as what the timeline for Arkansas is, in terms of the demands for social services, etc., we are behind the curve. If we don’t create private sector jobs, our ability to maintain services in the state will deteriorate at a rapid rate.

Really, just beyond that, the need to create freedom of people to make choices about their life by earning their own paycheck and making decisions about what to do with that is enhanced, and Arkansas needs to move forward in that direction.  Quite frankly, economically, I feel like Arkansas is in a position to come out of the recession now ahead of the surrounding states because we do balance our budget, and we have a chance to become the most attractive place for business to grow and locate and better livelihood, better lifestyle for citizens in the state.  But that’s the private job growth, so this is the biggest bang for the buck, if it even costs anything at all; I maintain it may not cost us anything at all in terms of the state budget[.]

Here’s the problem with Garner’s argument: It’s wrong.  All of it.1

II. Competitive Disadvantage

Let’s unpack his statement, starting with the ideas that Arkansas is at a competitive disadvantage compared to surrounding states because of our capital gains structure.  First, check out this list:

  • Arkansas–4.9%
  • Texas–0%
  • Oklahoma–5.5%
  • Missouri–6%
  • Tennessee–0%
  • Mississippi–5%
  • Louisiana–6%

Those are the capital gains rates for Arkansas and its neighbors.  Texas and Tennessee do not have state income tax, which is why their rates are 0% and which makes comparing Arkansas to them a bit of an apples-and-oranges thing.  Nevertheless, we’ll include them in our discussion just for the sake of being thorough.

As for the rest of the neighboring states, Arkansas’s capital gains rate is already lower than the others’.  Thus, if Garner’s hypothesis is correct — if lowering the rate equates to competitive advantage against states with higher rates — we should see that advantage somewhere, right?  We should see something that shows Texas and Tennessee faring much better than the other states on this list, with the rest in an order that somewhat resembles their relative rates.

To test this theory, we’ll look at two measurements.  First, we’ll look at each state’s percentage of GDP and, in order to normalize for population (and remove the skewing effect of Texas having the 11th largest economy in the world), we’ll examine GDP per capita for each state.  Second, we’ll see how the states rank relative to one another on Forbes’ most-recent ranking of the best states for business, and we’ll also look at the apparent effect (if any) of capital gains rates on those rankings.

A. GDP by state and GDP by state per capita

The Bureau of Economic Analysis recently released the 2009 GDP per state (full report plus tables here).  In current dollars, Arkansas’s GDP (in millions) was $101,818.  The surrounding states were as follows: Louisiana–$208,377, Mississippi–$95,905, Tennessee–$244,508, Missouri–$239,752, Oklahoma–$153,778, and Texas–$1,114,695.  On raw numbers alone, then, one could get the mistaken impression that Arkansas was at some sort of disadvantage compared to its neighbors.2

What that overlooks, however, is that Arkansas’s share of the national GDP grew by .6% from 2008 to 2009 (the national percentage was -2%).  Surrounding states had various levels of success or failure, with Louisiana growing by 2.5%, Mississippi declining by -.9%, Tennessee down -3.1%, Missouri falling by -2.2%, Oklahoma up 6.6%, and Texas down -1.5%.  Arkansas, Louisiana, and Oklahoma (a group of which Arkansas has the lowest capital gains rate, recall) were in the top quintile nationally in GDP growth from 2008 to 2009. Conversely, Texas was in the third quintile and Tennessee was in the bottom quintile, despite both states’ having no capital gains tax or state income tax at all.

From this, I think you can draw two conclusions regarding GDP.  1. Having a comparatively low GDP does not necessarily have any predictive effect on whether a state will fare better or worse during an economic downturn.  2.  Coupled with the fact that Arkansas was one of only four states to end their fiscal year in the black, nothing about the state’s GDP or its current prospects for growth suggests that our capital gains rate is holding us back.

B. Comparative Attractiveness to Business

If Arkansas’s GDP does not prove Garner’s theory, there has to be some other measure, right?  Rather than raw numbers, let’s look at Forbes’ recent ranking of best states for business.  Using the same surrounding states (with capital gains rate again in parentheses) on the most recent Forbes list (dated 10/13/10), we get:

  • 7. Texas (0%)
  • 18. Missouri (6%)
  • 22. Tennessee (0%)
  • 32. Arkansas (4.9%)
  • 33. Oklahoma (5.5%)
  • 44. Louisiana (6%)
  • 48. Mississippi (5%)

And, just like before, going more broadly so that we cover the entire South, we have:

  • 2. Virginia (5.75%)
  • 3. North Carolina (7.98%)
  • 7. Texas (0%)
  • 8. Georgia (6%)
  • 22. Tennessee (0%)
  • 25. Alabama (5%)
  • 26. Florida (0%)
  • 31. Kentucky (6%)
  • 32. Arkansas (4.9%)
  • 33. Oklahoma (5.5%)
  • 34. South Carolina (3.92%)
  • 41. West Virginia (6.5%)
  • 44. Louisiana (6%)
  • 48. Mississippi (5%)

Even more broadly, here’s the Forbes top twenty (with capital gains rate):

  • 1. Utah (5%)
  • 2. Virginia (5.75%)
  • 3. North Carolina (7.98%)
  • 4. Colorado (4.63%)
  • 5. Washington (0%)
  • 6. Oregon (11%)
  • 7. Texas (0%)
  • 8. Georgia (6%)
  • 9. Nebraska (6.68%)
  • 10. Kansas (6.45%)
  • 11. North Dakota (5.54%)
  • 12. Idaho (8.2%)
  • 13. Iowa (8.98%)
  • 14. Maryland (4.8%)
  • 15. Minnesota (7.85%)
  • 16. Massachusetts (12%)
  • 17. South Dakota (0%)
  • 18. Missouri (6%)
  • 19. New Hampshire (0%)
  • 20. Delaware (5.95%)

Of those twenty, I see 14 with higher capital gains rates than Arkansas.  Comparing these rankings to last year’s Forbes rankings, we see an average upward movement of 2.71 places among the 14 states with higher rates.  Conversely, of the 6 states with rates lower than Arkansas’s, we see an average downward movement of .82 places, meaning a net gain of 3.53 of states in the top 20 with rates higher than Arkansas’s.  Somewhat tellingly, only one of the 6 lower-rate states had any upward movement at all from 2009 to 2010, and that state (Texas) moved only one place, from 8 to 7.

Or how about this example: of the nine states (including Arkansas) that impose a capital gains tax at a preferential rate compared to that state’s standard income tax rate, only one (11. North Dakota) is in the top 20 in overall ranking on that Forbes list, and it fell from number 7 to number 11 from 2009 to 2010.  The rest of the states with preferential rates check in at 24 (Montana), 32 (Arkansas), 34 (South Carolina), 35 (New Mexico), 43 (Wisconsin), 45 (Vermont), 46 (Hawaii), and 49 (Rhode Island).  That’s an average preferential-rate-state ranking of 35.44, and, from 2009 to 2010, those states fell an average of 4.22 places.

I think, based on all of that evidence, it’s a fair to reach the conclusion that Rep. Garner is just flat wrong, both in his assertion that Arkansas’s capital gains rate puts the state at a competitive disadvantage or that lowering that rate would have a marked beneficial impact on the state’s business climate.

It’s not surprising that he’s wrong, either.  After all, it’s fairly simplistic to suggest that any one business-cost measure would in itself make any state more appealing to business.  Simplistic ideas may make for good soundbites, and Lord knows there are a lot of people who will never sniff a capital gain but who are in favor of anything that sounds like “tax cut,” but that doesn’t mean that those simplistic ideas are good ideas.  It’s demonstrable that business costs are not the leading indicator of which states are going to encourage new business; looking again at the top 20 states for business, however, nine of the 20 are in the top twenty in business costs, while six are in the bottom 20 in those costs.  The number one state in business costs is 17th overall … one space behind the state that that is 50th in business costs.

III. Effectiveness of Capital Gains Cuts

Even if we accept that Arkansas is not at a disadvantage relative to surrounding states due to our capital gains structure, I suppose we still have to address Garner’s claims that removing the long-term capital gains entirely will lead to more jobs in the state and will spur Arkansas’s economic growth by attracting new industry.

A. Job Creation

If Garner’s theory about job creation is correct, one would expect to see some sort of correlation between capital gains rates (listed above) and unemployment.  But here’s the unemployment for each of those states as of September 2010.

  • Arkansas–7.7%
  • Texas–8.1%
  • Oklahoma–6.9%
  • Missouri–9.3%
  • Tennessee–9.4%
  • Mississippi–9.8%
  • Louisiana–7.8%

The three highest totals — Mississippi, Missouri, and Tennessee — have capital gains rates of 5%, 6%, and 0% respectively.  Arkansas’s 7.7% falls between Oklahoma (5.5% capital gains rate) and Louisiana (6%), and Arkansas (4.9% capital gains rate) has a lower unemployment rate than Texas (0% capital gains).

Going more broadly and looking at the entire South, Arkansas has lower unemployment than Alabama (8.9% unemployment, 5% capital gains), Georgia (10%, 6%), Florida (11.9%, 0%), South Carolina (11%, 3.92%), West Virginia (9.2%, 6.5%), and Kentucky (10.1%, 6%).  Conversely, we have higher unemployment than Virginia (6.8%, 5.75%).

Looking at the math, it’s fairly easy to see why cutting capital gains taxes, especially in Arkansas, would not create an appreciable number of new jobs.  As I wrote previously:

[An] additional $4.90 per taxable $100 in capital gains is hardly a windfall for a company…. Even if we were to buy the incredibly specious argument that every dollar saved by eliminating the capital gains tax would be re-invested into labor, it would take $128 in gross capital gains for the tax savings to cover one additional minimum-wage hour [and] $1,024 in capital gains for the tax savings to cover a single day of minimum wage labor, and that’s without even accounting for employee benefits.

[***]

So, basically, Garner’s “plan” is to create four new minimum wage jobs for every MILLION DOLLARS in capital gains that a company makes, and that is with the ridiculous assumption that the company puts 100% of their new-found tax savings back into the company in the form of additional labor.

There is historical evidence that cutting capital gains taxes does not create jobs as well, at least on a national level.

The federal capital gains rate was raised in 1976, setting the top rate at 39%.  In November 1978, the top rate for capital gains was cut from 39% to 28%.  In August 1981, the rate was again cut from 28% to 20%.  The rate was then raised in 1986, undoing the August 1981 cuts and restoring the level from 20% to 28%.  The effect of capital gains tax changes on employment?  The unemployment rate rose after both the 1978 and 1981 capital gains tax cuts, yet it fell significantly after the 1976 and 1986 capital gains tax increases were passed.

B. As a Factor of Economic Growth

As discussed above in part II.A., Arkansas showed positive economic growth in 2009, while Texas and Tennessee — the only neighboring states with capital gains rates lower than Arkansas’s — saw losses of -1.5% and -3.1%, respectively.  It would seem odd, then, for Garner to bemoan the future prospects of Arkansas’s economy based on the impact of our 4.9% rate on capital gains.

Nevertheless, Garner couches much of his statement in terms of growing the private sector.  He makes it sound as if capital gains cuts will lower the cost of doing business, which will have a stimulative effect that will, in turn, allow Arkansas to meet social-service demands better in the future.  The part that Garner and those who would parrot him leave out is that it is generally accepted by everyone except partisan Republicans that capital gains cuts are an amazingly inefficient way to try to grow an economy.

[i]n 2002, the Congressional Budget Office (CBO) evaluated the stimulative effect that several different approaches to cutting taxes might have. It found that “capital gains tax cuts would provide little fiscal stimulus,” since most of the benefits of such cuts would accrue to high-income households[…]. Indeed, the CBO determined that, of the range of approaches it examined, capital gains tax cuts were among the least effective.

Similarly, but more recently, Mark Zandi, the Chief Economist of Moody’s economy.com, examined a set of proposals Congress could adopt to stimulate the economy in the wake of the credit crisis and the developing recession. He found that each dollar spent by the federal government in making President Bush’s dividend and capital gains tax cuts permanent would boost Gross Domestic Product (GDP) by just 38 cents. To put that in perspective, Zandi determined that each dollar dedicated to bolstering the food stamp program, extending Unemployment Insurance, or improving public infrastructure would yield over $1.50 in additional GDP.

(emphasis added)

In fact, far from enticing new business and growing the economy, historical evidence bears out that capital gains cuts can have a negative impact on an economy, at least on a federal level. In November 1978, the top rate for capital gains was cut from 39% to 28%. From November 1977 to November 1978, the economy had grown 5.8%; in the next eighteen months, it fell one percentage point.  In August 1981, the rate was again cut from 28% to 20%. From August 1980 to August 1981, the economy had grown by 3.5%; From August 1981 to August 1982, it fell by 2.8%.  Garner seems oblivious to all of this.

IV. Cost of the Cuts

There are two reasons why no one should take Garner’s comment that this measure “may not cost us anything at all in terms of the state budget” seriously.  First, when Garner previously proposed this bill, the Department of Finance & Administration estimated that the bill would cost Arkansas roughly $45M in year 1 and roughly $110M over the first two years; I trust that estimate far more than I trust a lawmaker speaking in generalities without offering concrete numbers.  Besides which, Garner’s failure to understand basic economic principles or to research his proposal rather than relying on the tired Republican idea of tax cuts as a panacea should cause everyone to question Garner’s assertion about this bill’s cost.

Second, and more simply, capital gains cuts do not pay for themselves.

In an article in the Journal of Public Economics, N. Gregory Mankiw — former chairman of President Bush’s Council of Economic Advisers — and Matthew Weinzierl asked, “To what extent does a tax cut pay for itself?” Mankiw and Weinzierl concluded, “In almost all cases, tax cuts are partly self-financing.” Mankiw explained:

Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) would recoup only about a quarter of the lost revenue through supply-side growth effects. For a cut in capital income taxes, the feedback is larger–about 50 percent–but still well under 100 percent.

50% payback, of course, also means 50% loss of money that will have to be made up elsewhere.

Somewhat ironically, I noted that Garner references Arkansas’s ability to pay for social programs down the road as a justification for this bill.  Where, pray tell, does Garner think the millions in lost revenue are going to come from if not from existing government programs?

V. Conclusion

In short, there is no proof that Arkansas is at a competitive disadvantage versus neighboring states due to Arkansas’s capital gains tax rate, no proof that cutting the remaining 4.9% tax on capital gains would result in better economic growth than Arkansas already has, and no proof that cutting the tax would lead to appreciable job creation.

On the other hand, there is evidence making this cut could have an adverse effect on Arkansas’s current positive growth, would not create jobs, would not remove whatever disadvantages Arkansas does have vis-a-vis neighboring states, and would not be self-financing.

Given all this, one wonders why in the world anyone would support Garner’s proposal, especially anyone elected to do what was best for his constituents.

1 Well, ok, technically Garner’s claim that “we do balance our budget” is correct, but that’s neither here nor there as far as this bill goes.  It’s also not anything special as compared to other states, nor does it give one any reason to conclude that Arkansas is in a better position than any other state to come out of the recession.  But I digress.

2 Though how one would then make the leap that such a disparity is due to the capital gains tax, when states with higher rates than Arkansas are above Arkansas in terms of total GDP remains a mystery.