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The unintended consequences of the Dayton tax plan

While job growth and fairness are two key policy goals of Gov.

While job growth and fairness are two key policy goals of Gov. Mark Dayton, his tax proposal hurts the job prospects of the very people he intends to help without ever creating a “fairer” distribution of income.

Dayton’s budget solution increases state income taxes on high-income taxpayers making $150,000 or more in taxable income ($250,000 for married couples).

According to mainstream economic thought, the trouble with raising state tax rates on a narrow tax base springs from the incentives higher tax rates create for taxpayers to avoid additional tax payments.

Taxpayers can avoid state income taxes through tax shelters, working less, making fewer taxable investments, or by moving to a lower tax state. Each tax avoidance avenue, in its own way, makes it harder for poor and middle class workers to find well-paying jobs in Minnesota.

Shelters divert resources to less efficient uses
Tax shelters are techniques employed to reduce taxable income. They pose the more straightforward jobs problem. Taxable income tends to spring from productive economic activity that creates value and jobs. Tax shelters divert resources from more productive, job-creating activities to less efficient uses.

Consider a wealthy widow collecting interest from a Minnesota bank. Her deposit is an important source of cash for business loans. Under Dayton’s plan, the state income tax rate on her interest would increase from 7.85 percent to 10.95 percent. She could avoid the Minnesota income tax completely by moving her savings out of the Minnesota bank into untaxed Treasuries or municipal bonds.

A large body of research confirms that individual taxpayers do indeed reduce their taxable income in response to tax hikes.

Raising income tax rates also reduces the rewards to entrepreneurial risk-taking. As a result, entrepreneurs work less and invest less in job creating ventures.

In a study of the effect of the federal 1986 tax reform on sole proprietors’ hiring and wage-setting decisions, economists Robert Carrol, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen found that “individual income taxes exert a substantial influence on the probability that an entrepreneur hires workers.” Moreover, the same economists find that “lower taxes also raise the total wage payments to those workers.”

The mobility issue
Dayton contends that his income tax hike would only affect the wealthiest 2 percent of Minnesotans. The mainstream public finance consensus beginning with liberal Harvard economist Richard Musgrave says the pain of this state tax hike would ultimately fall on poor and middle-class Minnesotans because highly skilled workers can avoid the tax by moving. Musgrave supported progressive federal income taxes versus attempting redistribution at the state level because of mobility.

According to University of Kentucky economist David Wildasin, if “the rich are mobile, it simply may not be possible for any one state to impose a net burden on its rich residents; the attempt to do so could be worse than self-defeating because it drives out resources — the skills of the high-income households — that help to raise the productivity of low-income residents.”

Even a passing familiarity with Minnesota’s research scientists, engineers, executives, or even our professional athletes shows Minnesota must attract high-skilled individuals from around the nation and even the world in order to compete effectively.

Employers can overcome an unattractive aspect of a job by paying what economists call a “compensating wage premium,” such as higher wages for working the night shift.

Competition in the national labor market would force Minnesota employers to raise pre-tax wages for high-income workers to compensate them for Dayton’s unfavorable income tax rates.

Less cash to pay the less mobile workers
The need to raise wages for high-income earners will damage the labor market for poor and middle-class workers. Most directly, more cash going to pay mobile high-income earners means less cash available to pay less mobile lower-income workers. In addition, companies will hire fewer high-income and high-skilled workers who, as Wildasin notes above, raise the productivity of low-income workers.

Notably, those high-income earners not hired will take their productivity and skill to other states. Thus, high-income earner would never actually be burdened by Dayton’s higher taxes, as they’ll either command higher wages in Minnesota or make equal after-tax wages elsewhere.
   
Research by Harvard economist Martin Feldstein and Marian Wrobel confirms that attempts to make state taxes relatively more progressive than other states only work to damage a state’s labor market without increasing the economic burden on its high-income taxpayers.

There is, in fact, agreement among economists on the best way to use the Minnesota tax code to promote growth. Economist Marsha Blumenthal sums up the “consensus position of economists” in a recent paper for the local left-of-center think tank Growth & Justice: “Make the base as broad as possible so as to keep the marginal rates as low as possible.”

As budget negotiations progress, we hope that Dayton will gain a better appreciation for this consensus view.

Peter J. Nelson is a policy fellow at Center of the American Experiment. John A. Spry is an associate professor in the department of finance at the University of St. Thomas.