January 20, 2006
Low-Tax Tiger
By Lawrence Kudlow

A year ago Gov. George Pataki asked me to chair a commission on tax reform that would improve New York state’s outlook for investment, job creation and economic prosperity. After numerous meetings, a review of the existing tax literature, and lengthy deliberation, we have come up with a statement of principles and a series of policy recommendations to promote an investment-friendly state tax structure that could, if implemented, restore New York to a preeminent economic position.

First and foremost, we concluded that there is a clear relationship between state tax burdens and state economic health. States with high and rising tax burdens are more likely to suffer economic decline; those with low and falling tax burdens are more likely to enjoy strong economic growth. Academic studies, as well as real-world experience, show clearly that low-tax states consistently outperform high-tax states.

Economic behavior, whether measured in terms of employment, work effort, saving, investment, risk-taking, entrepreneurship, or capital formation, is highly responsive to changes in marginal tax-rates. In other words, incentives matter. The economic power of lower tax-rate incentives has been proven at national and state levels. It is also borne out by the results of lower tax-rate systems put in place internationally. Allowing people to keep more of the extra dollar earned or the extra dollar invested by providing new incentive rewards is a tried and true prescription for economic growth. Raising after-tax rewards for work, investment and risk-taking is the surest path to long-term prosperity and competitiveness for the state of New York.

But there is a bigger picture here.

It is absolutely essential that New York be more competitive in the global race for capital. New York competes regionally, nationally and internationally. What is overlooked, however, is the state’s need for new capital and new capital formation. New jobs require new businesses, and new business formation requires new capital sources. Nothing will make New York more prosperous than improving its economic climate to make the state a more hospitable place for the treatment of smart money and smart people. We compete daily with low-tax states elsewhere in the U.S. and with newly attractive destinations for capital in places like Russia, Eastern Europe, China and India. Smart money and smart people are highly mobile. In the world race for capital, they go to where the return on capital is highest.

In the 21st century information economy, where capital is so vital in the creation of new technologies and the everyday application of these breakthroughs in the home and workplace, an expanded and well-trained workforce must be equipped with the low tax-rate benefits of easy capital access and large-scale capital inflows. For these important reasons the onerous and burdensome multiple taxation of capital in New York must be remedied and ameliorated.

So the commission recommended elimination of the state tax on capital gains and investor dividends. The multiple taxation of capital is a huge deterrent to growth. Eliminating these tax penalties on investment capital would set New York apart as the only state with an income tax that fully exempts capital. Removing the double and triple taxation of investment, which has already been taxed once as wage and salary income and again as corporate net income, would be a powerful stimulant for entrepreneurship and risk-taking. Similarly, we recommended the elimination of the corporate capital gains tax.

In addition, we recommended complete abolition of the state’s estate tax that penalizes family-owned and closely held businesses. This tax has accelerated a growing brain-drain and capital flight to Florida, South Carolina, and elsewhere. In a 2004 National Bureau of Economic Research paper, economists Jon Bakija of Williams College and Joel Slemrod of the University of Michigan, concluded that a 1% differential in estate tax rates was associated with a 4% reduction in the number of residents in a given state.

Our commission decided that waging class war against the wealthy is nonsensical; it merely wages war against the state’s non-rich working people who are deprived of scarce and valuable capital that is so necessary to creating new technologies, new businesses, new equipment, new jobs, and new job training.

On income taxes, we proposed a 5% solution for individuals and companies, down from the 6.85% tax rate on personal income and the 7.5% tax rate on corporate income. Additionally, we proposed to reduce the number of income tax brackets from five to three, along with a widening of brackets, as well as inflation-indexing to prevent tax-bracket creep. Complex supplemental taxes would be eliminated. And for businesses, all new investment would be cash-expensed to reduce complexity and lower the cost of capital. In all these cases, we adhered to a clear economic growth principle: tax something less and you get more of it. By raising after-tax rewards across-the-board for the entire state tax system, we believe that New York will generate significantly higher living standards and more rapid economic growth in the years ahead.

This complete restructuring will provide tax relief to taxpayers in every income class and would set New York apart from other states as the place for uninhibited growth and investment opportunities. In-migration will replace the high-tax population drain. Instead of voting against New York, people will vote with their feet and their money for New York.

New Yorkers have seen these economic growth tax principles work successfully in the past. When President Reagan and Gov. Hugh Carey lowered tax rates nationwide and statewide in the ’80s, New York shared in the U.S. economic boom. Gov. Pataki’s tax-rate reduction plan in the ’90s produced new jobs at a pace equal to or better than the U.S. average. President Bush’s 2003 tax cuts on capital gains and investor dividends ignited New York’s financial service and related industries, where employment, incomes, and tax revenues all soared in the aftermath of lower tax rates. But for all this progress, New York’s overall tax burden remains high. The Tax Foundation’s state business tax climate index in 2004 rated New York 49th. A huge tax hike in 2003 passed by the state legislature over the governor’s veto represented a body blow to current and future economic performance. This is why across-the-board tax rate relief is so vital to the economic future of the state. Economic rewards will replace penalties for those who live and work here.

Lawrence Kudlow is a former Reagan economic advisor, a syndicated columnist, and the co-host of CNBC's Kudlow & Company. Visit his blog, Kudlow's Money Politics.

Copyright 2006 Wall Street Journal

Lawrence Kudlow

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