The cost of government: how taxes affect economic health and social well-being

Joseph Eugene Mcphail

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: All government services require funding through taxes, but not all taxes have the same effect on the economy. Even when the amount raised is equal, taxes may have very different distortionary impacts on economic decisions. This thesis estimates this cost in the context of a dynamic general equilibrium model, which is fitted to a panel data set covering the 48 contiguous United States over the period 1977 to 2004. Taxes on wealth (property), income, consumption (sales), and capital gains are all compared in terms of their impacts on labor productivity, gross state product, and household welfare.Elasticities are estimated for labor productivity, gross state product, and household welfare. The theoretical model is calibrated using estimates for model parameters found in the state growth literature. Tax rates are not found to be on the wrong side of the Laffer curve, but state tax policies are estimated to rely too heavily on property tax revenues and too little on income and consumption taxes.The empirical model regresses state labor productivity, defined as output per worker, on state tax policy, six control groups, fixed state effects, and between year effects. The average state is estimated to lose 9.49% of its labor productivity annually because of its tax policy. Taxes on property are estimated to have the most disruptive effect on the economy, while taxes on consumption are found to have little effect if any.State tax policies are ranked according to their support for economic productivity using historical tax rates and estimates from the empirical model. Nevada, Tennessee, and Washington are found to have the least costly tax policies while Nebraska, Iowa, and Vermont are found to have the most costly. A state's tax policy is found to account for 10% of the variation in productivity from state to state.

Date: 2008-01-01
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