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By Lawrence B. Lindsey

The Growth Experiment Revisited: 
Why Lower, Simpler Taxes Really Are America's Best Hope for Recovery

New York Views

Lawrence B. Lindsey and Edwin Rubenstein
Did New York's Tax Cuts Work?
Autumn 1990

A recent New York Times dispatch from East Berlin tells why economics behind the Iron Curtain was an especially dismal science. “To penalize private property and stifle individual initiative,” it noted, “East Germany had imposed income taxes on self-employed individuals or on private companies of well beyond 50 percent.”

The story might have raised a grim smile in places closer to home-say in East Elmhurst, East Islip, or the East Eighties. Even after a series of highly publicized tax cuts, many New Yorkers face combined marginal tax rates approaching that stifling 50 percent level. And unlike inhabitants of Chemnitz and Leipzig, the beleaguered denizens of Chelsea and Levittown do not even have a sense of impending liberation: In New York, tax rates are headed up, not down.

In the worldwide war between taxes and growth, most governments are coming down firmly on the side of growth. But in New York, after a decade of supposedly record tax cuts (“Biggest tax cuts in New York history,” Governor Cuomo’s press releases have warbled), Albany recently agreed to raise taxes by $1.4 billion. Legislators argue that even after the recent hefty hike, taxes are still much lower than in the bad old 1970s. Well, aren’t they?

A look at the data reveals the oft repeated boasts of tax reform in New York (Gotham Glasnost? Mario-stroika?) are half right. New York did cut some taxes, and those tax cuts were a rousing success, actually increasing tax revenues as the affected taxpayers became more productive contributors to New York’s economy. But the tax cuts were a halting, halfway matter that failed to reach large segments of the middle class. And now that taxes are headed back up, the missed opportunities are looming larger than ever.

When marginal tax rates are cut, people work harder and longer, take more income as salary rather than perks, and stop devoting as much effort to sheltering income. The economy gets a boost; tax revenues do not drop as much as would otherwise be expected from the cuts, and in some cases may rise. At the level of state (as opposed to federal) tax policy, two added factors loom large that can magnify these “supply-side” effects: migration and allocation. New York’s tax climate notoriously drives people, especially retirees, out of state. Moreover, many people have some discretion over how to allocate income between states: They may, for example, decide to cash in large capital gains before moving to New York or after moving out.

Albany’s “static” analysis (which assumes that tax cuts have no effect on taxpayers’ behavior) estimates that New York’s tax reforms have cost state coffers from $1.5 billion to $3.4 billion a year. In reality, collections from the state’s income tax began skyrocketing when rates were cut. From fiscal 1985 to fiscal 1989 income tax revenues soared 38 percent, from $10.6 billion to an estimated $14.6 billion, far outpacing the growth in the state’s economy. Even as economic troubles began to cut into other tax revenues, income tax revenues continued to pour in at record levels.

But within this broadly favorable current were some disturbing eddies and undertows. For one thing, New York’s tax reforms were not straightforward cuts, but a combination of cuts and increases that produced losers as well as winners. Most of the winners fell into three broad categories:

* Taxpayers with high incomes. Taxes were cut across the board, but “bracket creep”—the tendency of inflation to push taxpayers into higher brackets—wiped out much or all of the cut for many taxpayers. The one group that need not worry about bracket creep is the group that is already well into the top bracket. As the top state rate on salaries dropped from 9.5 percent to today’s 7.875 percent, these taxpayers got a genuine cut.

* Taxpayers with savings income. New York had formerly maintained separate and extraordinarily punitive tax rates for interest, dividends, and other forms of return on savings. The high rates kicked in even at modest income levels: In 1985 a married couple making $28,000 in wages with a half-year's income salted away in a savings account faced a 13.75 percent marginal state tax rate on the savings interest. New York’s tax reform abolished the punitive differential, thus taxing savings income at the same rate as wages and salaries—a clear gain for retirees, especially.

* Taxpayers who take the standard deduction rather than itemizing. In a tricky maneuver, New York increased its standard deduction by $4,200, to $9,500 for a married couple, while abolishing its old personal exemption, which had amounted to $1,800 for a married couple. For taxpayers who would have taken the standard deduction anyway, the changes added up to a clear gain. But those who itemize their deductions lost the benefit of the old personal exemption and got nothing in return. Since both the standard deduction and the personal exemption are of limited benefit to the wealthy, both changes were proportionally more significant to low- and moderate-income taxpayers than to the affluent.

As for the economic and fiscal effects of the tax cuts, where New York gave genuine supply-side economics a try, it worked. The people who received the largest tax-rate cut wound up paying more taxes. The first piece of evidence to that effect is that Albany collected far more tax revenue than it would have expected to from normal income growth. A computer simulation using the National Bureau of Economic Research’s TAXSIM model indicates that given no change in taxpayer behavior as a result of the tax cuts, state tax receipts in the 1989 tax year (which is different from the fiscal year) “should” have come in at $14.1 billion. Preliminary figures suggest that actual receipts will be closer to $15.1 billion. The extra billion dollars represents 7 percent more revenue than expected, or an extra $135 per taxpayer, suggesting that taxpayers changed their behavior in response to the cuts by earning more taxable income.

Even stronger evidence of a supply-side effect is where the extra revenue came from. In 1985 the highest earning 100,000 taxpayers shouldered 22.8 percent of the total income tax burden; by 1989 they shouldered 27.8 percent, despite the fact that upper-income taxpayers got the biggest tax-rate cuts. The extra share represents about $650 million in extra taxes paid by the very wealthy. By cutting the tax rates of top-bracket taxpayers, the state got more revenue, just as supply-side theory predicts.

Nothing is ever simple in tax calculations, and a full analysis must take into account changes in the federal tax code. In particular, the 1986 federal tax reform slashed the marginal tax rate faced by high earners from 50 percent to 28 or 33 percent, while wiping out many deductions and shelters. On the other hand it eliminated the former capital-gains preference, raising federal taxes on that form of income from an effective 20 percent to 28 or 33 percent. Wealthier taxpayers thus had an incentive to earn and report less income from capital gains but more income from other sources. That is exactly what they did. At the federal level the two effects basically canceled each other out: The overall share of federal taxes paid by top earners remained about level between 1985 and 1988, after rising earlier in the decade in response to the supply-side tax cuts of 1981.

These federal changes were bound to affect New York’s tax collections because Albany uses much the same tax base as Washington. Better-off New Yorkers inevitably reported relatively more regular income and fewer capital gains, with their payments to state tax authorities rising and falling respectively. The significant fact is that while on the federal level the two changes canceled each other out in the later 1980s, in New York the positive revenue effect swamped the negative-suggesting that the state’s own tax cuts had a crucial independent impact. The data are never as precise as a social scientist could wish, but on current evidence it appears that supply-side economics can claim New York as one of its great successes.

So much for the good news. The bad news is that much of the middle class never got a tax cut at all. What the state was supposedly letting them keep through one set of policies, it was busily siphoning off through others.

To begin with, middle-class taxpayers frequently itemize deductions, and itemizers were clear losers from the state’s two-step exemption-and-deduction shuffle. Moderate-income taxpayers with high deductions, notably homeowners with mortgages, took the biggest proportional hit. In addition, the New York reforms forbade married couples to file separate returns as a means of cutting their tax bills. (This was camouflaged by talk of simplicity: “1987 marked the first year in which two-income married couples could file simple joint returns,” the Governor’s Message proclaimed in that year, although most couples would probably rather have kept the extra money and filled out the extra form.) Younger married homeowners, thus, were hit twice over.

Consider Mike and Debbie, a couple struggling to get a footing in the middle class. They earn $30,000 and $12,000 as a cabbie and beautician respectively. They bought a row house in Queens five years ago on a hefty mortgage and pay $10,000 in interest and $3,000 in property taxes a year. In 1985, they paid state taxes of $1,501. In 1989 they owe $1,566. To them, the “record” state tax cut looks more like an increase.

Most middle-class taxpayers did better than that, but not always by much. Schoolteachers David and Sylvia earn $30,000 apiece and bought a more expensive West Side co-op on which deductible payments total $18,000. They paid $2,698 in state taxes in 1985 and $2,590 in 1989. The “record” cut left them with just $2 a week more.

Of course these examples are unrealistic in one obvious respect: Most people’s income did not remain fixed over those four years, but went up, due partly to inflation and partly to real growth. Had David and Sylvia kept up with national norms, their combined earnings would have grown by 28 percent over those four years from $60,000 to $77,000. But then their tax bill would have risen by a whopping 46 percent, from $2,698 to $3,929. Each one percent rise in a New Yorker’s income leads, on average, to a 1.64 percent rise in the state tax payments.

The biggest culprit is bracket creep. New York has cut tax rates, but it refuses to follow the Federal Government by indexing its tax code to inflation. Between bracket creep, the exemption loss, and the marriage penalty, the state more than snatched back the middle class’s supposed tax cut.

Computer estimates done using the TAXSIM model show that the figures for David and Sylvia are in fact typical: A nationally representative 28 percent rise in New Yorkers’ incomes would have led, under the changes in the state’s tax code, to a 45 percent rise in state income tax collections. Had Albany’s income-tax revenues merely grown at the same rate as the income of state residents, they would have totaled $12.4 billion; instead, the model produces $14.1 billion (not counting behavior changes, which in the case of rising tax rates are likely to be negative). The middle class emerged from New York’s historic tax cuts with a net tax hike of $1.7 billion.

And so it goes. Middle-class New Yorkers continue to labor under a tax burden extraordinary by the standards of the rest of the country. Personal income taxes are more than twice as high here as in other states on average. Sales and other taxes are high too: Overall, Albany’s tax take runs 40 percent above the national average. The real kicker is that New York is one of only four states in the country—and the only large urban state—where local governments impose a higher tax burden than the state itself does.

New York’s political leaders have a sort of half-success on their hands that is more embarrassing than an outright failure. They did just enough tax-cutting at the top rates to establish that tax-cutting works, while withholding relief from most of the hard-pressed middle class. Rather than doing the obvious thing and extending tax reform to average New Yorkers, they prefer to get back on the tax-raising treadmill that served New York so poorly in the past. It is a poor doctor who has to bury his successes.

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