Economics of the Southwest

By: Greg Palmer and Michael Broughton

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Table of Contents

1) Introduction

2) Tax Climate

a)Tax Climate Ratings

b)Professor Edward Prescott’s Research

3)Economic Outlook

a)Econometrics Analysis of Taxes

b)California Outlook

c)Texas Outlook

4)Growth of other non­CA states

a)GDP

b)Labor Forces

5)Conclusion

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Introduction

The southwest region of the United States has quite a rich economy and houses

roughly a quarter of the entire US GDP13. We contend that these states place policies

and taxes that influence the business transactions that happened in these states. We

are analyzing the states of the region and how government, taxes, policies, and

regulations in one state have a very significant effect in the other areas of this

economically dense region.Our main focus will be the competition of jobs between

California and Texas.The rationale behind such a focus is to look at the difference

between the different economic viewpoint these two states harbor.

Our focus was narrowed into multiple sections in order to make sure that we

address the different problems as well as counter arguments where they are necessary.

The first of these will cover the findings of Professor Edward Prescott, an ASU

Professor, during his research that resulted in him receiving the Nobel Prize in

Economics.

We then changed gears and decided to focus on the econometrics reports that

came about the effect taxes have on wages, employment, and capital.These reports

help analyze the many issues that taxation brings to an economy.These papers illustrate

the problems that many supply side and free market economist bring up when

discussing the weakness of a state controlled government.

The last portion of our paper is dedicated to looking at the other states in the

southwest and how well the are doing.This section will also focus on how the Great

Recession affected these other states during these tumultuous times.The labor force will

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also be evaluated so as to determine the movement and projection of future

employment locations.

Lastly, we will reference a supply and demand graph in order to show what

happens when certain fiscal policies are put in place.

Tax Climate

Many economist believe that one of the main contributing factors to the

movement of jobs out of California is the anti­business climate perpetuated by higher

taxes. According to The Tax Foundation, which rates each state based on multiple

criteria and then gives the state a overall rating,Texas is consistently in the top ten best

states to do business whereas California is consistently in the bottom ten.The Tax

Foundation gives an overall rating based on the ratings of multiple subsections such as

state income tax and business taxes however that does not mean that the specific state

in question needs to have the absence of one of the major taxes in order to make the

top ten.The Tax Foundation states “But this does not mean that a state cannot rank in

the top ten while still levying all the major taxes.Indiana and Utah, for example, have all

the major tax types, but levy them with low rates on broad bases.14”

The Tax Foundation lists the reasons for many of the bottom ten being ranked

where they are as stated, “The states in the bottom ten suffer from the same afflictions:

complex, non­neutral taxes with comparatively high rates.New Jersey, for example,

suffers from some of the highest property tax burdens in the country, is one of just two

states to levy both an inheritance and an estate tax, and maintains some of the worst

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structured individual income taxes in the country.14” The Tax Foundation bases their

information off of the structure of the state’s tax system.From this information, we can

gather that California performs poorly in almost every category except Property Tax and

Unemployment Insurance Tax.The supply and demand graph shows us that as marginal

costs are increased, through taxation, the point where producers will supply the goods

and services moves to a lower quantity with a higher price14.

The Tax Foundation states that although taxes are a piece of the reasons behind

a business decision, they the swiftest way to impact a competitive industry.The Tax

Foundation goes on to state that the US Department of Labor finds more job relocations

are to other states in the United States rather than to a foreign nation such as Canada.

The Tax Foundation state that if law­makers were more concerned with jobs going from

one state to another state rather than placing much of their focus on the transfer of jobs

to other foreign entities that the state in question would be in much better shape 14.

An example of moving labor out of California can be found with the Intel

placement of a multi billion dollar chip facility into Arizona. One of the reasons behind

this is the high corporate tax rate in California compared to Arizona.This is one of many

examples of business moving to a laissez faire business environment which in turn

allows them to stay focused on business instead of taxes and regulators.

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Professor Edward Prescott’s Research

The economic study written by ASU’s Professor Edward Prescott, states that the

government cannot create a “perfect result” in regards to taxes because businesses will

always prepare for the future.Another reason he claims is that the government cannot

commit to a specific tax because if they do that in order to garner more in tax revenue

then the businesses will allocate resources differently resulting in lower taxes than

expected and a worse condition than under zero tax.His analysis was an incredible

contribution to the economic community which has influenced how economist,policy

makers,and government think about business cycles11.

Professor Prescott has also written articles for the Wall Street Journal where he

talks about the effect of tax rates on the labor market and the number of hours worked

per capita.His article states that as taxes increase, the incentive to work falls which can

be shown through evaluation of the Netherlands, France, and Germany; the former

being a decrease in tax leading to more working incentive.His argument hinges on the

fact that as marginal taxes increase, the trade­off between leisure and work becomes

more in favor of leisure due to decreasing marginal returns(PrescottandOhanion)10.

His analysis does not stop there however, he then reveals that in mainland

Europe, only one company formed between 1976 and 2006 reached success

comparable to Apple, Microsoft or many of the largest corporations in the United

States11. He asserts that this is attributed to the convoluted regulation and higher tax

rates inhibit the entrepreneurial sector of the economy.His claim goes further that unless

we stabilize or lower the tax rates present in the United States right now we will not be

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able to attract entrepreneurs(PrescottandOhanion).His argument then concludes with

the following statement regarding entrepreneurship, “We have lost more than three

years of growth since 2007, and our underachievement will continue unless

pro­productivity policies are adopted and marginal tax rates are stabilized or lowered to

prevent a decrease in work effort across the board12.That means lifting crushing

regulatory burdens such as those imposed by Dodd­Frank, and it means reforming

immigration policies so that we can substantially increase our base of entrepreneurs by

attracting the best and brightest creators from other countries. Economic growth

requires new ideas and new businesses, which in turn require a large group of talented

young workers who are willing to take on the considerable risk of starting a

business.This requires undoing the impediments that stand in the way of creating new

economic activity—and increasing the after­tax returns to succeeding.12”

One of the many aspects of Professor Prescott that is critical in understanding the

dangers of government intervention was his analogy to the Great Depression where

working hours per capita slumped by more than twenty five percent and the decrease in

the overall GDP growth of the nation relative to trend is startling10.Free Market

Economist have stated that a decrease in productivity as well as efficiency hampers the

economic activity of the nation.The article contends that unless we change this and start

allocating resources to the highest uses in society, that economic growth will continue to

slump and become stagnant which will decrease the overall living standards in the

nation.

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Tying this into our argument regarding taxes, we find that by providing a more

business friendly environment, states are able to attract businesses from other areas

resulting in higher productivity and efficiency.This may be the single most important

piece of evidence supporting the argument that taxes have a heavy influence on the

activity in a state.We conclude this section with a relationship analogy used by Steven

Moore,the head Economist for the Heritage Foundation, regarding the argument that

taxes played no part in the decision of Toyota to move to Texas, “The problem is me,

not you, California. But when the one who’s walking out the door says this, it’s always

really about you.6”

Econometric Model Analysis of Taxes

The Beacon Hill Institute for Economic Research developed a dynamic

econometric model for how taxes affect economic issues such as tax revenue,

wages,employment, and stock capital.This model called (STAMP) State Tax Analysis

Program Management has looked at how taxes has affected the state of Texas.In the

first model the dependent variable is a log function looking at the number of jobs in the

economy.This model states that for every 1% increase in government transfers equates

to a decrease in the number of jobs by ­.1342 % holding everything else constant.

Government Transfers include but are not limited to welfare,social security, subsidies for

businesses, and Medicare1.Economic Theory states that people respond to incentives

and since government transfers are free it creates a disincentive to work.This

Econometric Model supports that that economic theory with a negative coefficient that is

statistically significant for a negative coefficient for government transfers.Also in this

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econometric model nonlabor costs,sales tax, and the cost of capital all have a negative

coefficient associated with it.

The second econometric regression that Beacon Hill ran is using the log of wage

rate as the dependent variable In this regression if you increase government transfers

by 1 % you will see a .0190% increase in wages holding everything else constant1. As

Harvard Economist George J. Borjas states that,”The definition of the reservation wage

implies that the person will not work at all if the market wage is less that the reservation

wage, and the person will enter the labor force if the market wage exceeds the

reservation wage.2”This econometric study supports this notion that workers will need to

be paid above what they would be receiving from government transfers in order to be

incentivized to work.The reservation wage is driving people out of the workforce and

decreasing labor supply again.

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In the last econometric regression that Beacon Hill ran they used the log of stock

capital as the dependent variable.This model states a 1 % increase in the cost of capital

holding everything else constant will decrease the stock of capital used by .0309%. This

model states that if you increase property and sales tax that therefore makes capital

more expensive than businesses will take their business outside to more business

friendly states1.

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California Outlook

California’s economy is growing at a rate that is slightly worse rate compared to

the rest of the country.California’s economy dropped by 1.4% in 2013 and ended the

year at 8.3% which is slightly higher than the rest of the country which ended at 6.6%

according to Wells Fargo.The main sectors of the California Economy are the tourism,

technology, and retail sectors that account for a large portion of the economy. Wells

Fargo expects the unemployment to drop even further with manufacturing and

construction jobs in demand.In January of 2014 home prices had increased by 20.3

percent from a year ago and the median price of a home increased by 22.1 percent

from a year ago15.

Texas Outlook

Texas Economy created 3.2 % jobs in 2014 which is better the rest of the United

States which grew at a rate of 2.2 % in 2014.The Texas Unemployment rate which is at

5.2 percent is also lower than the the average in the rest of the United States. Texas

housing starts are up 24.9% from last year.Furthermore,Texas exports are up 10.4 %

higher than last year.Manufacturing jobs are the largest part of the Texas Economy7.

GDP

The economic growth of the state is the best indicator of business health in that

area.California, which has an enormous GDP by any standard has slowed down in

recent years and suffered a tremendous decline in GDP during the Great Recession.

However,Texas on the other hand only saw a slight decline of less than 1% during the

period of the Great Recession.This is attributed to the ability of companies in Texas to

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compete with companies in California much easier and this allows companies in Texas

greater margins to deal with recessions.Along with this, California is the only one of the 5

states that has been unable to attain a 5% growth since 2001 as shown in the following

graphs. The previous information and the following graphs are based on information

gathered from the St Louis Fed, placed into excel, then graphed on a single set of

axes10.

As is clearly shown from the graph, California has the highest GDP of the states

in the Southwest however, has had slower growth in recent years than multiple other

states despite receiving more than ⅔ of all the venture capitalist investments in the

country2.This is a serious issue when nearly twenty three billion dollars is invested in

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California startups in only the first three quarters of 2014 compared to Texas who

received less than one billion or around four percent that of California yet Texas is still

able to attain a higher growth rate in their GDP.All of this clearly leads to the assumption

that California’s Economy has slowed due to many factors and one of the many reasons

that they are able to continue growing at that slow rate is because of the of cash into

silicon valley based companies in the tech industry.13

Labor Force

The Labor Force and the migration of people to different states in the union, we

find that Texas has an unemployment nearly fifty percent less than California’s as well as

four times the job growth of California.Along with these claims, Stephen Moore

concludes that California is losing net taxpayers every year and that Texas salaries are

increasing at higher rates than California.6 One Forbes article claims that more than

three percent of Los Angeles labor force has left in the last ten years which is more than

Detroit, one of the picture examples of an economically crippled city9.

By using a supply and demand graph, we are able to see the shift in the supply

curve consistent with an increase in taxes which lowers the quantity supplied and

demanded at a higher price indicating that as it approaches a level of tax that is a heavy

burden, everybody loses to an extent whether it be through higher prices or lower

production for businesses which decreases the labor needed to produce the good. All of

this is a negative for the economy and therefore we are able to conclude that the

increase in taxes not only affects the businesses in the region but also the labor force

resulting in a larger loss than anticipated.

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Conclusion

Daniel J. Mason an economist from George Mason University has compared

California to the bureaucratic nation of Greece.He makes that comparison based off

similarities in the high tax rates and the corrupt government.California is making itself the

role model along with the city of Detroit on how to push away talented people.The

opportunity cost of doing business in California is so great that it is hard to see how the

state will survive in the future5.

David Henderson an economist at the Hoover Institute found out that if you make

one million dollars in the state of California, then you will owe $88,000 dollars of state

income tax.This figure was calculated before proposition fifty four was put in place. After

proposition fifty four was put into place that tax figurel increased by an additional 17,500

dollars, to make the final figure 107,500 dollars.You could save an additional 107,500

dollars just by moving to another state such as Texas, Nevada,or Florida8.This number

does not account for the high cost of living in California.

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Furthermore to prove that high taxes and regulation are forcing people and

businesses to leave the California as quickly as possible we can look at interstate

migration numbers. California lost 27 billion dollars in income between the years

1999­2009, while Texas made 16.6 billion dollars, Nevada made 980 million dollars, and

Florida made 70 billion dollars during that time period.All three of those states have one

crucial thing in common and that is no state income tax4.

As Professor Prescott has clearly illustrated throughout his illustrious career is that

labor supply is highly responsive to tax rates.The battle of the southwest for businesses

has clearly illustrated Professor Prescott’s findings.California has many natural

advantages over many bordering states, its a shame that California’s advantage is being

squandered by a greedy bureaucratic government.

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Citations

1 http://www.beaconhill.org/BHIStudies/TexasSTAMP299/texas_summary.html

2 blogs.wsj.com/venturecapital/2014/10/17/interactive­map­where­the­venture­capital­dollars­ are­going/ 3 Borjas, G. (2013). Labor economics (6th ed., p. 41). Boston: McGraw­Hill/Irwin. 4 http://www.cato.org/blog/krugmans­gotcha­moment­leaves­something­be­desired

5 http://www.cato.org/blog/will­last­job­creator­leave­california­please­turn­lights

6 http://dailysignal.com/2014/05/08/california­leavin­businesses­politicians­state­denial/

7 http://www.dallasfed.org/assets/documents/research/indicators/2014/tei1411.pdf

8 http://econlog.econlib.org/archives/2012/11/californias_laf.html

9http://www.forbes.com/sites/dalebuss/2014/04/30/texas­v­california­this­aint­over­when­t

oyota ­leaves/

10 https://www.minneapolisfed.org/research/prescott/papers/LaborSupply.pdf

11 http://www.nobelprize.org/nobel_prizes/economic­sciences/laureates/2004/advanced­

economicsciences2004.pdf

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http://online.wsj.com/news/articles/SB1000142412788732446930457814279085176714

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13 http://research.stlouisfed.org/fred2/

14 http://taxfoundation.org/article/2015­state­business­tax­climate­index

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https://www08.wellsfargomedia.com/downloads/pdf/com/insights/economics/presentation

s/ California_Economic_Outlook_03052014.pdf

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