Taxation and Economic Development: The State of the Economic Literature

T hose who shape state and local fiscal policy have had a sustained interest in the role that taxation plays in the economic development of states, regions, cities, and special districts or zones. At least 75 studies of employment growth, investment growth, or firm location include an analysis of taxes. Interest in the topic is fueled further when firms complain about the business climate in general or about taxation in particular. State or local policymakers then have the unenviable task of deciphering firms' complaints and deciding whether additional tax incentives and lower taxes represent economic rents or constitute a timely and necessary response to keep firms in place. Tax policy is not considered by firms or policymakers in isolation from other aspects of site selection, including benefits from public goods that might accrue to firms or to its workers. The literature also has pointed to a number of other variables as important determinants of firm location or employment growth decisions. Nonetheless, I leave the discussion of expenditures and of special tax abatement and incentive programs to other papers at this symposium, and this paper will limit its scope to the role of taxation. At one level, that tax policy influences economic behavior has become a basic tenet for economic policymakers. For example, taxation is assumed to influence multinational firms' financial decisions about repatriation of profits. Periodically, the World Bank relates economic performance in developing countries to the level of taxation and finds that countries with lower marginal tax rates have higher economic growth. In the United States, at least some economists believe that cutting federal taxes would spur enough growth in the national economy that the budget deficit would increase by only 73 percent of the tax cut. Moreover, recent evidence by Auerbach and Hassett (1992) suggests that the user cost of capital plays an important role in stimulating nonresidential fixed investment in the United States. In the state and local area, researchers have struggled mightily over