A Supply Side Solution to Michigan's Ailing Economy

So I recently wrote a paper for a scholarship on how to fix Michigan's economy. I thought it'd preface my blog post about the Arthur Laffer presentation, so I'm posting it here. Enjoy :)

"The current economic outlook for Michigan is rather bleak, with unemployment peaking at a staggering 15.8% of the total workforce, more than double of unemployment figures in January 2008 (BLS).  In 2009 alone, 300,000 jobs were lost in the state of Michigan. In this same time period of January 2008 to present, the civilian labor force has decreased 3.39%, signaling an increase in the number of discouraged workers in Michigan. Meanwhile, Michigan’s government is facing record deficits, with $1.6 billion of projected deficits for FY10 alone. It is clear that we need to make reforms to fix Michigan’s economy. 

The proposed solution to Michigan’s economic woes is perhaps not as revolutionary as one might expect. The policy solution outlined is, in majority, embodied by the school of economic thought known as supply side economics. Championed by famous economists of the 1970s (e.g. Arthur Laffer) and brought into practice by President Reagan (coining the term “Reaganomics”), supply side economics operates upon the fact that firms who hire workers for production cause a proportional increase in income in the economy. This is called Say’s Law. As these workers who receive income are also consumers, production side incentives create certain effects on demand. In other words, supply side factors “trickle down” into demand. 

Unfortunately, Michigan’s business tax code is somewhat less than ideal. The Michigan Business Tax (MBT) is composed of a Business Income Tax of 4.95%, a Modified Gross Receipts Tax of 0.8%, and an extra Surcharge Tax of 21.99%. 

According to a study by the Anderson Economic Group, the effective business tax rate as a percentage of profits for the year 2008 ranked 22^nd in the nation. Similarly, Michigan’s “State Business Tax Climate Index (SBTCI)” assigned by the tax foundation was 5.35, ranking Michigan 17^th in the nation. To the average reader, these numbers may not seem so bad, as 22^nd and 17^th in the nation are both well above the national median. However, a more in depth analysis of these numbers can be very enlightening. 

Contained within Michigan’s  SBTCI is its Corporate Tax Rating, which ranks an uncompetitive 48^th. No matter what one’s economic philosophy, the fact is that corporate taxes are one of the largest factors in many business decisions. A review of the economic literature involved will prove this. In a 1982 study, Newman showed that tax differentials among states were a major factor for the movement of industry to southern states. Harden and Hoyt concluded in 2003 that corporate taxes have the largest negative effect on the rate of growth in employment. Also, according to a 2001 study by Agostini and Tulayasatheien, for “foreign investors, the corporate tax rate is the most relevant tax in their investment decision.” 

In other words, high corporate taxes significantly hinder economic growth. Paired with supply side ideals, the two point to a powerful economic tool. The solution is simply to lower corporate tax rates. However, at a time of record deficits, a tax cut must be accompanied by a spending cut. As part of the current Michigan Business Tax, a wealth of tax credits is offered to businesses. Michigan’s government can start by cutting these tax credits, as they only serve to decrease the negative impact of a poorly-written tax code. 

The aggregate of these reforms should lead to a tax code that includes: a uniform corporate tax rate of 6.0%, continuation of Michigan’s Modified GRT Tax (a Value-Added Tax (VAT) in econ-speak, a highly efficient tax), and the elimination of most of Michigan’s tax credits that only serve to unlevel the business playing field. 

As stated previously, the solution presented is far from revolutionary. However, they are elegantly so. A few simple policy changes can lead to a number of changes that improve Michigan’s economy.

The most obvious effect of a corporate tax cut is that businesses have more profit as a percentage of revenue. Noting this as an important business incentive and keeping in mind that states are in a constant state of competition with surrounding states, businesses will unquestionably decide to relocate from an area with high tax rates to an area with low tax rates. The influx of business will significantly increase the amount of skilled labor in the workforce and will help to lay the foundation for the economy in the long term. 

Also a result of this effective increase in business income, firms will begin to hire more workers. However, as the economy does not exist in isolation, wages paid to workers by definition leads to a mirror increase in total income of the economy. Given this extra income, consumers will undoubtedly spend a portion of it, which increases demand for products in the economy. This increase in demand will lead firms to supply more of their goods, hiring workers in the process. Rinse and repeat. 

As evidenced above, decreasing corporate tax rates leads to more economic activity. This is nothing short of a blessing from a deficit reduction standpoint. The additional economic transactions provide a larger tax base for existing taxes. While it is slightly preposterous to claim that a decrease in taxes will lead to an increase in tax revenue, a corporate tax cut will in part be funded by the increase in economic activity involved. 

As you see, the suggested solutions will solve a host of Michigan’s economic problems and, with the necessary deficit reduction measures, come at little cost to Michigan’s government. All of these proposals are sound economic fact; the only obstacle lies in political attainment."