Cutting Taxes: Why and Why Now

The year is 2002. Maryland is flourishing, with robust economic growth – well above the 1.5 percent anemic growth of the mid-l980s. Businesses are moving to Maryland and expanding by the score. Small businesses are appearing all over to fill the niches vacated by retreating big government and merging companies. Location consultants brag about Maryland. Poverty is down. Employment is up. Neighboring states ask, what has Maryland got that we have not? The best and brightest from Maryland’s colleges and universities remain in the state after graduation to accept meaningful employment. At last, executives boast about Maryland’s business friendliness.

How did Maryland’s personal income tax fall enough to create this scenario? What happened between l997 and 2002, just five short years? It all began with a 10 percent cut in the personal income tax, proposed by Governor Parris N. Glendening and approved by Maryland’s General Assembly in spring 1997.

Why Do It?

Fortune telling aside, we must ask ourselves, could this one bold move in our economic environment make that big a difference. The answer is an unequivocal yes!1

At the top of my why-do-it list is competitiveness. In truth, Maryland does not compete with Nevada, Utah, Nebraska or Hawaii. Recently, these were cited by the Calvert Institute as the top four states in terms of the State Policy Research organization’s 1991 “Index of State Economic Momentum” (ISEM), a composite figure derived from states’ annual changes in income, employment and population growth.2 High ISEM scores, a good thing, are very strongly correlated with low state taxation rates; in 1991, these four states all enjoyed below average taxation. While these top-performing states may not be a direct threat to us, Maryland does compete regularly with eight other relatively low-tax states. Some border us; some do not. They are Virginia, West Virginia, North Carolina, South Carolina, New Jersey, Pennsylvania, Ohio and Kentucky. Among these states, Maryland has the highest personal income-tax rate.3 Can it be a coincidence that our economic growth rate lags behind the U.S. average?4

Next on the why-do-it list is job creation. Can a cut in personal income taxes be directly linked to job growth? Again, the answer is a resounding yes. According to some experts, a 10 percent reduction in the state income tax would increase income growth and employment in the state – in the case of the latter by at least 5,000 jobs per year, beginning in 2001, when the tax cut is fully phased in.5 Governor George Pataki (R) of New York would agree. The governor, who witnessed 500,000 jobs leave his state between 1990 and 1995, ran on a platform calling for cutting the state’s personal income-tax rate by 20 percent. He won. He cut. And the results were 90,000 new jobs in 12 short months.6 The ten states that raised taxes the most from fiscal year (FY) 1990 through 1996 created zero net new jobs.7 The ten that cut taxes deepest during the same period gained 1.84 million jobs, an increase of 10.8 percent.8 In addition, over FY 1991-1996, income for a family of four in the top 10 tax-cutting states grew by $1,600 more than in the tax-hiking states.9

The next argument for our proposed 10 percent tax reduction is small businesses, here defined as businesses employing fewer than 100 people. They are the dynamo of Maryland’s economy. Small businesses currently make up at least 83 percent of all businesses in Maryland.10 Small businesses are the economic engine of the future. Between 1989 and 1995, for example, well over 90 percent of Maryland’s net new jobs came from small businesses.11 Nationally, it is predicted by the U.S. Department of Labor that small businesses will be responsible for over two-thirds of new jobs generated in the U.S.12 A state’s personal income-tax rate is of crucial importance to small businesses because of the way they are set up. Most small businesses are structured as one of the following: (a) a sole proprietorship, whereby the owner acts independently, without partners, employees or formal incorporation procedures; (b) a partnership, which is similar to a sole proprietorship, but which involves more than one person; (c) an S corporation, whereby corporate profits and losses are reported with shareholders’ personal income; or (d) a limited-liability corporation (LLC), a corporation permitted to operate as a partnership, provided it terminates its own existence within a specified number of years.13 The principals of such entities pay taxes as individuals, as proprietors or with corporate income flowing through to their individual tax returns. A lower personal income-tax rate translates into more capital retained for hiring employees and buying goods and services – often not too far from a business’ base of operations. In other words, it will buy more and employ more – in Maryland.

Another reason for cutting taxes is – counterintuitively – for increased state revenues. Tax-cutting states not only balanced their budgets over the first half of the 1990s, but they also accumulated larger budget reserves than the tax-increasing states, 7.1 percent of state expenditures compared to 1.7 percent.14 Moody’s bond ratings are also higher in the states that cut taxes than in the states that raised them.15 The evidence shows that cutting state taxes improves the local fiscal condition and increases growth. A 25 percent increase in the state’s current rate of growth would significantly increase the flow of funds into Maryland’s general fund. In fact, general fund revenues would increase by $50 million annually by FY 2001 and increase thereafter as growth continued, according to College Park economics Professor Mahlon R. Straszheim.16

The final reason for implementing a 10 percent cut in the rate of personal income taxation is to retain Maryland’s best and brightest. The true test of a state’s economic health rests in its ability to retain and recruit its best and brightest candidates for well paid, family-supporting jobs. Potential employees, especially in the high-paying professional and technical fields, who wish to live and work in the mid-Atlantic region may be forced to choose between a job offer in Maryland and job offers in Maryland’s neighboring states. Quite often, the deciding factor is a state’s personal income-tax rate. Such was the case with Capers McDonald, CEO of Microbiological Associates, located in Montgomery County. Mr. McDonald says that, when recruiting mid-level information technology managers from both Virginia and Maryland, the decision often boils down to net – not gross – pay. On this count, Virginia always comes out on top. “In fact,” Mr. McDonald says, “Virginia employers even point out this fact to prospective candidates by asking them, ‘Have you sat down and calculated the after-tax, take-home compensation you’ll receive from a Virginia company versus a Maryland company?’ Unless Maryland’s personal income-tax rate can compete with Virginia’s, we’ll always lose this battle between the states.”17

Governor Glendening’s proposed state income-tax cut will ease Mr. McDonald’s fears. Jobs – that is what it is all about. It is the issue that is driving Governor Glendening’s proposal to cut income taxes by 10 percent.

Mr. Brady has been the secretary of the Maryland Department of Business & Economic Development since May 1995. Formerly, he was the managing partner of Arthur Andersen LLP’s Baltimore office for 10 years, and was an employee of the firm for 33 years. Mr. Brady holds a bachelor’s degree in business administration from Iona College in New Rochelle, New York. He also holds two honorary degrees – doctor of laws, Iona College, and doctor of humane letters, Villa Julie College, Maryland.

End Notes

[Top] 1. Maryland Business Research Partnership, “Business Climate Survey,” 3rd quarter, 1996.

[Top] 2. John E. Berthoud, “The Do’s and Don’ts of a Tax Cut for Maryland,” Calvert Institute Calvert Comment, Vol. II, No. 1, February 1, 1997; also Berthoud, “High Taxes, Low Growth: What Maryland Hasn’t Learned from Others,” Calvert Institute Calvert News, Vol. I, No. 1, Winter 1996, p. 7, table 1.

[Top] 3. State of Maryland, General Assembly, Department of Fiscal Services (DFS), The Joint Committee on State Economic Development Initiatives Report (Annapolis, Md.: DFS, 1996), p. 5.

[Top] 4. State of Maryland, General Assembly, Joint House Committee on Competitive Taxation and Economic Development, “Employment Growth in Maryland and the U.S.,” unpublished draft report of 1996, p. 12, table 2.

[Top] 5. Mahlon R. Straszheim, Department of Economics, University of Maryland at College Park, testimony before the Joint House Committee on Competitive Taxation and Economic Development, General Assembly of Maryland, December 11, 1996, p. 5.

[Top] 6. Stephen Moore and Dean Stansel, “Tax Cuts and Balanced Budgets: Lessons from the States,” Cato Institute Fact Sheet [September 17, 1996], p. 4.

[Top] 7. A tax increase is here defined to include all taxes, not just personal income taxes. See Moore and Stansel, “Tax Cuts and Balanced Budgets,” p. [10], figure 3.

[Top] 8. A tax decrease is here defined to include all taxes, not just personal income taxes. See Moore and Stansel, “Tax Cuts and Balanced Budgets,” p. [10], figure 3.

[Top] 9. Moore and Stansel, “Tax Cuts and Balanced Budgets,” p. 1.

[Top] 10. According to the Maryland Comptrollers’ Office, 83 percent of business tax returns are from entities employing fewer than 100 people. This underestimates the actual proportion of small businesses in the private sector because one small-business tax return (via U.S. Internal Revenue Service Form 510) may be filed for multiple establishments. According to 1993 comptroller’s data, that year 371,640 returns represented sole-proprietor income, partnerships, S corporations and limited-liability companies. By contrast, 73,667 returns come from “big business”: corporations (72,952 in 1990), public-utility franchises (229 in 1995) and financial franchise establishments (486 in 1994). Thus, small-business returns represent 83.45 percent of the 445,307 returns mentioned here. Figures derived from unpublished data supplied by the State of Maryland, Office of the Comptroller.

[Top] 11. U.S. Bureau of the Census, County Business Patterns, 1994: Maryland (Washington, D.C.: Government Printing Office, 1996), p. 3.

[Top] 12. From unpublished data supplied by State of Maryland, Office of the Governor.

[Top] 13. Michael D. Jenkins, Starting & Operating a Business in Maryland (Grants Pass, Ore.: Oasis, 1995), ch. 2.

[Top] 14. Moore and Stansel, “Tax Cuts and Balanced Budgets,” p. 1.

[Top] 15.. Moore and Stansel, “Tax Cuts and Balanced Budgets,” p. 1.

[Top] 16. Straszheim, testimony.

[Top] 17. Capers McDonald, CEO, Microbiological Associates, testimony before the Joint House Committees on Appropriations, Economics Matters, and Ways and Means, General Assembly of Maryland, January 24, 1997.

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