Connecticut Discovers The Laffer Curve The Hard Way
/Somewhere way back in the 70s, legend has it that economist Arthur Laffer got into a discussion over dinner with Dick Cheney and Donald Rumsfeld about the reason for America's then-slow economic growth. Laffer thought the reason for the slow growth was unduly high marginal tax rates, which then included a federal top rate of 70%. To illustrate the problem, Laffer supposedly drew on a napkin a curve showing tax collections increasing with rates, but only as long as rates are low; then at some point, as rates get higher, collections start to decrease, and then continue to drop until the rate reaches 100%, at which point collections fall to zero because nobody bothers to earn or report any income. This very simple concept has since gone by the name of the "Laffer Curve." Here is a version from The Intelligent Economist:
Note, though, that the curve is unspecific as to exactly where to find that point "c," where higher tax rates stop bringing in increased revenue and become counter-productive. And thus a few years ago we saw the likes of Barack Obama, Andrew Cuomo, and Bill de Blasio all proposing at the same time to add just a few more points to the income tax rates of the same group of highest-income taxpayers, all in the name of "fairness"; and the likes of Paul Krugman always finding a way to claim that higher tax rates are a good idea.
But can we get an idea of where the point of inflection might be found? Fortunately, the great state of Connecticut has decided to oblige our need to know by conducting a real live ongoing experiment.
The experiment started way back in the 70s and 80s, when the combined top marginal rate in New York State and City reached 19% (approximately 15% for the State and 4% for the City), and Connecticut had no income tax at all. The Connecticut towns closest to New York City -- Greenwich, Stamford, Darien, New Canaan, Westport -- experienced an enormous boom, and became some of the wealthiest places in the country. Then, in 1992, Connecticut -- experiencing normal budget problems common to all states -- decided to take the plunge and impose its own income tax. Hey, it was only going to be 3%. Who would even notice?
And it has continued from there. In the 80s, New York State recognized that it had become uncompetitive, and started cutting its top tax rate significantly; and that process continued during the 90s. By the mid-90s the top New York State rate was under 7% (add about 4% additional for New York City -- a figure that hasn't changed much during the period under discussion). Connecticut? Per a chart from the Tax Foundation here, by 2000 Connecticut's top rate had reached 4.5% (New York State's top rate that year was 6.85%); by 2005 Connecticut's was 5% (and New York State's had snuck up to 7.7% on a "temporary" basis); and in 2011 Connecticut pushed its top rate all the way to 6.5% (on income over $1 million for a couple filing jointly). Then in 2012 New York pulled a sneaky trick, raising its top rate to 8.82%, but only on income over $2 million (couple filing jointly), while lowering the rate for income between $300,000 and $2 million back to 6.85%. And finally, in 2015, Connecticut pushed its top rate to 6.99% on income over $1 million, and 6.90% on income over $500,000 (both couple filing jointly). Suddenly, Connecticut found itself with income tax rates higher even than New York for people making between $500,000 and $2 million per year and not residing in New York City. A $1 million per year earner could now actually live in Rye (just on the NY side of the border) and work in New York City, and pay less income tax than if he lived and worked in Connecticut. (Only New York City residents pay New York City income tax.)
Well, how has that been going? The early rumblings were stories of some of the major hedge funds picking up and moving to Florida, home of zero income tax. In July 2016, it was Paul Tudor Jones, reported in this article from the Yankee Institute to have had a personal income of about $600 million per year. That one move cost Connecticut about $30 - 40 million per year in income tax revenue just from the one guy. (Total annual income tax collections for the entire state of Connecticut run around $9 billion. This one guy paid almost half a percent of the total for the whole state.) A couple of months later came the report that Barry Sternlicht (of Starwood Capital) had also moved to Florida.
That's the anecdotal evidence; how about the overall numbers? With this year's April 18 tax deadline having passed, Connecticut now knows its tax collections for 2016. On Monday May 1, a guy named Ben Barnes (Connecticut's Secretary of the Office of Policy and Management) gave a presentation to the legislature. As reported in the CT Mirror here, Barnes described a "precipitous drop in revenue [that] we experienced in late April." And which of the various taxes is the main source of that precipitous drop?
The income tax, the state’s largest revenue engine, saw the most erosion by far. According to analysts, income tax receipts this fiscal year now are expected to total just under $9 billion. Not only is that well below the $9.44 billion analysts were anticipating just four months ago, but it falls short of the $9.2 billion collected last fiscal year. . . . Income tax receipts are experiencing their first major decline since 2009 — just as Connecticut fell into The Great Recession. And the bulk of the latest income tax erosion was tied not to paycheck withholding but to quarterly filings, most of which involves capital gains, dividends and other investment-related earnings. According to the governor’s budget office, the state’s 100 largest-income taxpayers paid 45 percent less this year than last.
It looks like Connecticut has gone over to the back side of the Laffer curve. What to do? You won't be surprised to learn that a coalition of progressive groups, including unions representing state employees, is calling for raising the top income tax rate yet again, to 7.49%, and also imposing a special 20% rate on income from hedge funds:
For example, labor advocates and other progressives have suggested that Connecticut respond to the “carried interest” loophole within the federal income tax system by imposing a surcharge close to 20 percent on the earnings of hedge fund managers.
But Governor Malloy -- a Democrat who was the driving force behind the 2011 and 2015 tax increases that were supposed to fix the state's revenue problems once and for all -- is not going along this time. He has told his Democrat and union allies that such tax increases are off the table and shouldn't even be discussed publicly for fear of driving additional big taxpayers out of the state.
Meanwhile, Connecticut has dug itself into a really deep hole, with no easy way out. It's not just that they can't increase taxes further; it's that even the current level of taxes has gotten them into a death spiral.
Readers familiar with Connecticut will know that it is a state without any dominant or particularly large city. (The largest currently is Bridgeport, at a little under 150,000.). But it has a dozen or so cities in the 35,000 to 150,000 range. In the past few years, I have had occasion to visit or pass through more than half of them: Bridgeport, New Haven, Hartford, New London, Waterbury, Torrington, Bristol. Without exception, they are dreary and run-down. In a recent East-West drive through Torrington on state Route 4, there were three large factory complexes, all appearing to be vacant, with prominent signs reading "Factory Space For Rent." The only formerly-industrial Connecticut town I know of that has experienced a significant revival is South Norwalk. Of course, it is directly between the fancy New York suburbs of Darien and Westport. Does any reader know of another formerly-industrial Connecticut town that is on its way back?
If Connecticut continues to follow the strategy of higher and higher taxes -- or even leaving taxes at the current uncompetitive levels -- there is not much hope for any of these small cities to revive any time soon. What they need is new investors, people willing to take a big risk in the hope of having a big success. But the message that Connecticut sends out is, if you have any meaningful success, we will treat you like a goose to be plucked. Nobody wants anything to do with them. Too bad.