Tarnished by Taxes

Story Highlights:

• New York and California are facing economic problems and budget shortfalls. Investors may wonder how the national economy can recover if big states continue suffering.
• Often, state economic and budget problems are self-inflicted. High taxes, in particular, place a heavy burden on economic growth and lessen tax revenues.
• That doesn't mean economic growth overall must take a hit—it will instead be redistributed to more business-friendly states.

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What do you get for paying some of the highest taxes in all the land of the "free"? Top quality schools? Safe cities? Perfect roads? None of the above actually. In one state (bet you can't guess which!), folks end up with an ex-muscle man in a suit and a multi-billion dollar budget breach. California, the not-so-golden state, is facing among the worst economic conditions in the US and a budget crisis of historic proportions. Investors may wonder how America's economy can recover if a huge state like California continues suffering.

But California isn't indicative of nationwide problems—most of California's problems are self-inflicted. High taxes, in particular, place a big burden on economic growth and make it harder to solve California's current budget woes. The Laffer Curve long ago postulated there's a sweet spot for tax collection. Higher tax rates can mean lower tax receipts because the tax base shrinks—either because people are motivated to earn less, report less income, or even take their income elsewhere. It's no coincidence lower-tax states are weathering the downturn better than average, while high-tax states like California and New York face the two biggest deficits in the nation. Further, in healthier times, job creation and income have grown faster in low-tax states than high-tax states.

But still, won't ongoing malaise from a major economic contributor like California imperil economic recovery generally? Probably not. Remember, people and capital are portable—productive businessmen and women can start firms where they please. And high-tax states like California, New York, and New Jersey have lost higher-earning populace to lower-tax states. As long as states like Florida, Nevada, New Hampshire, Texas, Tennessee, and even Washington agree lower taxes are a boon to their economies, individuals can pick up and move there. High-tax states may be left in the dust, struggling with a slower economy, fewer jobs, and fewer tax receipts—but GDP as a whole can grow. In fact, productivity can actually increase as firms move to more business-friendly environments.

Economic recovery isn't handcuffed to California or any other single state. Some big, high-tax states may remain sluggish for some time, but only relative to faster growth in other, more business-friendly states. And maybe those high-tax states will eventually figure it out! If not, look to Texas to surpass California in both population and GDP. Hey! Like they say, don't mess with Texas.