Too often in the last decade, Michigan's lackluster economic performance was attributed to the declining role of the U.S. motor vehicle industry.

. . . some states and cities recognized that in order to prosper, lower taxes and less government spending were the proper cures.

Add in the accelerating transformation from manufacturing to services, and the cause of Michigan's below-average economic growth could too easily be blamed on external factors beyond our control. From unfair Japanese trade practices to low wage Sunbelt states, the smoking gun for Michigan's sluggish economic growth was identified beyond our state's borders.

To some degree, the same economic misfortunes that plagued Michigan's poorest performing cities in the 1980's could also be blamed on external forces. External forces alone, however, do not adequately explain subpar economic growth. State and local tax and spending policies also played major roles. Typically, a state or city whose tax burden and spending patterns exceed the national or state averages will experience below-average economic growth.

That premise is validated in this latest and important offering from the Mackinac Center for Public Policy. Stephen Moore and Dean Stansel, both nationally-respected economists, provide here the first definitive link between the economic performance of Michigan's largest cities and their local tax and spending policies. Their research reveals that among Michigan's eleven largest cities, the five that experienced economic decline in the 1980's had the highest tax burdens and the most excessive government spending growth rates. Conversely, the remaining six cities, which witnessed above-average economic growth, had lower tax burdens and exhibited greater spending restraint.

The role of taxes and spending and their impact on economic growth has been a major debate for the past decade. The issue was first concentrated at the national level, when in the late 1970s the stagnation of the U.S. economy could not entirely be blamed on higher oil prices. Rising tax rates, excessive government spending and greater government regulation were recognized as impediments to U.S. economic growth.

That recognition prompted deregulation in the twilight of the Carter Presidency and income tax reduction as a cornerstone of the Reagan Presidency. The impact on economic policy and, in turn, the economy, was decidedly favorable. Pro-growth fiscal policy, combined with the Federal Reserve Board's efforts to foster a low inflation environment, produced the nation's longest peacetime economic expansion, lasting nearly eight years.

In fact, the nearly 20 million jobs created during the 1980s were unmatched by any country, at any time in history.

Concurrently, some states and cities recognized that in order to prosper, lower taxes and less government spending were the proper prescriptions. For example, California and Massachusetts significantly reduced their property taxes in the late 1970's, and in response, their state's economies witnessed above average growth. While other factors, such as emerging technology and the Reagan defense buildup, assisted these two states, lower taxes unquestionably had a major positive impact.

In fact, several economic studies have documented the positive impact on state and local economies from low tax burdens. For example, a study by economist Robert Genetski, at the Harris Bank of Chicago, found that when a state's tax burden was 1 per-cent above the national average, income growth would be 0.6 percent below the average.

Noted economists Arthur Laffer and Victor Canto of Laffer-Canto and Associates observed that a state's municipal bond rating was inversely related to tax burden. States with declining tax burdens were more likely to witness a bond rating upgrade, an event that is crucial to minimizing long term financing costs of needed infrastructure spending. Conversely, states with rising tax rates were found to experience rating downgrades, thereby increasing their capital costs.

My former associate, David Littmann, Chief Economist at Comerica Bank and a fellow Mackinac Center Advisor, found that the states with the highest tax burden suffered the weakest population growth in the 1980s. Specifically, the top ten states in tax burden suffered the poorest population performance; consequently, in political terms they suffered a net loss of 24 electoral votes, thus losing political clout.

Not surprisingly, Michigan was one of the ten states with the highest tax burden and, as a result, lost 2 electoral votes from the 1980 to 1990 census. Consequently, if state and local policy makers do not recognize the negative effect that high taxes have on economic performance, they should surely recognize its negative impact on electoral vote counts, and thus, political clout. Michigan remains one of the largest states in electoral votes, but continued erosion in its population relative to competing states will lead to further loss in its political power.

The same cause and effect relationship of high taxes and excessive government spending producing below average economic growth also exists at the local level. In the state of Michigan, the City of Detroit evidences this relationship. Detroit has suffered tremendous economic decline. A study from the Washington, D.C.-based Cato Institute revealed that, among 76 of the largest American cities, Detroit experienced the poorest economic growth from 1965 to 1990, based on the combination of population, employment and income growth.

Detroit must contend with a total tax burden that is about seven times higher than the average Michigan city, village and township. The municipal income tax rates of 3 percent on residents, 2 percent on corporations and 1.5 percent on non-residents who work in the city; the 5 percent utility users excise tax; and the combined city, school and property tax rate of more than 90 mills represent obstacles to economic development and have contributed to eroding the tax base.

Detroit's effectiveness in lowering its income taxes would prove beneficial for both the city and the suburbs. A 1992 nationwide study by the Federal Reserve Bank of Philadelphia revealed that there is a direct correlation between city and suburban economic growth. The study found that a stagnating or declining city leads to slower growth for its surrounding suburbs. It concluded that cities can compete through "the elimination of large differences in local tax rates, especially taxes on mobile factors such as labor." Not surprisingly, Philadelphia, like Detroit, has one of the highest tax burdens and poorest economic performance track records in the country.

Happily, in Michigan and many of our state's cities, economic performance improved in 1993. For most of 1993, the state's unemployment rate has been below the U.S. jobless rate for the first time since 1978. In August, Michigan's unemployment rate was 6.5%, a full 3% below levels which prevailed only 18 months before. In fact, Michigan witnessed the sharpest drop in the jobless rate in that span of time when contrasted with that of all large industrial states. In addition, to satisfy those critics who claim that Michigan's lower unemployment rate is merely the result of no labor force growth, state job growth is expanding at more than twice the rate of the national average – 3.8 percent versus 1.5 percent.

By most measurements, Michigan's economy is growing faster than the United States'. In fact, by six business indicators, Michigan is outperforming the U.S.: retail sales growth, state stock price performance, labor market conditions, motor vehicle production and local purchasing managers' economic surveys are exceeding U.S. growth rates, and have been for more than a year.

Much of Michigan's improved performance is due to a favorable, cyclical rebound in the auto industry. For the first nine months of 1993, U.S. motor vehicle sales have risen 10 percent, roughly double the sales forecasts made at the beginning of the year by the auto companies. Domestic auto sales have fared even better, rising 12 percent this year. Correspondingly, the domestic auto companies' market share has increased nearly 2 percentage points, the industry's best turnaround in more than ten years.

However, for Michigan and its major municipalities to continue their above average economic growth, even in this improved cyclical economy, the tax climate and other structural forces must improve. State government deserves high marks for resisting the urge to raise taxes during the latest recession/fiscal crisis. As a result, Michigan's tax burden has modestly improved in relation to other large industrial states.

The Citizens Research Council of Michigan notes that Michigan's 1991 state and local tax receipts per $1,000 of personal income were approximately 4 percent higher than the average for the 10 largest industrial states, down from 1985 levels when it was 10 percent above the average. In contrast, California, which opted for an $8 billion tax hike to solve its fiscal crisis, now faces an unemployment rate of nearly 10 percent, with little improvement in its budget deficit. Who would have forecasted three years ago that Michigan's jobless rate would be more than 3 percentage points lower than the Golden State? A stronger than anticipated recovery for the domestic auto industry coupled with defense downsizing has played well for Michigan versus California, but contrasting tax and regulatory policies between the two states also had a significant impact.

While Michigan retains a higher than average tax burden, combined with an intrusive regulatory climate, it is encouraging, nevertheless, that the state's business climate has moved in the proper direction. Now, local governments should follow the same path.

A Prosperity Agenda for Michigan's Cities provides a detailed analysis of the impact local tax and spending policies have on the economic growth of Michigan's cities. More importantly, the study also outlines a prescription for all Michigan cities to prosper in the competitive 1990's.

David G. Sowerby
Chief Economist and Director of Fixed Income
Beacon Investment Company – Ann Arbor, Michigan
and Adjunct Scholar with the Mackinac Center for Public Policy
October 1993