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Monday, November 4, 2019

True Cost of Government: A Review of State Data

How is it possible that Tennessee can do with a government that only costs two thirds of the government in Wyoming? Why does Wyoming have to have a government that is as costly as it is in New York?


The Census Bureau's new set of numbers on government finances is a treasure trove of information. It shows, e.g., that what looks like a strong improvement in government finances is really essentially just skin-deep, due almost entirely to improvements in insurance revenue. 

I also compared revenue changes in corporate-income taxes across states with changes in state GDP. It turns out that this tax, which is being lauded in Wyoming as a solution to the budget deficit, actually destabilizes revenue. Later this week I will make a similar analysis of property and sales taxes, and of income taxes; based on the highly unstable nature of corporate-tax revenue, it is reasonable to expect similar results from at least personal-income and sales tax revenue. 

There is another kind of information hidden in the state-local government finance data, namely the true cost of government. Many statistical products rank states different ways, such as the Tax Foundation's tax-climate studies or the Fraser Institute's Index of Economic Freedom. Key Policy Data, run by J Scott Moody, also has some important numbers to report, such as their own version of the Government Employment Ratio that I originated.

However, the only way to actually understand the size of government is to compare its total cost to the only tax base out there: income earned by employees in the private sector. Ultimately, the cost of government always falls back on the paychecks of private-sector employees; taxes paid by government employees are funded by taxes. The private sector is the only real tax base because it is exposed to competition, and because its products are sold under voluntary contracts. Unlike government, businesses and households are not allowed to hold a gun to anyone's head and force them to give up their money.

Since the private sector is exposed to competition, it is limited in its ability to fund enforced expenses; the higher the cost of government, the more that cost stifles the private sector. All other expenses can be mitigated or eliminated through renegotiations of contracts or, simply, changes in non-contract voluntary agreements. 

Within the private sector, in turn, the tax buck stops with personal income. Even if you tax profits or other formally non-personal transactions within the public sector, that cost is eventually transferred to employees. This happens in the form of reduced employment and as higher prices passed on to consumers. 

The alternative is to look at private-sector GDP as a whole; this is attractive from a direct tax-policy perspective, especially when one of the goals of tax reforms is to broaden and "diversify" the tax base. Private-sector GDP is the broadest possible tax base available, making it interesting for future analysis. For now, we focus on private-sector personal income simply because that is where the bills for all taxes eventually end up.

Figure 1 compares the total cost of state and local government, per state, for 2017 with private-sector personal income in that state. The total cost includes all taxes, fees and charges that state and local governments impose; it is important to include fees and charges, as some states over time have shifted some of their spending away from their general funds into the other-funds category. In theory this allows them to charge a fee instead of a tax to fund the same government activity.

As Figure 1 explains, the true cost of government varies from 11.3 percent in well-run Tennessee to 19.3 percent in highly troubled Alaska:

Figure 1
Sources of raw data: Census Bureau (government revenue), Bureau of Economic Analysis (personal income)

The previous year, 2016, New York ranked at the top with Wyoming a smidge behind. Both these states have seen marginal reductions in their true-cost ratio, primarily due to growth in their tax bases. 

In the case of Wyoming, this means recovering about half of the private-sector personal income lost in 2016. That year marked the bulk of a 17,000-strong loss of private sector employment in the Cowboy State; when the two-year downturn flattened out in 2017, the private sector started clawing its way back to growth again. 

The only reason why New York and Wyoming are not in top is that the true cost of government has gone up dramatically in Alaska, Hawaii and North Dakota. These states have different reasons for edging out the top ranks from 2016, but regardless of why the true cost of government goes up it is important to keep in mind that it does not matter why government wants money from us. The cost is the same if it is for a tax, a fee or a charge, and it certainly makes no difference what the money is for if our income is shrinking. 

On the brighter side of things, it is nice to note that the five states with the lowest true cost of government have a noticeably lower burden on their taxpayers than the year before:

  • In 2016 the five lowest-cost states ranked between 13.5 percent of private-sector income (New Hampshire) to 14.3 percent (Georgia);
  • In 2017 the five lowest-cost states ran from 11.5 percent (Tennessee) to 12.4 percent (Florida).

A comparison of two years does not tell us very much about long-term trends. Furthermore, these are two-year-old numbers, suggesting that more recent changes to tax policy are not taken into account. These are valid points, but it is also important to remember that government is a structure that does not change radically; what was true two years ago is a good approximation of what is true today. States with a high-costing government are unlikely to change that any time soon, though the fact that other states can get by with a substantially lower true cost of government should serve as a source of inspirations for politicians in high-cost states (no particular Cowboy State mentioned).

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