Capital ideas for an ailing New York

Larry Kudlow
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Posted: Jan 21, 2006 12:05 AM

New York, New York, is still a helluva town. But New York state has some heavy lifting to do if it intends to remain competitive with its neighbors and the world.

The problem is that New York's overall tax burden remains terribly high. The Tax Foundation's State Business Tax Climate Index for 2004 rated New York 49th in the country -- just one spot ahead of last place. While New York had been moving in a low-tax, pro-growth direction under Gov. George Pataki, a huge tax hike in 2003 passed by the state legislature over the governor's veto represented a body blow to current and future economic performance. This is why across-the-board tax-rate relief is so vital to the economic future of the state.

There is a clear relationship between state tax burdens and state economic health. States with high and rising tax burdens are more likely to suffer economic decline; those with low and falling tax burdens are more likely to enjoy strong economic growth. Economic behavior -- whether measured by employment, work effort, saving, investment, risk-taking, entrepreneurship or capital formation -- is highly responsive to changes in marginal tax rates.

In other words, incentives matter. If New York would raise the after-tax rewards for work, investment and risk-taking, it would get more of each -- putting it on a sure path to long-term prosperity and competitiveness.

But there is a bigger picture here. It is essential that New York be more competitive in the global race for capital. New jobs require new businesses, and new business formation requires new capital sources. Let there be no doubt about it: Smart money and smart people are highly mobile. In the world race for capital, each goes to where the return on capital is highest. If not New York, then somewhere else.

In the 21st century information economy, an expanded and well-trained workforce must be equipped with easy capital access and large-scale capital inflows. For these important reasons, the onerous and burdensome multiple taxation of capital in New York must be remedied and ameliorated.

To begin, New York lawmakers should eliminate the state tax on capital gains and investor dividends. Investment in the state is now taxed once as wage and salary income and again as corporate net income. This multiple taxation of capital is a huge deterrent to growth, while its elimination would be a powerful stimulant to entrepreneurship and risk-taking. Similarly, the corporate tax on capital gains should be removed. Abolishing these tax penalties would set New York apart as the only state with an income tax that fully exempts capital.

Next, lawmakers should completely abolish New York's estate tax, which penalizes family-owned and closely held businesses. This tax has accelerated a brain-drain and capital flight to Florida, South Carolina and elsewhere. A 2004 National Bureau of Economic Research paper concluded that a 1 percent differential in estate-tax rates was associated with a 4 percent reduction in the number of residents in a given state. Clearly, New York's estate tax is pushing residents out.

Lawmakers in Albany may not know it, but the class war they're waging against the rich is actually robbing the state's non-rich of the capital necessary to create new technologies, new businesses, new equipment, new jobs and new job training. It's a nonsensical policy that must be ended.

As for income taxes, lowering the tax rates on personal income (6.85 percent) and corporate income (7.5 percent) both to 5 percent would raise the after-tax rewards for the entire state tax system. That alone would generate significantly higher living standards in New York and more rapid economic growth. Complexity can also be addressed. Instead of five income brackets, why not three wider brackets and inflation-indexing to prevent bracket creep? For businesses, all new investment could be cash-expensed to reduce complexity and lower the cost of capital.

New Yorkers have seen economic-growth tax principles work successfully in the past. When President Reagan and Gov. Hugh Carey lowered tax rates nationwide and statewide in the 1980s, New York shared in the U.S. economic boom. In the 1990s, Gov. Pataki's tax-rate reduction plan produced new jobs at a pace equal to or better than the U.S. average. President Bush's 2003 tax cuts on capital gains and investor dividends ignited New York's financial service and related industries, where employment, incomes and tax revenues all soared.

A complete restructuring of New York's tax system would provide relief to taxpayers in every income class and would set the state apart as the place for uninhibited growth and investment opportunities.  In-migration will replace the population drain. Instead of voting against New York, people will vote for it with both their feet and their money.