Mercatus Center Misses the Mark with “Simple” Tax Index

The Mercatus Center, a think tank run by “America’s Hottest Economist,” has attempted to quantify the level of “freedom” enjoyed within each state.  If this sounds impossible, that’s because it is.  A quick look at the “taxes” component of each state’s “freedom score” should make this very clear.

According to the Center, freedom requires that “individuals should be allowed to dispose of their lives, liberties, and properties as they see fit, as long as they do not infringe on the rights of others.”  This, according to the study, requires “a deep distrust of taxation.”

In order to measure the impact of taxes on freedom, the Center does what it correctly describes as a “simple” calculation: it tallies up the size of all tax revenues (with a few exceptions) as a share of the state’s economy.  Basically, more tax revenue means less freedom under the authors’ assumptions — and taxes account for about 10 percent of each state’s overall “freedom score.”  But as everybody outside the Mercatus Center knows, taxes are never this simple.

For starters, states routinely use their tax codes to encourage (and discourage) a huge range of decisions that affect our day-to-day lives.  Most states, for example, offer strings-attached tax incentives designed to spur specific companies into building factories within their borders.  Under the Mercatus Center’s assumptions, a state that uses its tax code to subsidize private sector construction will actually score better on the “freedom” index than an otherwise identical state, simply because the subsidy cuts into its revenue collections.  In reality, however, a state without the subsidy offers a freer and more level playing field with “unhampered markets,” as the authors put it.

Of course, factory construction isn’t the only area where the government tries to manipulate behavior with special breaks.  States offer special tax breaks for everything from competing in a livestock show to purchasing binoculars — each of which the Mercatus Center’s calculations would classify as “freedom enhancing.”

Taxes can also affect freedom in unintentional ways.  For example, a handful of states have placed caps on the rate at which a homeowner’s property tax bill can grow each year.  These tax caps result in huge tax cuts for many homeowners, especially those that have lived in their homes for many years.  Obviously, under the Mercatus Center’s assumptions, these caps are big freedom enhancers.  In reality, however, the opposite is true.

An article in the March 2011 edition of the National Tax Journal showed what anecdotes from homeowners have always suggested: these caps result in a “lock-in effect” where residents are either unable or unwilling to leave their homes, out of fear of losing the tax savings they’ve accumulated over many years.  “Locking” residents into their homes with convoluted property tax breaks is hardly the definition of a free society.  But don’t count on the Mercatus Center’s “freedom index” being able to capture these types of nuanced, but vitally important implications of state tax policies.

Finally, it’s worth noting that the Mercatus index also falls short in its failure to examine who pays taxes.   This is most obvious in the 48th and 49th place fiscal policy rankings received by Hawaii and Alaska, respectively. 

Hawaii’s sales and excise tax revenues are very robust, in large part because of the huge quantities of hotel rooms, car rentals, tours, and souvenirs that are sold to out-of-state tourists.  Similarly, a significant amount of Alaska’s tax revenue (even excluding severance taxes, which the study omits) comes from multinational oil companies. 

In each of these states, many tax dollars flow into state coffers from outside the state — and while every one of those dollars sinks the state lower in the Mercatus “freedom index,” it has little if any impact on the freedom of anybody living within those states’ borders.  For this reason alone, readers should hesitate before taking the authors’ advice that “individuals can use the data to plan a move or retirement.”

At the end of the day, how taxes are collected is equally if not more important than how much taxes are collected.  Economists recognized this a long time ago when they discovered the tax policy principle of “neutrality,”  which basically means that tax systems should interfere with our decisions as little as possible.  A tax system that doesn’t generate much revenue can still reduce our freedom in important ways if it’s applied in a narrow and discriminatory fashion.  Anybody interested in enhancing freedom through tax reform should be focused on the plethora of special breaks contained in state systems — not the overall revenue yield of those systems.