Obama Hit by Blowback From Earlier Tea Partiers

Aug. 31 (Bloomberg) -- Governors in the U.S. don't usually brawl, but this year seems to be the exception.

When Massachusetts Governor Deval Patrick proudly scheduled a two-day sales-tax holiday for his citizens this month, just in time for back-to-school shopping, Governor John Lynch of New Hampshire punched back with a reminder that New Hampshire levies no sales tax at all. To rub it in, Governor Lynch travelled to Baron's Major Brands, an appliance retailer located practically within inches of the Massachusetts state line. Citizens of Massachusetts, Lynch bellowed over the border, ought to remember that "in New Hampshire, every day is a sales-tax holiday."

A similar contest rages between Governor David Paterson of New York and Connecticut Governor Jodi Rell. The New York State legislature had a plan to treat any carried interest earned by hedge-fund employees who commute into the state as income, subject to the state's high income-tax rates.

As Bloomberg has reported, Rell penned hedge-fund executives a smarmy letter inviting them to put their offices in the Nutmeg state. "I would like to convey a simple, yet, heartfelt message: Connecticut welcomes you."

There are other contests across the nation, statistically documented by the Tax Foundation. As Bill Ahern of the Foundation notes, "Nevada plays New Hampshire to California's Massachusetts."

Tax Brawls

What's up here? Many economic experts, including conservative ones, have long contended that marginal changes in tax rates don't weigh as heavily as other aspects of economic decision-making. The environment has changed. If you study the 2010 state tax brawls, you can see their import stretches far beyond their respective regions, even beyond U.S. borders.

The most visible reason for the escalation is the increase in federal-tax rates that will come in 2011. Barack Obama's administration has made it clear it will raise the statutory top rate to 39.6 percent, with all the additional taxes going up, including a wicked health-care-related levy on unearned income.

The federal government is itself, of course, thinking of taxing carried interest as income shortly. That likelihood is what originally emboldened Governor Paterson. As a result of the federal push upward, any diminution in state taxes becomes precious to companies, employees and consumers.

Time Is Cheaper

The second aspect at work here is recession. When you have less money, you care more about the sales tax or taxes paid on behalf of employees. When you have no job, your time is cheaper, and a drive across a border to get a break on a new washing machine suddenly begins to make sense.

The third aspect is political identity. States are like siblings. They have trouble remembering who they are unless they are competing with a brother or a sister. To feel good, states need someone else to feel better than. A tax race provides that opportunity to beat someone else.

And that state competitiveness results in a benefit for all citizens, not just those who live in the tax-cutting state. Other topics preoccupied Governor Rell this spring. But espying Paterson's weakness, and the readiness of the hedge funds to pack up their terminals and ergonomic chairs, Rell couldn't resist some tax fun. Paterson and his income-tax blunder made her political day. Her constituents won, too, for their carried-interest cash was now less likely to confront a tax increase.

Competitive Moves

Rell won't want to look like a hypocrite. She may have even helped New York because Paterson, wounded by his Rell battle, retreated from the plan for carried interest. Maybe not permanently, since Paterson doesn't believe in low taxes as a creed. He only moved due to the competition. Still, Paterson will be warier next time.

There is no doubt state taxes would be higher if the states didn't have each other breathing down their tax necks.

And states don't merely compete with each other. They compete with their own federal government, sometimes over revenue, but mostly political concepts. I wrote about this in last week's column, too, in reference to another battle, that between Maine and New Hampshire.

New Hampshire isn't just better than Maine, and Massachusetts; it is also in tax terms, better than Washington. The Granite State represents a kind of "woulda, coulda, shoulda" version of the country the U.S. isn't. This is as the country's framers intended. Down the centuries, individual U.S. states played the Tea Partiers, fighting back against Washington and reminding it of its fiscal limits. The check has worked, for low-tax politicians' success on the state level has often won them a place on the national stage, where they kept taxes from going up, and sometimes even cut them.

Best Match

This leads us to the most important competition of all, that involving nations. Britain has played the competitor role for Europe at times, and played it well. But the U.S. has also mattered. Though corporate taxes are high, the general tax burden in the U.S. is lower than the levels in the European Union. In economic heft and population terms, the U.S. is the best match for Europe.

When President Obama and Congress raise taxes, they make Europe's day. But they don't make Europe's decade, or its century. For without the U.S. to goad them, Europe's politicians -- like Paterson, hardly tax-cutters by temperament -- will surely raise taxes eventually. And they will do so because they don't have the U.S. to beat them.

(Amity Shlaes, senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2010 Bloomberg

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To contact the writer of this column: Amity Shlaes at amityshlaes@hotmail.com

To contact the editor responsible for this column: David Henry at dhenry2@bloomberg.net