October 1, 2004
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Background Paper No. 45
Executive Summary
With this study, the Tax Foundation presents its second annual estimate of each state’s “business tax friendliness,” the 2004 State Business Tax Climate Index. Most stories about how states compete for business revolve around the deliberately hyped efforts of politicians and economic development offices to lure high-profile companies to locate there. Usually, the object of their affection is a sports franchise or a famous international company, and the recent competition for the Montreal Expos is a case in point. States and cities routinely assemble generous packages of tax abatements and public spending to lure such firms. But under the media radar, each state’s tax system is constantly competing with its neighbors for start-ups and business expansion. In fact, politicians who have to aggressively market their state with huge tax giveaways are often trying to make up for a generally bad business tax climate.
One major element of that competition is the size of each state’s tax burden—the percentage of a state’s income taken in taxes. For many years the Tax Foundation has published estimates of each state’s combined state-local tax burden as part of its wellknown Tax Freedom Day report. The nationwide average in 2004 is 10.0 percent, and state-specific estimates range around that average from 6.3 percent in Alaska to 12.9 percent in New York. While businesses have always taken note of these tax burden estimates, the structure and complexity of a state’s tax system can be as important to businesses as the amount collected. Domestic and even international competition forces businesses to constantly search for more tax-friendly environments. Therefore, the state-local tax burden estimates and the State Business Tax Climate Index are complementary, answering the questions:How much are we paying? and Are we paying it in an conomically efficient way?
Business leaders and government policymakers an use the State Business Tax Climate Index as a comparative gauge of state tax systems. Each score that a state receives on the various measures is determined not only by the state in question but by the competition—the 49 other states. Policymakers can use the index to determine if their state tax system is needlessly hampering either the efforts of local entrepreneurs or the possible entry of new business.
The touchstone of the State Business Tax Climate Index is neutrality. If a state’s tax system maintains a “level playing field” for all types of businesses and business transactions,we consider it neutral and rate it highly.An economically neutral tax system benefits and punishes all businesses equally, so this index is a measure of each state’s tax friendliness to all business activity, not just small businesses or large businesses, capitalintensive or service-intensive, existing companies or start-ups. Therefore, if a state’s tax burden is relatively low and the state’s tax system does not favor some economic activities while penalizing others, we conclude that the state’s economy will be comparatively efficient, producing more jobs and yield higher incomes for everyone.
The overall index is a composite of five specific indexes devoted to major features of a state’s tax system, features that definitely influence business decisions or the economy in general: the corporate income tax, the individual income tax, the sales and gross receipts tax, the unemployment insurance tax, and the state’s fiscal balance.These five indexes are themselves composites of more than 100 separate variables.
In 2004, the ten states that are deemed to have entered 2004 with the most business-friendly tax systems are South Dakota, Florida,Alaska,Texas, New Hampshire, Nevada, Wyoming, Colorado,Washington, and Oregon. On the other end of the spectrum, the ten tax systems least hospitable to business in 2004 are found in Hawaii, New York, Minnesota, West Virginia, Rhode Island, Vermont, Kentucky, Arkansas, Maine and Wisconsin.
Generally speaking, states that rank highly manage without at least one of the major taxes. Indeed,Alaska scores well despite having one of the worst corporate tax systems in the nation because it taxes neither individual income nor sales. Colorado has a “traditional” tax system that imposes all three of the major state-level revenueraisers—a corporate income tax, an individual income tax and a sales tax—but ranks highly by keeping all of its taxes simple with low, flat rates. The common characteristics of states that rank poorly are: multiple-rate corporate and individual tax codes that impose above-average tax rates; above-average sales tax rates that exempt few business-to-business transactions; complex unemployment tax systems; and high overall state tax collections with few if any constitutional or statutory restraints on taxing or spending.
The 2004 State Business Tax Climate Index is determined by the tax laws in place at the beginning of the year.Therefore, such tax changes as the higher sales and corporate income taxes that Virginia enacted during 2004 are not included.