The Tax Foundation

May 1, 2003

State Business Tax Climate Index (First Edition)

by Scott A. Hodge, Wendy P. Warcholik, Ph.D. and J. Scott Moody

PLEASE DO NOT CITE—AN UPDATED VERSION OF THIS STUDY IS AVAILABLE. Please email publications@taxfoundation.org for details.

Background Paper No. 41

Executive Summary
With this study, the Tax Foundation presents its first annual estimate of each state’s “business tax friendliness,” the State Business Tax Climate Index.

Most stories about how states compete for business revolve around the location decisions of sports franchises and famous international companies. States and cities routinely assemble and publicize generous packages of tax abatements and public spending to lure a large employer, whether it’s the Montreal Expos, or a new auto plant or the corporate headquarters of a major firm. But under the media radar, each state’s tax system is constantly competing with its neighbors for start-ups and business expansion.

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 well-known Tax Freedom Day report. The nationwide average in 2002 was 9.6 percent, and the state-specific estimates ranged around that average from 5.8 percent in Alaska to 12.8 percent in the District of Columbia. These estimates include adjustments for the many complex ways that states shift tax burdens to nonresidents, making them more significant than raw collection data for individuals and policymakers who are assessing their states’ tax burdens.

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. Business leaders and government policy-makers can use this new ranking of state tax systems, the State Business Tax Climate Index, as a comparative gauge of their state’s tax system. Each score that a state receives on the various measures is determined not only by the state in question but by the competition—the other states. Policy-makers 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 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, capital-intensive 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 state’s fiscal balance, and the administrative complexity of the state’s tax system as measured by its conformity with other systems. These five indexes are themselves composites of several sub-indexes.

Table 1 shows the overall results. The ten states that are deemed to have the most business-friendly tax systems are Wyoming, New Hampshire, Nevada, Colorado, Alaska, South Dakota, Florida, Washington, Oregon and Tennessee. On the other end of the spectrum, the ten tax systems least hospitable to business are found in Mississippi, California, Arkansas, Ohio, Nebraska, Hawaii, New York, Maine, Minnesota and Louisiana. Generally speaking, states that rank highly manage without at least one of the major taxes. Indeed, Alaska scores well despite having the worst corporate tax system in the nation because it does not have either an individual income tax or a sales tax. Colorado has a “traditional” tax system that imposes 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 input items; high overall state/local tax burdens that have grown faster than taxpayers’ incomes; and tax codes that impose considerable compliance costs and double-taxation on businesses.

Attached Files