September 22, 2009
2010 State Business Tax Climate Index (Seventh Edition)
Background Paper No. 59
Introduction
The Tax Foundation presents the 2010 State Business Tax Climate Index (hereafter the SBTCI or the Index) as a tool for lawmakers, businesses and individuals alike to gauge how their states' tax systems compare. Policymakers can use the SBTCI to pinpoint changes to their tax systems that will explicitly improve their states' standing in relation to competing states.
American companies often function at a competitive disadvantage in the global economy. They pay one of the highest corporate tax rates of any of the industrialized countries. The top federal rate on corporate income is 35 percent, and states with punitive tax systems cause companies to be even less competitive globally.
The modern market is characterized by mobile capital and labor. Therefore, companies will locate where they have the greatest competitive advantage. States with the best tax systems will be the most competitive in attracting new businesses and most effective at generating economic and employment growth.
Although the market is now global, the Department of Labor reports that most mass job relocations are from one U.S. state to another rather than to an overseas location. Certainly job creation is rapid overseas, as previously underdeveloped nations enter the world economy. So state lawmakers are right to be concerned about how their states rank in the global competition for jobs and capital, but they need to be more concerned with companies moving from Ithaca, NY, to Indianapolis, IN, than from Ithaca to India. This means that state lawmakers must be aware of how their states' tax climates match up to their immediate neighbors and to other states within their regions.
State lawmakers are always mindful of their states' business tax climates, but they are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition as a case in Florida illustrates. In July of 2004 Florida lawmakers cried foul because a major credit card company announced it would close its Tampa call center, lay off 1,110 workers, and outsource those jobs to another company. The reason for the lawmakers' ire was that the company had been lured to Florida with a generous tax incentive package and had enjoyed nearly $3 million worth of tax breaks during the previous nine years. Another example comes from USA Today article chronicled that similar problems other states are having with companies who receive generous tax incentives.
Lawmakers create these deals under the banner of job creation and economic development, but the truth is that if a state really can't attract employers without such packages, it is often because punitive tax laws have created a woeful business tax climate. Alas, it's a vicious cycle. States give away tax revenue to new businesses, creating pressure for higher tax rates; and the higher the state's statutory tax rates, the more important special packages become. A far more effective approach is to systematically improve the business tax climate for the long term so as to improve the state's competitiveness. When assessing which changes to make, lawmakers need to remember these two rules:
1. Taxes matter to business. Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system, and the long-term health of a state's economy. Most importantly, taxes diminish profits. If taxes take a larger portion of profits, that cost is passed along to either consumers (through higher prices), workers (through lower wages or fewer jobs), or shareholders (through lower dividends or share value). Thus, a state with lower tax costs will be more attractive to business investment, and more likely to experience economic growth.
2. States do not enact tax changes (increase or cuts) in a vacuum. Every tax law will in some way change a state's competitive position relative to its immediate neighbors, its geographic region, and even globally. Ultimately it will affect the state's national standing as a place to live and to do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high-tax states.
Clearly, there are many non-tax factors that affect a state's overall business climate: its proximity to raw materials or transportation centers, its regulatory or legal structures, the quality of its education system and the skill of its workforce, not to mention the intangible perception of a state's "quality of life." The 2010 SBTCI does not measure the impact of these important features of a state's overall business climate. Rather, the SBTCI merely seeks to measure the tax component of each state's business climate.
Some of the non-tax factors of a state's business climate are outside of the control of elected officials. Montana lawmakers cannot change the fact that Montana's businesses have no immediate access to deepwater ports. Lawmakers do, however, have direct control over how friendly their tax systems are to business. Furthermore, unlike changes to a state's health care, transportation or education system, which can take decades to implement, changes to the tax code bring almost instantaneous benefits to a state's business climate.
The ideal tax system, whether at the local, state or federal level, is simple, transparent, stable, neutral to business activity, and pro-growth. In such an ideal system, individuals and businesses would spend a minimum amount of resources to comply with the tax system, understand the true cost of the tax system, base their economic decisions solely on the merits of the transactions, without regard to tax implications, and not have the tax system impede their growth and prosperity.
In reality, tax-induced economic distortions are a fact of life, and a more realistic goal is to maximize the occasions when people's economic decisions, whether in business or personal life, are guided by their own judgments, and minimize those cases where economic decisions are micromanaged or even dictated by a tax system. Therefore, the most competitive tax systems, and the ones that score best in the SBTCI, are those that create the fewest economic distortions by enforcing the most simple, pro-growth tax systems characterized by broad bases and low rates.
The SBTCI does not measure business tax burdens. While it is unquestionably important how much revenue states collect in business taxes, the manner in which they extract tax revenue is also important. In other words, quite apart from whether a state's total business tax burden is higher than in other states, it can enact (and many states do) a set of business tax laws that cause great damage to the economy. The SBTCI does not allow states with poor business tax regimes to hide behind low business tax burdens.
Good state tax systems levy low, flat rates on the broadest bases possible, and they treat all taxpayers the same. Variation in the tax treatment of different industries favors one economic activity or decision over another. The more riddled a tax system is with politically motivated preferences the less likely it is that business decisions will be made in response to market forces. The SBTCI rewards those states that apply these principles in five important areas of taxation: major business taxes, individual income taxes, sales taxes, unemployment insurance taxes and property taxes.
Tax competition is an unpleasant reality for state revenue and budget officials, but it is an effective restraint on state and local taxes. It also helps to more efficiently allocate resources because businesses can locate in the state where they receive the services they need at the lowest cost. When a state imposes higher taxes than a neighboring state, businesses will cross the border to some extent. Therefore states with more competitive tax systems score well in the SBTCI because they are best suited to generate economic growth.
Ranking the competitiveness of 50 very different tax systems presents many challenges, especially when a state dispenses with a major tax entirely. Should Utah's tax system which includes three relatively neutral taxes on general sales, individual income and corporate income be considered more or less competitive than Alaska's tax system, which includes a particularly burdensome corporate income tax but no tax on individual income or general statewide sales?
The 2010 SBTCI deals with such questions by comparing the states on five separate aspects of their tax systems and then adding the results up to a final, overall ranking. This approach has the advantage of rewarding states on particularly strong aspects of their tax systems (or penalizing them on particularly weak aspects) while also measuring the general competitiveness of their overall tax systems. The results are a score that can be compared to other states' scores. Ultimately, both Alaska and Utah score well.
This edition is the 2010 SBTCI and represents the tax climate of each state as of July 1, 2009, the first day of the standard 2010 fiscal year.
To learn more about the SBTCI, watch this slideshow.
