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2019 State Business Tax Climate Index PRINCIPLED INSIGHTFUL ENGAGED By Jared Walczak, Scott Drenkard, and Joseph Bishop-Henchman ISBN: 978-1-942768-22-7 © 2018 Tax Foundation 1325 G Street, NW, Suite 950 Washingtion, D.C. 20005 202.464.6200 taxfoundation.org 1 TAX FOUNDATION EXECUTIVE SUMMARYExecutive Summary The Tax Foundation’s State Business Tax Climate Index enables business leaders, government policymakers, and taxpayers to gauge how their states’ tax systems compare. While there are many ways to show how much is collected in taxes by state governments, the Index is designed to show how well states structure their tax systems and provides a road map for improvement. The 10 best states in this year’s Index are: 1. Wyoming 2. Alaska 3. South Dakota 4. Florida 5. Montana 6. New Hampshire 7. Oregon 8. Utah 9. Nevada 10. Indiana The 10 lowest ranked, or worst, states in this year’s Index are: 41. Vermont 42. Ohio 43. Minnesota 44. Louisiana 45. Iowa 46. Arkansas 47. Connecticut 48. New York 49. California 50. New Jersey 2019 State Business Tax Climate Index Note: A rank of 1 is best, 50 is worst. Rankings do not average to the total. States without a tax rank equally as 1. D.C.’s score and rank do not affect other states. The report shows tax systems as of July 1, 2018 (the beginning of Fiscal Year 2019). Source: Tax Foundation. 10 Best Business Tax Climates 10 Worst Business Tax Climates VA #22 NC #12 SC #35 GA #33 FL #4 AL #39 MS #31 TN #16 KY #23 OH #42 IN #10 IL #36 MO #14 AR #46 LA #44 IA #45 MN #43 WI #32 MI #13 PA #34 NY #48 ME #30 TX #15 OK #26 KS #28 NE #24 SD #3 ND #17 MT #5 WY #1 CO #18 NM #25 AZ #27 UT #8 NV #9 ID #21 OR #7 WA #20 CA #49 AK #2 HI #38 WV #19 #29 MA #37 RI #47 CT #50 NJ #11 DE #40 MD (#46) DC #41 VT #6 NH 2 STATE BUSINESS TAX CLIMATE INDEX EXECUTIVE SUMMARYThe absence of a major tax is a common factor among many of the top 10 states. Property taxes and unemployment insurance taxes are levied in every state, but there are several states that do without one or more of the major taxes: the corporate income tax, the individual income tax, or the sales tax. Wyoming, Nevada, and South Dakota have no corporate or individual income tax (though Nevada imposes gross receipts taxes); Alaska has no individual income or state-level sales tax; Florida has no individual income tax; and New Hampshire, Montana, and Oregon have no sales tax. This does not mean, however, that a state cannot rank in the top 10 while still levying all the major taxes. Indiana and Utah, for example, levy all of the major tax types, but do so with low rates on broad bases. The states in the bottom 10 tend to have a number of afflictions in common: complex, nonneutral taxes with comparatively high rates. New Jersey, for example, is hampered by some of the highest property tax burdens in the country, recently implemented the second highest-rate corporate income tax in the country, levies an inheritance tax, and maintains some of the nation’s worst-structured individual income taxes. 3 TAX FOUNDATION EXECUTIVE SUMMARYTABLE 1. 2019 State Business Tax Climate Index Ranks and Component Tax Ranks Overall Rank Corporate Tax Rank Individual Income Tax Rank Sales Tax Rank Property Tax Rank Unemployment Insurance Tax Rank Alabama 39 20 30 48 15 12 Alaska 2 25 1 5 23 35 Arizona 27 17 19 47 5 13 Arkansas 46 40 40 44 26 34 California 49 31 49 43 14 17 Colorado 18 16 14 38 12 40 Connecticut 47 29 43 30 50 23 Delaware 11 50 41 2 9 3 Florida 4 6 1 22 11 2 Georgia 33 8 38 29 24 38 Hawaii 38 14 47 24 16 26 Idaho 21 26 23 26 4 48 Illinois 36 39 13 36 45 42 Indiana 10 18 15 12 2 11 Iowa 45 48 42 19 39 33 Kansas 28 34 21 31 20 15 Kentucky 23 27 17 14 35 47 Louisiana 44 36 32 50 32 4 Maine 30 41 24 7 41 24 Maryland 40 22 45 18 42 28 Massachusetts 29 37 11 13 46 50 Michigan 13 11 12 11 22 49 Minnesota 43 42 46 27 31 25 Mississippi 31 15 27 35 36 5 Missouri 14 4 25 25 7 8 Montana 5 12 22 3 10 21 Nebraska 24 28 26 9 40 9 Nevada 9 33 5 40 8 45 New Hampshire 6 45 9 1 44 44 New Jersey 50 47 50 45 48 32 New Mexico 25 21 31 41 1 10 New York 48 7 48 42 47 31 North Carolina 12 3 16 20 33 7 North Dakota 17 23 20 32 6 14 Ohio 42 46 44 28 13 6 Oklahoma 26 9 33 39 19 1 Oregon 7 30 36 4 17 37 Pennsylvania 34 43 18 21 34 46 Rhode Island 37 32 29 23 43 29 South Carolina 35 19 34 34 27 27 South Dakota 3 1 1 33 28 39 Tennessee 16 24 8 46 29 22 Texas 15 49 6 37 37 18 Utah 8 5 10 16 3 16 Vermont 41 38 37 15 49 20 Virginia 22 10 35 10 30 43 Washington 20 44 6 49 25 19 West Virginia 19 13 28 17 18 30 Wisconsin 32 35 39 8 21 41 Wyoming 1 1 1 6 38 36 District of Columbia 46 27 45 25 47 33 Note: A rank of 1 is best, 50 is worst. Rankings do not average to the total. States without a tax rank equally as 1. D.C.’s score and rank do not affect other states. The report shows tax systems as of July 1, 2018 (the beginning of Fiscal Year 2019). Source: Tax Foundation. 4 STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESConnecticut A temporary corporate income tax surcharge in Connecticut was permitted to phase down from 20 to 10 percent in 2018, reducing the top marginal rate (surcharge-inclusive) from 9.0 to 8.25 percent. Originally set to expire at the end of 2015, legislation adopted that year postponed its elimination until 2019, with a phasedown in 2018. This year’s budget will further postpone the surcharge’s repeal, but the 2018 rate reduction helped the state improve four places on the corporate component of the Index, from 33rd to 29th. Connecticut’s overall rank remains unchanged at 47th. Delaware Delaware reversed its short-lived and counterproductive experiment with the estate tax, repealing it as of January 1, 2018. First adopted less than a decade ago, the tax generated very little revenue while driving wealthy seniors out of the state. Legislators scrapped the tax this year, and its elimination is the driving force behind the state’s improvement from 20th to 9th on the property tax component of the Index, and from 16th to 11th overall. Hawaii Last year, Hawaii legislators voted to restore the higher rates and brackets associated with a temporary tax increase which had been allowed to expire a year ago. The legislation reestablished three individual income tax brackets that had been eliminated and restored the top marginal rate to 11 percent, up from 8.25 percent. These changes went into effect in calendar year 2018 and caused the state to slip four places overall, from 34th to 38th, and from 38th to 47th on the individual income tax component. Idaho Idaho improved from 23rd to 21st overall due to individual and corporate income tax rate cuts adopted in response to base-broadening provisions of federal tax reform. Policymakers trimmed both rates by 0.475 percentage points, from 7.4 to 6.925 percent. Indiana Indiana saw consistent rate reductions through a series of responsible tax reform efforts between 2011 and 2016. Subsequent legislation established a further schedule of corporate income tax reductions through fiscal year 2022. For 2018, the corporate income tax rate declined from 6 to 5.75 percent. This rate reduction, among other changes, drove an improvement of six places on the corporate component of the Index. The Hoosier State and Utah continue to post the best rankings among states which impose all the major taxes. Kansas Recurring revenue shortfalls precipitated by a shortsighted package of tax cuts adopted in 2012 which, among other things, exempted all pass-through income from taxation, prompted legislators to phase in individual income tax rate increases over the past two years. Last year’s rate increase, which also added an additional tax bracket, resulted in a decline in the state’s overall ranking. However, this year’s further rate increase, from 5.2 to 5.7 percent, had no effect on the state’s overall rank. It did, however, drop Kansas two places–from 19th to 21st–on the individual income tax component. Notable Ranking Changes in this Year’s Index 5 TAX FOUNDATION RECENT CHANGESTABLE 2. State Business Tax Climate Index (2016–2019) State 2016 Rank 2016 Score 2017 Rank 2017 Score 2018 Rank 2018 Score 2019 Rank 2019 Score Change from 2018 to 2019 Rank Score Alabama 38 4.69 37 4.77 37 4.73 39 4.61 -2 -0.12 Alaska 2 7.34 3 7.25 3 7.15 2 7.35 +1 +0.20 Arizona 27 5.08 26 5.10 25 5.09 27 5.00 -2 -0.09 Arkansas 46 4.25 43 4.36 43 4.35 46 4.28 -3 -0.07 California 48 3.91 48 3.91 48 3.88 49 4.00 -1 +0.12 Colorado 18 5.26 18 5.25 18 5.28 18 5.19 0 -0.09 Connecticut 47 4.19 47 4.17 47 4.17 47 4.23 0 +0.06 Delaware 11 5.53 16 5.34 16 5.34 11 5.55 +5 +0.21 Florida 4 6.78 4 6.82 4 6.82 4 6.86 0 +0.04 Georgia 34 4.81 33 4.89 31 4.92 33 4.85 -2 -0.07 Hawaii 35 4.72 31 4.90 34 4.86 38 4.66 -4 -0.20 Idaho 26 5.10 25 5.10 23 5.11 21 5.12 +2 +0.01 Illinois 30 4.97 28 4.99 33 4.86 36 4.74 -3 -0.12 Indiana 10 5.58 9 5.73 9 5.75 10 5.70 -1 -0.05 Iowa 42 4.40 45 4.29 46 4.30 45 4.33 +1 +0.03 Kansas 25 5.11 24 5.11 28 5.04 28 4.99 0 -0.05 Kentucky 37 4.70 38 4.66 39 4.69 23 5.10 +16 +0.41 Louisiana 39 4.68 44 4.31 44 4.32 44 4.34 0 +0.02 Maine 33 4.82 35 4.87 30 4.97 30 4.95 0 -0.02 Maryland 41 4.51 40 4.47 40 4.48 40 4.53 0 +0.05 Massachusetts 28 4.99 29 4.98 27 5.04 29 4.98 -2 -0.06 Michigan 13 5.46 12 5.50 12 5.50 13 5.45 -1 -0.05 Minnesota 45 4.36 46 4.29 45 4.31 43 4.37 +2 +0.06 Mississippi 29 4.98 30 4.98 29 4.98 31 4.95 -2 -0.03 Missouri 16 5.29 15 5.36 15 5.34 14 5.38 +1 +0.04 Montana 5 6.25 5 6.22 5 6.21 5 6.30 0 +0.09 Nebraska 21 5.14 23 5.12 26 5.08 24 5.06 +2 -0.02 Nevada 9 5.86 7 5.92 7 5.92 9 5.81 -2 -0.11 New Hampshire 6 5.99 6 5.97 6 5.99 6 6.06 0 +0.07 New Jersey 50 3.51 50 3.51 50 3.44 50 3.20 0 -0.24 New Mexico 24 5.11 27 5.09 24 5.11 25 5.06 -1 -0.05 New York 49 3.84 49 3.86 49 3.87 48 4.02 +1 +0.15 North Carolina 12 5.49 11 5.55 11 5.58 12 5.52 -1 -0.06 North Dakota 19 5.24 19 5.23 19 5.23 17 5.28 +2 +0.05 Ohio 43 4.40 41 4.46 41 4.44 42 4.51 -1 +0.07 Oklahoma 23 5.12 21 5.16 21 5.13 26 5.05 -5 -0.08 Oregon 8 5.86 10 5.73 10 5.74 7 5.88 +3 +0.14 Pennsylvania 36 4.72 32 4.90 36 4.82 34 4.85 +2 +0.03 Rhode Island 40 4.53 39 4.50 38 4.70 37 4.71 +1 +0.01 South Carolina 31 4.90 34 4.88 32 4.89 35 4.83 -3 -0.06 South Dakota 3 7.33 2 7.34 2 7.34 3 7.27 -1 -0.07 Tennessee 17 5.27 14 5.41 14 5.42 16 5.30 -2 -0.12 Texas 14 5.46 13 5.48 13 5.46 15 5.37 -2 -0.09 Utah 7 5.88 8 5.88 8 5.89 8 5.83 0 -0.06 Vermont 44 4.39 42 4.38 42 4.39 41 4.53 +1 +0.14 Virginia 22 5.13 22 5.13 22 5.12 22 5.11 0 -0.01 Washington 15 5.31 17 5.32 17 5.31 20 5.18 -3 -0.13 West Virginia 20 5.23 20 5.18 20 5.17 19 5.18 +1 +0.01 Wisconsin 32 4.84 36 4.80 35 4.85 32 4.87 +3 +0.02 Wyoming 1 7.62 1 7.64 1 7.70 1 7.62 0 -0.08 District of Columbia 45 4.37 48 4.03 48 4.04 46 4.32 0 +0.28 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. D.C.'s score and rank do not affect other states. Source: Tax Foundation. 6 STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESKentucky Kentucky adopted revenue-positive tax reform which increases tax collections (primarily to address unfunded pension liabilities) while improving the overall tax structure. The state moved from a six-bracket individual income tax with a top rate of 6 percent to a 5 percent single-rate tax and scrapped its three-bracket corporate income tax for a single-rate tax as well. Lawmakers also suspended several business tax credits, broadened the sales tax base, and raised the cigarette tax, among other changes. These structural changes and tax simplifications yielded a 16-place improvement in Kentucky’s overall ranking, from 39th to 23rd, with a particularly strong improvement on the individual income tax component, where the state jumped from 37th to 17th nationwide. New Jersey New Jersey completed the phaseout of its estate tax in 2018 and reduced its sales tax rate from 6.875 to 6.625 percent, the culmination of a two-year swap involving higher gas tax rates. At the same time, however, lawmakers created a new individual income tax bracket with a rate of 10.75 percent, the third-highest in the country, and added a corporate income tax surcharge on companies with income of $1 million or more, which brings their tax rate to 11.5 percent. The sales tax rate reduction improves the state one place on that component, while estate tax repeal drives an improvement from 50th to 48th on the property tax component. The state’s individual income tax rank drops from 48th to 50th, and its corporate income tax rank falls from 42nd to 47th with the new rate increases. The state continues to rank worst overall on the Index. Vermont Set to experience a substantial revenue windfall due to federal tax reform, Vermont eliminated an individual income tax bracket while changing the top rate to 8.75 percent, down from 8.95 percent. The rate reduction and bracket contraction drove an improvement of six places on the individual income tax component, from 43rd to 37th, and helped the state improve one place, from 42nd to 41st, overall. District of Columbia In 2014, the District of Columbia began phasing in a tax reform package which lowered individual income taxes for middle-income brackets, expanded the sales tax base, raised the estate tax exemption, and reduced the corporate income tax rate. This year saw the final stage of those reforms implemented, with the corporate income tax declining to 8.25 percent and the standard deduction increasing to match the new federal deduction of $12,000. These changes helped D.C. improve two places overall, from 48th to 46th. 7 TAX FOUNDATION RECENT CHANGESRecent and Proposed Changes Not Reflected in the 2019 Index Arkansas Arkansas legislators are closing in on a comprehensive tax reform package which would overhaul individual and corporate income taxes as well as state-imposed property and wealth taxes, the culmination of the work of a state tax reform commission. Should the state adopt such a plan, it would be reflected in subsequent editions of the Index. Georgia This year, Georgia lawmakers approved a tax reform package which could reduce the individual income tax rate from 6.0 to 5.5 percent by 2020, among other changes. These changes will begin to go into effect in 2019 and will be reflected in next year’s edition of the Index. Iowa In 2018, Iowa legislators adopted a comprehensive tax reform package which will ultimately reduce both individual and corporate income tax rates and eliminate the state’s unusual provision of a deduction for federal income tax payments, subject to revenue availability. These changes are not in effect in 2018, but Iowa’s rankings can be expected to improve as reforms phase in over the next few years. Louisiana With a temporary one percentage-point sales tax increase known as the “clean penny” set to expire, lawmakers chose a partial extension, keeping the rate above where it was when the temporary increase was adopted, but lower than it was last year. While the state rate declined from 5 to 4.45 percent, Louisiana’s combined average state and local sales tax rate remains the second highest in the nation at 9.46 percent, and its exceedingly complex and uncompetitive sales tax structure is still ranked worst in the nation on the sales tax component of the Index. Missouri In the waning days of the legislative session, Missouri legislators approved bills which will overhaul both the individual and corporate income taxes in coming years. The legislation will eliminate the choice of apportionment factors for most corporate taxpayers, paying for a rate reduction from 6.25 to 4 percent, while the individual income tax is set on a path toward a top rate of 5.1 percent (from 5.9 percent this year). These changes, however, lay in the future, and will show up in subsequent editions of the Index. New Mexico New Mexico completed its phase-in of corporate income tax rate reductions that began in 2014, with the rate dropping from 6.2 to 5.9 percent. This final reduction was not enough to improve the state’s ranking on the corporate component of the Index, though the state has improved several places since the rate reductions began. 8 STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESTennessee In 2016, Tennessee began phasing out its Hall Tax, a tax on interest and dividend income, though the state does not tax wage income. The Index includes this tax at a calculated rate to reflect its unusually narrow base. Initial reductions are too small to change any component rankings, but Tennessee’s rank will improve once the tax is fully phased out in 2022. Utah Utah shaved both its corporate and individual income tax rates from 5 to 4.95 percent in response to higher anticipated revenue in the aftermath of federal tax reform. These minor reductions were not enough to improve the state’s rank, but Utah continues to rank the best of any state which imposes all the major tax types. 9 TAX FOUNDATION METHODOLOGYIntroduction Taxation is inevitable, but the specifics of a state’s tax structure matter greatly. The measure of total taxes paid is relevant, but other elements of a state tax system can also enhance or harm the competitiveness of a state’s business environment. The State Business Tax Climate Index distills many complex considerations to an easy-to-understand ranking. The modern market is characterized by mobile capital and labor, with all types of businesses, small and large, tending to locate where they have the greatest competitive advantage. The evidence shows that states with the best tax systems will be the most competitive at attracting new businesses and most effective at generating economic and employment growth. It is true that taxes are but one factor in business decision-making. Other concerns also matter–such as access to raw materials or infrastructure or a skilled labor pool–but a simple, sensible tax system can positively impact business operations with regard to these resources. Furthermore, unlike changes to a state’s health-care, transportation, or education systems, which can take decades to implement, changes to the tax code can quickly improve a state’s business climate. It is important to remember that even in our global economy, states’ stiffest competition often comes from other states. The Department of Labor reports that most mass job relocations are from one U.S. state to another rather than to a foreign location.1 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 Detroit, Michigan, to Dayton, Ohio, than from Detroit to New Delhi, India. This means that state lawmakers must be aware of how their states’ business climates match up against their immediate neighbors and to other regional competitor states. Anecdotes about the impact of state tax systems on business investment are plentiful. In Illinois early last decade, hundreds of millions of dollars of capital investments were delayed when then- Governor Rod Blagojevich (D) proposed a hefty gross receipts tax.2 Only when the legislature resoundingly defeated the bill did the investment resume. In 2005, California-based Intel decided to build a multibillion-dollar chip-making facility in Arizona due to its favorable corporate income tax system.3 In 2010, Northrup Grumman chose to move its headquarters to Virginia over Maryland, citing the better business tax climate.4 In 2015, General Electric and Aetna threatened to decamp from Connecticut if the governor signed a budget that would increase corporate tax burdens, and General Electric actually did so.5 Anecdotes such as these reinforce what we know from economic theory: taxes matter to businesses, and those places with the most competitive tax systems will reap the benefits of business-friendly tax climates. Tax competition is an unpleasant reality for state revenue and budget officials, but it is an effective restraint on state and local taxes. When a state imposes higher taxes than a neighboring 1 See U.S. Department of Labor, “Extended Mass Layoffs, First Quarter 2013 ,” Table 10, May 13, 2013. 2 Editorial, “Scale it back, Governor,” Chicago Tribune, , Mar. 23, 2007. 3 Ryan Randazzo, Edythe Jenson, and Mary Jo Pitzl, “Cathy Carter Blog: Chandler getting new $5 billion Intel facility,” AZCentral.com, Mar. 6, 2013. 4 Dana Hedgpeth and Rosalind Helderman, “Northrop Grumman decides to move headquarters to Northern Virginia,” The Washington Post, Apr. 27, 2010. 5 Susan Haigh, “Connecticut House Speaker: Tax ‘mistakes’ made in budget,” Associated Press, Nov. 5, 2015. 10 STATE BUSINESS TAX CLIMATE INDEX METHODOLOGYstate, businesses will cross the border to some extent. Therefore, states with more competitive tax systems score well in the Index, because they are best suited to generate economic growth. State lawmakers are mindful of their states’ business tax climates, but they are sometimes tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition, as the example of Dell Computers and North Carolina illustrates. North Carolina agreed to $240 million worth of incentives to lure Dell to the state. Many of the incentives came in the form of tax credits from the state and local governments. Unfortunately, Dell announced in 2009 that it would be closing the plant after only four years of operations.6 A 2007 USA TODAY article chronicled similar problems other states have had with companies that receive generous tax incentives.7 Lawmakers make these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for an undesirable business tax climate. A far more effective approach is the systematic improvement of the state’s business tax climate for the long term to improve the state’s competitiveness. When assessing which changes to make, lawmakers need to remember 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), employees (through lower wages or fewer jobs), or shareholders (through lower dividends or share value), or some combination of the above. 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 (increases or cuts) in a vacuum. Every tax law will in some way change a state’s competitive position relative to its immediate neighbors, its 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. To some extent, tax-induced economic distortions are a fact of life, but policymakers should strive to maximize the occasions when businesses and individuals are guided by business principles and minimize those cases where economic decisions are influenced, micromanaged, or even dictated by a tax system. 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 Index rewards those states that minimize tax-induced economic distortions. 6 Austin Mondine, “Dell cuts North-Carolina plant despite $280m sweetener,” TheRegister.co.uk, Oct. 8, 2009. 7 Dennis Cauchon, “Business Incentives Lose Luster for States,” USA TODAY, Aug. 22, 2007. 11 TAX FOUNDATION METHODOLOGYRanking the competitiveness of 50 very different tax systems presents many challenges, especially when a state dispenses with a major tax entirely. Should Indiana’s tax system, which includes three relatively neutral taxes on 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 statewide tax on individual income or sales? The Index deals with such questions by comparing the states on more than 100 variables in the five major areas of taxation (corporate taxes, individual income taxes, sales taxes, unemployment insurance taxes, and property taxes) and then adding the results to yield a final, overall ranking. This approach rewards states on particularly strong aspects of their tax systems (or penalizes them on particularly weak aspects), while measuring the general competitiveness of their overall tax systems. The result is a score that can be compared to other states’ scores. Ultimately, both Alaska and Indiana score well. Literature Review Economists have not always agreed on how individuals and businesses react to taxes. As early as 1956, Charles Tiebout postulated that if citizens were faced with an array of communities that offered different types or levels of public goods and services at different costs or tax levels, then all citizens would choose the community that best satisfied their particular demands, revealing their preferences by “voting with their feet.” Tiebout’s article is the seminal work on the topic of how taxes affect the location decisions of taxpayers. Tiebout suggested that citizens with high demands for public goods would concentrate in communities with high levels of public services and high taxes while those with low demands would choose communities with low levels of public services and low taxes. Competition among jurisdictions results in a variety of communities, each with residents who all value public services similarly. However, businesses sort out the costs and benefits of taxes differently from individuals. For businesses, which can be more mobile and must earn profits to justify their existence, taxes reduce profitability. Theoretically, businesses could be expected to be more responsive than individuals to the lure of low-tax jurisdictions. Research suggests that corporations engage in “yardstick competition,” comparing the costs of government services across jurisdictions. Shleifer (1985) first proposed comparing regulated franchises in order to determine efficiency. Salmon (1987) extended Shleifer’s work to look at subnational governments. Besley and Case (1995) showed that “yardstick competition” affects voting behavior, and Bosch and Sole-Olle (2006) further confirmed the results found by Besley and Case. Tax changes that are out of sync with neighboring jurisdictions will impact voting behavior. The economic literature over the past 50 years has slowly cohered around this hypothesis. Ladd (1998) summarizes the post-World War II empirical tax research literature in an excellent survey article, breaking it down into three distinct periods of differing ideas about taxation: (1) taxes do not change behavior; (2) taxes may or may not change business behavior depending on the circumstances; and (3) taxes definitely change behavior. 12 STATE BUSINESS TAX CLIMATE INDEX METHODOLOGYPeriod one, with the exception of Tiebout, included the 1950s, 1960s, and 1970s and is summarized succinctly in three survey articles: Due (1961), Oakland (1978), and Wasylenko (1981). Due’s was a polemic against tax giveaways to businesses, and his analytical techniques consisted of basic correlations, interview studies, and the examination of taxes relative to other costs. He found no evidence to support the notion that taxes influence business location. Oakland was skeptical of the assertion that tax differentials at the local level had no influence at all. However, because econometric analysis was relatively unsophisticated at the time, he found no significant articles to support his intuition. Wasylenko’s survey of the literature found some of the first evidence indicating that taxes do influence business location decisions. However, the statistical significance was lower than that of other factors such as labor supply and agglomeration economies. Therefore, he dismissed taxes as a secondary factor at most. Period two was a brief transition during the early- to mid-1980s. This was a time of great ferment in tax policy as Congress passed major tax bills, including the so-called Reagan tax cut in 1981 and a dramatic reform of the federal tax code in 1986. Articles revealing the economic significance of tax policy proliferated and became more sophisticated. For example, Wasylenko and McGuire (1985) extended the traditional business location literature to nonmanufacturing sectors and found, “Higher wages, utility prices, personal income tax rates, and an increase in the overall level of taxation discourage employment growth in several industries.” However, Newman and Sullivan (1988) still found a mixed bag in “their observation that significant tax effects [only] emerged when models were carefully specified.” Ladd was writing in 1998, so her “period three” started in the late 1980s and continued up to 1998, when the quantity and quality of articles increased significantly. Articles that fit into period three begin to surface as early as 1985, as Helms (1985) and Bartik (1985) put forth forceful arguments based on empirical research that taxes guide business decisions. Helms concluded that a state’s ability to attract, retain, and encourage business activity is significantly affected by its pattern of taxation. Furthermore, tax increases significantly retard economic growth when the revenue is used to fund transfer payments. Bartik concluded that the conventional view that state and local taxes have little effect on business is false. Papke and Papke (1986) found that tax differentials among locations may be an important business location factor, concluding that consistently high business taxes can represent a hindrance to the location of industry. Interestingly, they use the same type of after-tax model used by Tannenwald (1996), who reaches a different conclusion. Bartik (1989) provides strong evidence that taxes have a negative impact on business start-ups. He finds specifically that property taxes, because they are paid regardless of profit, have the strongest negative effect on business. Bartik’s econometric model also predicts tax elasticities of -0.1 to -0.5 that imply a 10 percent cut in tax rates will increase business activity by 1 to 5 percent. Bartik’s findings, as well as those of Mark, McGuire, and Papke (2000), and ample anecdotal evidence of the importance of property taxes, buttress the argument for inclusion of a property index devoted to property-type taxes in the Index. By the early 1990s, the literature had expanded sufficiently for Bartik (1991) to identify 57 studies on which to base his literature survey. Ladd succinctly summarizes Bartik’s findings: 13 TAX FOUNDATION METHODOLOGYThe large number of studies permitted Bartik to take a different approach from the other authors. Instead of dwelling on the results and limitations of each individual study, he looked at them in the aggregate and in groups. Although he acknowledged potential criticisms of individual studies, he convincingly argued that some systematic flaw would have to cut across all studies for the consensus results to be invalid. In striking contrast to previous reviewers, he concluded that taxes have quite large and significant effects on business activity. Ladd’s “period three” surely continues to this day. Agostini and Tulayasathien (2001) examined the effects of corporate income taxes on the location of foreign direct investment in U.S. states. They determined that for “foreign investors, the corporate tax rate is the most relevant tax in their investment decision.” Therefore, they found that foreign direct investment was quite sensitive to states’ corporate tax rates. Mark, McGuire, and Papke (2000) found that taxes are a statistically significant factor in private- sector job growth. Specifically, they found that personal property taxes and sales taxes have economically large negative effects on the annual growth of private employment. Harden and Hoyt (2003) point to Phillips and Gross (1995) as another study contending that taxes impact state economic growth, and they assert that the consensus among recent literature is that state and local taxes negatively affect employment levels. Harden and Hoyt conclude that the corporate income tax has the most significant negative impact on the rate of growth in employment. Gupta and Hofmann (2003) regressed capital expenditures against a variety of factors, including weights of apportionment formulas, the number of tax incentives, and burden figures. Their model covered 14 years of data and determined that firms tend to locate property in states where they are subject to lower income tax burdens. Furthermore, Gupta and Hofmann suggest that throwback requirements are the most influential on the location of capital investment, followed by apportionment weights and tax rates, and that investment-related incentives have the least impact. Other economists have found that taxes on specific products can produce behavioral results similar to those that were found in these general studies. For example, Fleenor (1998) looked at the effect of excise tax differentials between states on cross-border shopping and the smuggling of cigarettes. Moody and Warcholik (2004) examined the cross-border effects of beer excises. Their results, supported by the literature in both cases, showed significant cross-border shopping and smuggling between low-tax states and high-tax states. Fleenor found that shopping areas sprouted in counties of low-tax states that shared a border with a high-tax state, and that approximately 13.3 percent of the cigarettes consumed in the United States during FY 1997 were procured via some type of cross-border activity. Similarly, Moody and Warcholik found that in 2000, 19.9 million cases of beer, on net, moved from low- to high-tax states. This amounted to some $40 million in sales and excise tax revenue lost in high- tax states. 14 STATE BUSINESS TAX CLIMATE INDEX METHODOLOGYAlthough the literature has largely congealed around a general consensus that taxes are a substantial factor in the decision-making process for businesses, disputes remain, and some scholars are unconvinced. Based on a substantial review of the literature on business climates and taxes, Wasylenko (1997) concludes that taxes do not appear to have a substantial effect on economic activity among states. However, his conclusion is premised on there being few significant differences in state tax systems. He concedes that high-tax states will lose economic activity to average or low- tax states “as long as the elasticity is negative and significantly different from zero.” Indeed, he approvingly cites a State Policy Reports article that finds that the highest-tax states, such as Minnesota, Wisconsin, and New York, have acknowledged that high taxes may be responsible for the low rates of job creation in those states.8 Wasylenko’s rejoinder is that policymakers routinely overestimate the degree to which tax policy affects business location decisions and that as a result of this misperception, they respond readily to public pressure for jobs and economic growth by proposing lower taxes. According to Wasylenko, other legislative actions are likely to accomplish more positive economic results because in reality, taxes do not drive economic growth. However, there is ample evidence that states compete for businesses using their tax systems. A recent example comes from Illinois, where in early 2011 lawmakers passed two major tax increases. The individual income tax rate increased from 3 percent to 5 percent, and the corporate income tax rate rose from 7.3 percent to 9.5 percent.9 The result was that many businesses threatened to leave the state, including some very high-profile Illinois companies such as Sears and the Chicago Mercantile Exchange. By the end of the year, lawmakers had cut deals with both firms, totaling $235 million over the next decade, to keep them from leaving the state.10 Measuring the Impact of Tax Differentials Some recent contributions to the literature on state taxation criticize business and tax climate studies in general.11 Authors of such studies contend that comparative reports like the State Business Tax Climate Index do not take into account those factors which directly impact a state’s business climate. However, a careful examination of these criticisms reveals that the authors believe taxes are unimportant to businesses and therefore dismiss the studies as merely being designed to advocate low taxes. 8 State Policy Reports, Vol. 12, No. 11, Issue 1, p. 9, June 1994. 9 Both rate increases had a temporary component, and were allowed to partially expire before legislators overrode a gubernatorial veto to increase rates above where they would have been should they have been allowed to sunset. 10 Benjamin Yount, “Tax increase, impact, dominate Illinois Capitol in 2011,” Illinois Statehouse News, Dec. 27, 2011. 11 A trend in tax literature throughout the 1990s was the increasing use of indices to measure a state’s general business climate. These include the Center for Policy and Legal Studies’ Economic Freedom in America’s 50 States: A 1999 Analysis and the Beacon Hill Institute’s State Competitiveness Report 2001. Such indexes even exist on the international level, including the Heritage Foundation and The Wall Street Journal’s 2004 Index of Economic Freedom. Plaut and Pluta (1983) examined the use of business climate indices as explanatory variables for business location movements. They found that such general indices do have a significant explanatory power, helping to explain, for example, why businesses have moved from the Northeast and Midwest toward the South and Southwest. In turn, they also found that high taxes have a negative effect on employment growth. 15 TAX FOUNDATION METHODOLOGYPeter Fisher’s Grading Places: What Do the Business Climate Rankings Really Tell Us? now published by Good Jobs First, criticizes four indices: The U.S. Business Policy Index published by the Small Business and Entrepreneurship Council, Beacon Hill’s Competitiveness Report, the American Legislative Exchange Council’s Rich States, Poor States, and this study. The first edition also critiqued the Cato Institute’s Fiscal Policy Report Card and the Economic Freedom Index by the Pacific Research Institute. In the report’s first edition, published before Fisher summarized his objections: “The underlying problem with the … indexes, of course, is twofold: none of them actually do a very good job of measuring what it is they claim to measure, and they do not, for the most part, set out to measure the right things to begin with” (Fisher 2005). In the second edition, he identified three overarching questions: (1) whether the indices included relevant variables, and only relevant variables; (2) whether these variables measured what they purport to measure; and (3) how the index combines these measures into a single index number (Fisher 2013). Fisher’s primary argument is that if the indexes did what they purported to do, then all five would rank the states similarly. Fisher’s conclusion holds little weight because the five indices serve such dissimilar purposes, and each group has a different area of expertise. There is no reason to believe that the Tax Foundation’s Index, which depends entirely on state tax laws, would rank the states in the same or similar order as an index that includes crime rates, electricity costs, and health care (the Small Business and Entrepreneurship Council’s Small Business Survival Index), or infant mortality rates and the percentage of adults in the workforce (Beacon Hill’s State Competitiveness Report), or charter schools, tort reform, and minimum wage laws (the Pacific Research Institute’s Economic Freedom Index). The Tax Foundation’s State Business Tax Climate Index is an indicator of which states’ tax systems are the most hospitable to business and economic growth. The Index does not purport to measure economic opportunity or freedom, or even the broad business climate, but rather the narrower business tax climate, and its variables reflect this focus. We do so not only because the Tax Foundation’s expertise is in taxes, but because every component of the Index is subject to immediate change by state lawmakers. It is by no means clear what the best course of action is for state lawmakers who want to thwart crime, for example, either in the short or long term, but they can change their tax codes now. Contrary to Fisher’s 1970s’ view that the effects of taxes are “small or non-existent,” our study reflects strong evidence that business decisions are significantly impacted by tax considerations. Although Fisher does not feel tax climates are important to states’ economic growth, other authors contend the opposite. Bittlingmayer, Eathington, Hall, and Orazem (2005) find in their analysis of several business climate studies that a state’s tax climate does affect its economic growth rate and that several indices are able to predict growth. Specifically, they concluded, “The State Business Tax Climate Index explains growth consistently.” This finding was confirmed by Anderson (2006) in a study for the Michigan House of Representatives, and more recently by Kolko, Neumark, and Mejia (2013), who, in an analysis of the ability of 10 business climate indices to predict economic growth, concluded that the State Business Tax Climate Index yields “positive, sizable, and statistically significant estimates for every specification” they measured, and specifically cited the Index as one of two business climate indices (out of 10) with particularly strong and robust evidence of predictive power. 16 STATE BUSINESS TAX CLIMATE INDEX METHODOLOGYBittlingmayer et al. also found that relative tax competitiveness matters, especially at the borders, and therefore, indices that place a high premium on tax policies do a better job of explaining growth. They also observed that studies focused on a single topic do better at explaining economic growth at borders. Lastly, the article concludes that the most important elements of the business climate are tax and regulatory burdens on business (Bittlingmayer et al. 2005). These findings support the argument that taxes impact business decisions and economic growth, and they support the validity of the Index. Fisher and Bittlingmayer et al. hold opposing views about the impact of taxes on economic growth. Fisher finds support from Robert Tannenwald, formerly of the Boston Federal Reserve, who argues that taxes are not as important to businesses as public expenditures. Tannenwald compares 22 states by measuring the after-tax rate of return to cash flow of a new facility built by a representative firm in each state. This very different approach attempts to compute the marginal effective tax rate of a hypothetical firm and yields results that make taxes appear trivial. The taxes paid by businesses should be a concern to everyone because they are ultimately borne by individuals through lower wages, increased prices, and decreased shareholder value. States do not institute tax policy in a vacuum. Every change to a state’s tax system makes its business tax climate more or less competitive compared to other states and makes the state more or less attractive to business. Ultimately, anecdotal and empirical evidence, along with the cohesion of recent literature around the conclusion that taxes matter a great deal to business, show that the Index is an important and useful tool for policymakers who want to make their states’ tax systems welcoming to business. Methodology The Tax Foundation’s State Business Tax Climate Index is a hierarchical structure built from five components: · Individual Income Tax · Sales Tax · Corporate Income Tax · Property Tax · Unemployment Insurance Tax Using the economic literature as our guide, we designed these five components to score each state’s business tax climate on a scale of 0 (worst) to 10 (best). Each component is devoted to a major area of state taxation and includes numerous variables. Overall, there are 118 variables measured in this report. The five components are not weighted equally, as they are in some indices. Rather, each component is weighted based on the variability of the 50 states’ scores from the mean. The standard deviation of each component is calculated and a weight for each component is created from that measure. The result is a heavier weighting of those components with greater variability. 17 TAX FOUNDATION METHODOLOGYThe weighting of each of the five major components is: · 30.1% — Individual Income Tax · 25.3% — Sales Tax · 19.5% — Corporate Tax · 15.4% — Property Tax · 9.8% — Unemployment Insurance Tax This improves the explanatory power of the State Business Tax Climate Index as a whole, because components with higher standard deviations are those areas of tax law where some states have significant competitive advantages. Businesses that are comparing states for new or expanded locations must give greater emphasis to tax climates when the differences are large. On the other hand, components in which the 50 state scores are clustered together, closely distributed around the mean, are those areas of tax law where businesses are more likely to de-emphasize tax factors in their location decisions. For example, Delaware is known to have a significant advantage in sales tax competition, because its tax rate of zero attracts businesses and shoppers from all over the Mid-Atlantic region. That advantage and its drawing power increase every time another state raises its sales tax. In contrast with this variability in state sales tax rates, unemployment insurance tax systems are similar around the nation, so a small change in one state’s law could change its component ranking dramatically. Within each component are two equally weighted subindices devoted to measuring the impact of the tax rates and the tax bases. Each subindex is composed of one or more variables. There are two types of variables: scalar variables and dummy variables. A scalar variable is one that can have any value between 0 and 10. If a subindex is composed only of scalar variables, then they are weighted equally. A dummy variable is one that has only a value of 0 or 1. For example, a state either indexes its brackets for inflation or does not. Mixing scalar and dummy variables within a subindex is problematic, because the extreme valuation of a dummy can overly influence the results of the subindex. To counter this effect, the Index generally weights scalar variables 80 percent and dummy variables 20 percent. Relative versus Absolute Indexing The State Business Tax Climate Index is designed as a relative index rather than an absolute or ideal index. In other words, each variable is ranked relative to the variable’s range in other states. The relative scoring scale is from 0 to 10, with zero meaning not “worst possible” but rather worst among the 50 states. Many states’ tax rates are so close to each other that an absolute index would not provide enough information about the differences among the states’ tax systems, especially for pragmatic business owners who want to know which states have the best tax system in each region. Comparing States without a Tax. One problem associated with a relative scale is that it is mathematically impossible to compare states with a given tax to states that do not have the tax. 18 STATE BUSINESS TAX CLIMATE INDEX METHODOLOGYAs a zero rate is the lowest possible rate and the most neutral base, since it creates the most favorable tax climate for economic growth, those states with a zero rate on individual income, corporate income, or sales gain an immense competitive advantage. Therefore, states without a given tax generally receive a 10, and the Index measures all the other states against each other. Three notable exceptions to this rule exist. The first is in Washington and Texas, which do not have taxes on wage income but do apply their gross receipts taxes to limited liability corporations (LLCs) and S corporations. Because these entities are generally taxed through the individual code, these two states do not score perfectly in the individual income tax component. The second exception is found in Nevada, where a payroll tax (for purposes other than unemployment insurance) is also included in the individual income tax component. The final exception is in zero sales tax states–Alaska, Montana, New Hampshire, Oregon, and Washington–which do not have general sales taxes but still do not score a perfect 10 in that component section because of excise taxes on gasoline, beer, spirits, and cigarettes, which are included in that section. Alaska, moreover, forgoes a state sales tax, but does permit local option sales taxes. Normalizing Final Scores. Another problem with using a relative scale within the components is that the average scores across the five components vary. This alters the value of not having a given tax across major indices. For example, the unadjusted average score of the corporate income tax component is 6.96 while the average score of the sales tax component is 5.23. In order to solve this problem, scores on the five major components are “normalized,” which brings the average score for all of them to 5.00, excluding states that do not have the given tax. This is accomplished by multiplying each state’s score by a constant value. Once the scores are normalized, it is possible to compare states across indices. For example, because of normalization, it is possible to say that Connecticut’s score of 4.97 on corporate income taxes is better than its score of 4.59 on the sales tax. Time Frame Measured by the Index (Snapshot Date) Starting with the 2006 edition, the Index has measured each state’s business tax climate as it stands at the beginning of the standard state fiscal year, July 1. Therefore, this edition is the 2019 Index and represents the tax climate of each state as of July 1, 2018, the first day of fiscal year 2019 for most states. District of Columbia The District of Columbia (D.C.) is only included as an exhibit and its scores and “phantom ranks” offered do not affect the scores or ranks of other states. 2019 Changes to Methodology 19 TAX FOUNDATION METHODOLOGYTax changes to the treatment of capital investment featured prominently in the federal Tax Cuts and Jobs Act, and now assumes a larger role in the Index. This year we have added new variables for the expensing of capital investment under both the corporate and individual income tax components. States which follow the federal government in permitting corporations the full and immediate expensing of machinery and equipment purchases under Section 168(k) are rewarded, while lesser credit is given to states which offer some degree of accelerated first-year “bonus” depreciation, short of full expensing. Similarly, a new scalar variable on the individual income tax component of the Index scores states by the dollar cap (currently ranging from $25,000 to $1 million) they place on Section 179 small business expensing, with higher caps yielding better scores. A change in how net operating loss carrybacks are treated at the federal level is also reflected in the Index. Whereas before, the federal government provided two years of uncapped loss carrybacks and 20 years of uncapped loss carryforwards, the new law provides for indefinite carryforwards and no carrybacks, while limiting the amount of carryforwards claimed in any given year to 80 percent of taxable income. Previously, the Index gave the maximum score to states which offered the most generous number of carryback and carryforward years, while penalizing states with stingy carryover periods or caps on the amount that could be carried forward or backward. Under the revised methodology, states can achieve a perfect score on this subcomponent either through generous statutory provisions or by conforming to the new federal law. This year, Oregon joined Nevada in imposing a payroll tax unrelated to a program of unemployment insurance. Oregon’s tax is levied in addition to the individual income tax, while Nevada’s is in lieu of an income tax. We now model such payroll taxes as a single-rate individual income tax falling exclusively on wage income, gifting the state the best possible scores on structural components of individual income taxation irrelevant to the imposition of a payroll tax. Finally, modest weighting changes were made to the income tax component as new variables were added. For the individual income tax, the marriage penalty assumes less significance under the revised methodology, now representing 10 percent of the base subindex, while double taxation variables are assigned 40 percent of the base subindex, and other variables, including the new Section 179 scalar variable, are worth 50 percent of the base subindex. On the corporate income tax component, a minor tweak is made to the weighting of net operating loss variables to better capture variations in treatment. Past Rankings and Scores This report includes 2016, 2017, and 2018 Index rankings and scores that can be used for comparison with the 2019 rankings and scores. These can differ from previously published Index rankings and scores due to enactment of retroactive statutes, backcasting of the above methodological changes, and corrections to variables brought to our attention since the last report was published. The scores and rankings in this report are definitive. 20 STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXCorporate Tax This component measures the impact of each state’s principal tax on business activities and accounts for 19.5 percent of each state’s total score. It is well established that the extent of business taxation can affect a business’s level of economic activity within a state. For example, Newman (1982) found that differentials in state corporate income taxes were a major factor influencing the movement of industry to Southern states. Two decades later, with global investment greatly expanded, Agostini and Tulayasathien (2001) determined that a state’s corporate tax rate is the most relevant tax in the investment decisions of foreign investors. Most states levy standard corporate income taxes on profit (gross receipts minus expenses). Some states, however, problematically impose taxes on the gross receipts of businesses with few or no deductions for expenses. Between 2005 and 2010, for example, Ohio phased in the Commercial Activities Tax (CAT), which has a rate of 0.26 percent. Washington has the Business and Occupation (B&O) Tax, which is a multi-rate tax (depending on industry) on the gross receipts of Washington businesses. Delaware has a similar Manufacturers’ and Merchants’ License Tax, as does Virginia with its locally-levied Business/Professional/Occupational License (BPOL) tax. Texas also added the Margin Tax, a complicated gross receipts tax, in 2007, and Nevada adopted the gross receipts-based multi-rate Commerce Tax in 2015. However, in 2011, Michigan passed a significant corporate tax reform that eliminated the state’s modified gross receipts tax and replaced it with a 6 percent corporate income tax, effective January 1, 2012.12 The previous tax had been in place since 2007, and Michigan’s repeal followed others in Kentucky (2006) and New Jersey (2006). Several states contemplated gross receipts taxes in 2017, but none were adopted. Since gross receipts taxes and corporate income taxes are levied on different bases, we separately compare gross receipts taxes to each other, and corporate income taxes to each other, in the Index. For states with corporate income taxes, the corporate tax rate subindex is calculated by assessing three key areas: the top tax rate, the level of taxable income at which the top rate kicks in, and the number of brackets. States that levy neither a corporate income tax nor a gross receipts tax achieve a perfectly neutral system in regard to business income and thus receive a perfect score. States that do impose a corporate tax generally will score well if they have a low rate. States with a high rate or a complex and multiple-rate system score poorly. To calculate the parallel subindex for the corporate tax base, three broad areas are assessed: tax credits, treatment of net operating losses, and an “other” category that includes variables such as conformity to the Internal Revenue Code, protections against double taxation, and the taxation of “throwback” income, among others. States that score well on the corporate tax base subindex generally will have few business tax credits, generous carryback and carryforward provisions, deductions for net operating losses, conformity to the Internal Revenue Code, and provisions that alleviate double taxation. 12 See Mark Robyn, “Michigan Implements Positive Corporate Tax Reform,” Tax Foundation, Feb. 10, 2012. 21 TAX FOUNDATION CORPORATE TAXTABLE 3. Corporate Tax Component of the State Business Tax Climate Index (2016–2019) State 2016 Rank 2016 Score 2017 Rank 2017 Score 2018 Rank 2018 Score 2019 Rank 2019 Score Change from 2018 to 2019 Rank Score Alabama 22 5.27 13 5.63 18 5.43 20 5.39 -2 -0.04 Alaska 25 5.14 26 5.15 26 5.15 25 5.28 +1 +0.13 Arizona 21 5.31 18 5.37 15 5.49 17 5.42 -2 -0.07 Arkansas 39 4.62 41 4.57 41 4.57 40 4.52 +1 -0.05 California 34 4.83 32 4.83 31 4.83 31 4.84 0 +0.01 Colorado 13 5.62 15 5.55 13 5.55 16 5.47 -3 -0.08 Connecticut 35 4.81 34 4.81 33 4.81 29 4.97 +4 +0.16 Delaware 50 2.98 50 2.66 50 2.66 50 2.63 0 -0.03 Florida 17 5.42 18 5.37 19 5.36 6 5.91 +13 +0.55 Georgia 6 5.80 7 5.76 7 5.76 8 5.82 -1 +0.06 Hawaii 11 5.73 12 5.70 14 5.49 14 5.56 0 +0.07 Idaho 23 5.22 25 5.19 25 5.19 26 5.26 -1 +0.07 Illinois 30 4.94 27 5.12 34 4.74 39 4.56 -5 -0.18 Indiana 26 5.05 24 5.21 24 5.26 18 5.41 +6 +0.15 Iowa 48 3.66 48 3.70 48 3.70 48 3.77 0 +0.07 Kansas 36 4.77 35 4.73 35 4.73 34 4.69 +1 -0.04 Kentucky 28 4.99 29 4.93 28 4.93 27 5.09 +1 +0.16 Louisiana 32 4.87 36 4.70 36 4.70 36 4.69 0 -0.01 Maine 41 4.44 39 4.63 39 4.63 41 4.49 -2 -0.14 Maryland 19 5.36 20 5.35 21 5.35 22 5.36 -1 +0.01 Massachusetts 37 4.70 38 4.68 38 4.68 37 4.67 +1 -0.01 Michigan 10 5.75 10 5.71 10 5.71 11 5.66 -1 -0.05 Minnesota 43 4.40 43 4.21 43 4.21 42 4.40 +1 +0.19 Mississippi 12 5.69 14 5.63 12 5.63 15 5.56 -3 -0.07 Missouri 3 6.09 5 6.06 5 6.05 4 6.02 +1 -0.03 Montana 15 5.54 11 5.70 11 5.70 12 5.57 -1 -0.13 Nebraska 27 5.03 28 5.01 27 5.00 28 4.99 -1 -0.01 Nevada 38 4.68 37 4.70 37 4.69 33 4.78 +4 +0.09 New Hampshire 47 3.81 46 3.85 46 4.00 45 3.98 +1 -0.02 New Jersey 40 4.45 42 4.44 42 4.44 47 3.87 -5 -0.57 New Mexico 24 5.19 23 5.22 20 5.36 21 5.37 -1 +0.01 New York 8 5.80 6 5.90 6 5.90 7 5.87 -1 -0.03 North Carolina 5 6.03 3 6.18 3 6.39 3 6.26 0 -0.13 North Dakota 16 5.52 17 5.45 17 5.44 23 5.36 -6 -0.08 Ohio 46 3.88 47 3.83 47 3.82 46 3.89 +1 +0.07 Oklahoma 9 5.78 9 5.73 9 5.73 9 5.79 0 +0.06 Oregon 29 4.94 30 4.92 29 4.92 30 4.90 -1 -0.02 Pennsylvania 45 4.12 44 4.13 44 4.12 43 4.24 +1 +0.12 Rhode Island 33 4.86 33 4.82 32 4.82 32 4.79 0 -0.03 South Carolina 14 5.54 16 5.47 16 5.47 19 5.40 -3 -0.07 South Dakota 1 9.79 1 9.79 1 9.79 1 9.79 0 0.00 Tennessee 18 5.39 21 5.35 22 5.35 24 5.31 -2 -0.04 Texas 49 3.32 49 3.36 49 3.56 49 3.63 0 +0.07 Utah 4 6.06 4 6.15 4 6.14 5 5.94 -1 -0.20 Vermont 42 4.42 40 4.61 40 4.60 38 4.60 +2 0.00 Virginia 6 5.80 7 5.76 7 5.76 10 5.71 -3 -0.05 Washington 44 4.15 45 4.02 45 4.01 44 4.09 +1 +0.08 West Virginia 20 5.33 22 5.29 23 5.29 13 5.57 +10 +0.28 Wisconsin 31 4.88 31 4.86 30 4.85 35 4.69 -5 -0.16 Wyoming 1 9.79 1 9.79 1 9.79 1 9.79 0 0.00 District of Columbia 37 4.70 31 4.90 28 4.94 27 5.10 +1 +0.16 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. D.C.'s score and rank do not affect other states. Source: Tax Foundation. 22 STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXCorporate Tax Rate The corporate tax rate subindex is designed to gauge how a state’s corporate income tax top marginal rate, bracket structure, and gross receipts rate affect its competitiveness compared to other states, as the extent of taxation can affect a business’s level of economic activity within a state (Newman 1982). A state’s corporate tax is levied in addition to the federal corporate income tax of 21 percent, substantially reduced by the Tax Cuts and Jobs Act of 2017 from a graduated-rate tax with a top rate of 35 percent, the highest rate among industrialized nations. Two states levy neither a corporate income tax nor a gross receipts tax: South Dakota and Wyoming. These states automatically score a perfect 10 on this subindex. Therefore, this section ranks the remaining 48 states relative to each other. Top Tax Rate. Iowa’s 12 percent corporate income tax rate qualifies for the worst ranking among states that levy one, followed by New Jersey’s new 11.5 percent rate (including a surcharge). Other states with comparatively high corporate income tax rates are Pennsylvania (9.99 percent), Minnesota (9.8 percent), Alaska (9.4 percent), and Connecticut (9.0 percent). By contrast, North Carolina’s relatively new rate of 3.0 percent is the lowest nationally, followed by North Dakota’s at 4.31 percent and Colorado’s at 4.63 percent. Other states with comparatively low top corporate tax rates are Utah at 4.95 percent and Mississippi and South Carolina, both at 5 percent. Graduated Rate Structure. Two variables are used to assess the economic drag created by multiple-rate corporate income tax systems: the income level at which the highest tax rate starts to apply and the number of tax brackets. Twenty-nine states and the District of Columbia have single-rate systems, and they score best. Single-rate systems are consistent with the sound tax principles of simplicity and neutrality. In contrast to the individual income tax, there is no meaningful “ability to pay” concept in corporate taxation. Jeffery Kwall, the Kathleen and Bernard Beazley Professor of Law at Loyola University Chicago School of Law, notes that graduated corporate rates are inequitable—that is, the size of a corporation bears no necessary relation to the income levels of the owners. Indeed, low-income corporations may be owned by individuals with high incomes, and high-income corporations may be owned by individuals with low incomes.13 A single-rate system minimizes the incentive for firms to engage in expensive, counterproductive tax planning to mitigate the damage of higher marginal tax rates that some states levy as taxable income rises. 13 Jeffrey L. Kwall, “The Repeal of Graduated Corporate Tax Rates,” Tax Notes, June 27, 2011, 1395. 23 TAX FOUNDATION CORPORATE TAXThe Top Bracket. This variable measures how soon a state’s tax system applies its highest corporate income tax rate. The highest score is awarded to a single-rate system that has one bracket that applies to the first dollar of taxable income. Next best is a two-bracket system where the top rate kicks in at a low level of income, since the lower the top rate kicks in, the more the system is like a flat tax. States with multiple brackets spread over a broad income spectrum are given the worst score. Number of Brackets. An income tax system creates changes in behavior when the taxpayer’s income reaches the end of one tax rate bracket and moves into a higher bracket. At such a break point, incentives change, and as a result, numerous rate changes are more economically harmful than a single-rate structure. This variable is intended to measure the disincentive effect the corporate income tax has on rising incomes. States that score the best on this variable are the 29 states–and the District of Columbia–that have a single-rate system. Alaska’s 10-bracket system earns the worst score in this category. Other states with multi-bracket systems include Arkansas (six brackets) and Louisiana (five brackets). Corporate Tax Base This subindex measures the economic impact of each state’s definition of what should be subject to corporate taxation. The three criteria used to measure the competitiveness of each state’s corporate tax base are given equal weight: the availability of certain credits, deductions, and exemptions; the ability of taxpayers to deduct net operating losses; and a host of smaller tax base issues that combine to make up the other third of the corporate tax base subindex. Under a gross receipts tax, some of these tax base criteria (net operating losses and some corporate income tax base variables) are replaced by the availability of deductions from gross receipts for employee compensation costs and cost of goods sold. States are rewarded for granting these deductions because they diminish the greatest disadvantage of using gross receipts as the base for corporate taxation: the uneven effective tax rates that various industries pay, depending on how many levels of production are hit by the tax. Net Operating Losses. The corporate income tax is designed to tax only the profits of a corporation. However, a yearly profit snapshot may not fully capture a corporation’s true profitability. For example, a corporation in a highly cyclical industry may look very profitable during boom years but lose substantial amounts during bust years. When examined over the entire business cycle, the corporation may actually have an average profit margin. The deduction for net operating losses (NOL) helps ensure that, over time, the corporate income tax is a tax on average profitability. Without the NOL deduction, corporations in cyclical industries pay much higher taxes than those in stable industries, even assuming identical average profits over time. Simply put, the NOL deduction helps level the playing field among cyclical and noncyclical industries. Under the Tax Cuts and Jobs Act, the federal government allows losses to be carried forward indefinitely, though they may only reduce taxable income by 80 percent in 24 STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXany given year. Because gross receipts taxes inherently preclude the possibility of carrying net operating losses backward or forward, the Index treats states with statewide gross receipts taxes as having the equivalent of no NOL carryback or carryforward provisions. Number of Years Allowed for Carryback and Carryforward. This variable measures the number of years allowed on a carryback or carryforward of an NOL deduction. The longer the overall time span, the higher the probability that the corporate income tax is being levied on the corporation’s average profitability. Generally, states entered FY 2019 with better treatment of the carryforward (up to a maximum of 20 years) than the carryback (up to a maximum of three years). States score well on the Index if they conform to the new federal provisions or provide their own robust system of carryforwards and carrybacks. Caps on the Amount of Carryback and Carryforward. When companies have a larger NOL than they can deduct in one year, most states permit them to carry deductions of any amount back to previous years’ returns or forward to future returns. States that limit those amounts are ranked lower in the Index. Four states limit the amount of carrybacks: Delaware, Idaho, Montana, and Utah. Of states that allow a carryforward of losses, only New Hampshire and Pennsylvania limit carryforwards. As a result, these states score poorly on this variable. Gross Receipts Tax Deductions. Proponents of gross receipts taxation invariably praise the steadier flow of tax receipts into government coffers in comparison with the fluctuating revenue generated by corporate income taxes, but this stability comes at a great cost. The attractively low statutory rates associated with gross receipts taxes are an illusion. Since gross receipts taxes are levied many times in the production process, the effective tax rate on a product is much higher than the statutory rate would suggest. Effective tax rates under a gross receipts tax vary dramatically by industry or individual business, a stark departure from the principle of tax neutrality. Firms with few steps in their production chain are relatively lightly taxed under a gross receipts tax, and vertically-integrated, high-margin firms prosper, while firms with longer production chains are exposed to a substantially higher tax burden. The pressure of this economic imbalance often leads lawmakers to enact separate rates for each industry, an inevitably unfair and inefficient process. Two reforms that states can make to mitigate this damage are to permit deductions from gross receipts for employee compensation costs and cost of goods sold, effectively moving toward a regular corporate income tax. Delaware, Nevada, Ohio, and Washington score the worst, because their gross receipts taxes do not offer full deductions for either the cost of goods sold or employee compensation. Texas offers a deduction for either the cost of goods sold or employee compensation but not both. The Virginia BPOL tax and the Pennsylvania business privilege tax are not included in this survey, because they are assessed at the local level and not levied uniformly across the state. Federal Income Used as State Tax Base. States that use federal definitions of income reduce the tax compliance burden on their taxpayers. Two states (Arkansas and Mississippi) do not conform to federal definitions of corporate income and they score poorly. 25 TAX FOUNDATION CORPORATE TAXAllowance of Federal ACRS and MACRS Depreciation. The vast array of federal depreciation schedules is, by itself, a tax complexity nightmare for businesses. The specter of having 50 different schedules would be a disaster from a tax complexity standpoint. This variable measures the degree to which states have adopted the federal Accelerated Cost Recovery System (ACRS) and Modified Accelerated Cost Recovery System (MACRS) depreciation schedules. One state (California) adds complexity by failing to fully conform to the federal system. Deductibility of Depletion. The deduction for depletion works similarly to depreciation, but it applies to natural resources. As with depreciation, tax complexity would be staggering if all 50 states imposed their own depletion schedules. This variable measures the degree to which states have adopted the federal depletion schedules. Thirteen states are penalized because they do not fully conform to the federal system: Alaska, California, Delaware, Iowa, Louisiana, Maryland, Minnesota, Mississippi, New Hampshire, North Carolina, Oklahoma, Oregon, and Tennessee. Alternative Minimum Tax. The federal Alternative Minimum Tax (AMT) was created to ensure that all taxpayers paid some minimum level of taxes every year. Unfortunately, it does so by creating a parallel tax system to the standard corporate income tax code. Evidence shows that the AMT does not increase efficiency or improve fairness in any meaningful way. It nets little money for the government, imposes compliance costs that in some years are actually larger than collections, and encourages firms to cut back or shift their investments (Chorvat and Knoll, 2002). As such, states that have mimicked the federal AMT put themselves at a competitive disadvantage through needless tax complexity. Eight states have an AMT on corporations and thus score poorly: Alaska, California, Florida, Iowa, Kentucky, Maine, Minnesota, and New Hampshire. Deductibility of Taxes Paid. This variable measures the extent of double taxation on income used to pay foreign taxes, i.e., paying a tax on money the taxpayer has already mailed to foreign taxing authorities. States can avoid this double taxation by allowing the deduction of taxes paid to foreign jurisdictions. Twenty-three states allow deductions for foreign taxes paid and score well. The remaining states with corporate income taxation do not allow deductions for foreign taxes paid and thus score poorly. Indexation of the Tax Code. For states that have multiple-bracket corporate income taxes, it is important to index the brackets for inflation. That prevents de facto tax increases on the nominal increase in income due to inflation. Put simply, this “inflation tax” results in higher tax burdens on taxpayers, usually without their knowledge or consent. All 16 states with graduated corporate income taxes fail to index their tax brackets: Alaska, Arkansas, Hawaii, Iowa, Kansas, Kentucky, Louisiana, Maine, Mississippi, Nebraska, New Jersey, New Mexico, North Dakota, Ohio, Oregon, and Vermont. 26 STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXThrowback. To reduce the double taxation of corporate income, states use apportionment formulas that seek to determine how much of a company’s income a state can properly tax. Generally, states require a company with nexus (that is, sufficient connection to the state to justify the state’s power to tax its income) to apportion its income to the state based on some ratio of the company’s in-state property, payroll, and sales compared to its total property, payroll, and sales. Among the 50 states, there is little harmony in apportionment formulas. Many states weight the three factors equally while others weight the sales factor more heavily (a recent trend in state tax policy). Since many businesses make sales into states where they do not have nexus, businesses can end up with “nowhere income,” income that is not taxed by any state. To counter this phenomenon, many states have adopted what are called throwback rules because they identify nowhere income and throw it back into a state where it will be taxed, even though it was not earned in that state. Throwback rules add yet another layer of tax complexity. Since two or more states can theoretically lay claim to “nowhere” income, rules have to be created and enforced to decide who gets to tax it. States with corporate income taxation are almost evenly divided between those with and without throwback rules. Twenty states do not have them, while 25 states and the District of Columbia do. Section 168(k) expensing. Because corporate income taxes are intended to fall on net income, they should include deductions for business expenses—including investment in machinery and equipment. Historically, however, businesses have been required to depreciate the value of these purchases over time. In recent years, the federal government offered “bonus depreciation” to accelerate the deduction for these investments, and under the Tax Cuts and Jobs Act, investments in machinery and equipment are fully deductible in the first year, a policy known as “full expensing.” Fourteen states follow the federal government in offering full expensing, while two offer “bonus depreciation” short of full expensing. Tax Credits Many states provide tax credits which lower the effective tax rates for certain industries and investments, often for large firms from out of state that are considering a move. Policymakers create these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for a bad business tax climate. Economic development and job creation tax credits complicate the tax system, narrow the tax base, drive up tax rates for companies that do not qualify, distort the free market, and often fail to achieve economic growth.14 A more effective approach is to systematically improve the business tax climate for the long term. Thus, this component rewards those states that do not offer the following tax credits, with states that offer them scoring poorly. 14 For example, see Alan Peters and Peter Fisher, “The Failures of Economic Development Incentives,” Journal of the American Planning Association 70(1), Winter 2004, 27; and William F. Fox and Matthew N. Murray, “Do Economic Effects Justify the Use of Fiscal Incentives?” Southern Economic Journal 71(1), July 2004, 78. 27 TAX FOUNDATION CORPORATE TAXInvestment Tax Credits. Investment tax credits typically offer an offset against tax liability if the company invests in new property, plants, equipment, or machinery in the state offering the credit. Sometimes, the new investment will have to be “qualified” and approved by the state’s economic development office. Investment tax credits distort the market by rewarding investment in new property as opposed to the renovation of old property. Job Tax Credits. Job tax credits typically offer an offset against tax liability if the company creates a specified number of jobs over a specified period of time. Sometimes, the new jobs will have to be “qualified” and approved by the state’s economic development office, allegedly to prevent firms from claiming that jobs shifted were jobs added. Even if administered efficiently, job tax credits can misfire in a number of ways. They induce businesses whose economic position would be best served by spending more on new equipment or marketing to hire new employees instead. They also favor businesses that are expanding anyway, punishing firms that are already struggling. Thus, states that offer such credits score poorly on the Index. Research and Development (R&D) Tax Credits. Research and development tax credits reduce the amount of tax due by a company that invests in “qualified” research and development activities. The theoretical argument for R&D tax credits is that they encourage the kind of basic research that is not economically justifiable in the short run but that is better for society in the long run. In practice, their negative side effects–greatly complicating the tax system and establishing a government agency as the arbiter of what types of research meet a criterion so difficult to assess–far outweigh the potential benefits. Thus, states that offer such credits score poorly on the Index. 28 STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXIndividual Income Tax The individual income tax component, which accounts for 30.1 percent of each state’s total Index score, is important to business because a significant number of businesses, including sole proprietorships, partnerships, and S corporations, report their income through the individual income tax code. The number of individuals filing federal tax returns with business income has more than doubled over the past 30 years, from 13.3 million in 1980 to 32.8 million in 2014.15 Taxes can have a significant impact on an individual’s decision to become a self-employed entrepreneur. Gentry and Hubbard (2004) found, “While the level of the marginal tax rate has a negative effect on entrepreneurial entry, the progressivity of the tax also discourages entrepreneurship, and significantly so for some groups of households.” Using education as a measure of potential for innovation, Gentry and Hubbard found that a progressive tax system “discourages entry into self-employment for people of all educational backgrounds.” Moreover, citing Carroll, Holtz-Eakin, Rider, and Rosen (2000), Gentry and Hubbard contend, “Higher tax rates reduce investment, hiring, and small business income growth” (p. 7). Less neutral individual income tax systems, therefore, hurt entrepreneurship and a state’s business tax climate. Another important reason individual income tax rates are critical for businesses is the cost of labor. Labor typically constitutes a major business expense, so anything that hurts the labor pool will also affect business decisions and the economy. Complex, poorly designed tax systems that extract an inordinate amount of tax revenue reduce both the quantity and quality of the labor pool. This is consistent with the findings of Wasylenko and McGuire (1985), who found that individual income taxes affect businesses indirectly by influencing the location decisions of individuals. A progressive, multi-rate income tax exacerbates this problem by increasing the marginal tax rate at higher levels of income, continually reducing the value of work vis-à-vis the value of leisure. For example, suppose a worker has to choose between one hour of additional work worth $10 and one hour of leisure which to him is worth $9.50. A rational person would choose to work for another hour. But if a 10 percent income tax rate reduces the after-tax value of labor to $9, then a rational person would stop working and take the hour to pursue leisure. Additionally, workers earning higher wages–$30 per hour, for example–who face progressively higher marginal tax rates–20 percent, for instance–are more likely to be discouraged from working additional hours. In this scenario, the worker’s after-tax wage is $24 per hour; therefore, those workers who value leisure more than $24 per hour will choose not to work. Since the after-tax wage is $6 lower than the pretax wage in this example, compared to only $1 lower in the previous example, more workers will choose leisure. In the aggregate, the income tax reduces the available labor supply.16 The individual income tax rate subindex measures the impact of tax rates on the marginal dollar of individual income using three criteria: the top tax rate, the graduated rate structure, and the standard deductions and exemptions which are treated as a zero percent tax bracket. The rates and brackets used are for a single taxpayer, not a couple filing a joint return. 15 Internal Revenue Service, Individual Income Tax Returns 2014, Rev. 08-2016, Table 1.4. 16 See Edward C. Prescott, “Why Do Americans Work So Much More than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review, July 2004. See also J. Scott Moody and Scott A. Hodge, “Wealthy Americans and Business Activity,” Tax Foundation, Aug. 1, 2004. 29 TAX FOUNDATION INDIVIDUAL INCOME TAXTABLE 4. Individual Income Tax Component of the State Business Tax Climate Index (2016–2019) State 2016 Rank 2016 Score 2017 Rank 2017 Score 2018 Rank 2018 Score 2019 Rank 2019 Score Change from 2018 to 2019 Rank Score Alabama 27 4.94 28 4.93 28 4.93 30 4.85 -2 -0.08 Alaska 1 10.00 1 10.00 1 10.00 1 10.00 0 0.00 Arizona 18 5.42 19 5.40 18 5.40 19 5.31 -1 -0.09 Arkansas 37 4.35 39 4.12 39 4.12 40 4.09 -1 -0.03 California 50 1.91 50 1.84 50 1.85 49 2.55 +1 +0.70 Colorado 14 5.97 14 5.98 14 5.98 14 5.88 0 -0.10 Connecticut 43 3.80 44 3.76 44 3.77 43 3.90 +1 +0.13 Delaware 40 4.11 40 4.06 40 4.06 41 4.08 -1 +0.02 Florida 1 10.00 1 10.00 1 10.00 1 10.00 0 0.00 Georgia 35 4.60 35 4.56 35 4.57 38 4.36 -3 -0.21 Hawaii 46 3.49 38 4.14 38 4.14 47 3.54 -9 -0.60 Idaho 22 5.06 22 5.02 23 5.02 23 5.05 0 +0.03 Illinois 11 6.21 11 6.22 13 6.02 13 5.89 0 -0.13 Indiana 15 5.95 15 5.97 15 5.98 15 5.81 0 -0.17 Iowa 39 4.28 42 3.93 42 3.93 42 3.96 0 +0.03 Kansas 19 5.41 18 5.41 19 5.25 21 5.19 -2 -0.06 Kentucky 38 4.34 37 4.31 37 4.31 17 5.49 +20 +1.18 Louisiana 21 5.08 21 5.07 22 5.08 32 4.75 -10 -0.33 Maine 29 4.86 25 4.95 20 5.18 24 5.01 -4 -0.17 Maryland 44 3.54 47 3.48 47 3.49 45 3.66 +2 +0.17 Massachusetts 12 6.19 12 6.21 11 6.21 11 6.08 0 -0.13 Michigan 13 6.08 13 6.10 12 6.10 12 5.97 0 -0.13 Minnesota 45 3.51 46 3.49 46 3.49 46 3.62 0 +0.13 Mississippi 24 5.00 24 5.00 25 5.00 27 4.93 -2 -0.07 Missouri 30 4.81 32 4.74 32 4.74 25 4.98 +7 +0.24 Montana 20 5.14 20 5.10 21 5.10 22 5.05 -1 -0.05 Nebraska 23 5.03 23 5.02 24 5.02 26 4.97 -2 -0.05 Nevada 5 8.64 5 8.67 5 8.68 5 8.47 0 -0.21 New Hampshire 9 6.55 9 6.56 9 6.57 9 6.42 0 -0.15 New Jersey 48 2.73 48 2.69 48 2.70 50 1.87 -2 -0.83 New Mexico 28 4.91 29 4.89 29 4.89 31 4.84 -2 -0.05 New York 49 2.56 49 2.53 49 2.53 48 3.12 +1 +0.59 North Carolina 16 5.78 16 5.79 16 5.83 16 5.72 0 -0.11 North Dakota 26 4.95 27 4.93 27 4.93 20 5.27 +7 +0.34 Ohio 47 3.46 45 3.71 45 3.71 44 3.88 +1 +0.17 Oklahoma 33 4.71 31 4.76 31 4.76 33 4.71 -2 -0.05 Oregon 36 4.42 36 4.40 36 4.40 36 4.45 0 +0.05 Pennsylvania 17 5.52 17 5.54 17 5.54 18 5.41 -1 -0.13 Rhode Island 31 4.80 30 4.78 30 4.78 29 4.90 +1 +0.12 South Carolina 32 4.73 34 4.69 34 4.70 34 4.65 0 -0.05 South Dakota 1 10.00 1 10.00 1 10.00 1 10.00 0 0.00 Tennessee 8 7.14 8 7.22 8 7.22 8 7.12 0 -0.10 Texas 6 8.10 6 8.13 6 8.13 6 7.94 0 -0.19 Utah 10 6.21 10 6.23 10 6.23 10 6.13 0 -0.10 Vermont 42 3.94 43 3.91 43 3.91 37 4.40 +6 +0.49 Virginia 34 4.71 33 4.69 33 4.70 35 4.64 -2 -0.06 Washington 6 8.10 6 8.13 6 8.13 6 7.94 0 -0.19 West Virginia 25 4.96 26 4.94 26 4.94 28 4.92 -2 -0.02 Wisconsin 41 4.02 41 4.00 41 4.00 39 4.23 +2 +0.23 Wyoming 1 10.00 1 10.00 1 10.00 1 10.00 0 0.00 District of Columbia 44 3.60 48 2.83 48 2.84 45 3.69 +3 +0.85 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. D.C.'s score and rank do not affect other states. Source: Tax Foundation. 30 STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXThe individual income tax base subindex takes into account measures enacted to prevent double taxation, whether the code is indexed for inflation, and how the tax code treats married couples compared to singles. States that score well protect married couples from being taxed more severely than if they had filed as two single individuals. They also protect taxpayers from double taxation by recognizing LLCs and S corporations under the individual tax code and indexing their brackets, exemptions, and deductions for inflation. States that do not impose an individual income tax generally receive a perfect score, and states that do impose an individual income tax will generally score well if they have a flat, low tax rate with few deductions and exemptions. States that score poorly have complex, multiple-rate systems. The six states without an individual income tax or non-UI payroll tax are, not surprisingly, the highest scoring states on this component: Alaska, Florida, South Dakota, Texas, Washington, and Wyoming. Nevada, which taxes wage income (but not unearned income) at a low rate under a non-UI payroll tax, also does extremely well in this component of the Index. New Hampshire and Tennessee also score well, because while they levy a significant tax on individual income in the form of interest and dividends, they do not tax wages and salaries.17 Colorado, Illinois, Indiana, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah score highly because they have a single, low tax rate. Scoring near the bottom of this component are states that have high tax rates and very progressive bracket structures. They generally fail to index their brackets, exemptions, and deductions for inflation, do not allow for deductions of foreign or other state taxes, penalize married couples filing jointly, and do not recognize LLCs and S corporations. Individual Income Tax Rate The rate subindex compares the states that tax individual income after setting aside the four states that do not and therefore receive perfect scores: Alaska, Florida, South Dakota, and Wyoming. Texas and Washington do not have an individual income tax, but they do tax LLC and S corporation income through their gross receipts taxes and thus do not score perfectly in this component. Nevada has a low-rate payroll tax on wage income. New Hampshire and Tennessee, meanwhile, do not tax wage and salary income but do tax interest and dividend income. Top Marginal Tax Rate. California has the highest top income tax rate of 13.3 percent. Other states with high top rates include Hawaii (restored to 11.0 percent), New Jersey (just raised to 10.75 percent), Oregon (9.9 percent), Minnesota (9.85 percent), Iowa (8.98 percent), New York (8.82 percent), and Vermont (8.75 percent). States with the lowest top statutory rates are North Dakota (2.9 percent), Pennsylvania (3.07 percent), Indiana (3.23 percent of federal AGI), Michigan (4.25 percent of federal AGI), Arizona (4.54 percent), Colorado (4.63 percent of federal income), New Mexico (4.9 percent), Utah (4.95 percent), and Ohio (4.997 percent). Alabama, Mississippi, and Oklahoma all impose a top 17 Tennessee has begun the process of phasing out its tax on interest and dividend income. 31 TAX FOUNDATION INDIVIDUAL INCOME TAXstatutory rate of 5 percent.18 Illinois and Kansas, which previously boasted rates below 5 percent, both adopted rate increases in recent years. (Although Illinois’ statutory rate is 4.95 percent, it also imposes an additional 1.5 percent tax on pass-through businesses, discussed elsewhere, bringing the rate for these entities to 6.45 percent.) In addition to statewide income tax rates, some states allow local-level income taxes.19 We represent these as the mean between the rate in the capital city and most populous city. In some cases, states authorizing local-level income taxes still keep the level of income taxation modest overall. For instance, Alabama, Indiana, Michigan, and Pennsylvania allow local income add-ons, but are still among the states with the lowest overall rates. Top Tax Bracket Threshold. This variable assesses the degree to which pass-through businesses are subject to reduced after-tax return on investment as net income rises. States are rewarded for a top rate that kicks in at lower levels of income, because doing so approximates a less distortionary flat-rate system. For example, Alabama has a progressive income tax structure with three income tax rates. However, because Alabama’s top rate of 5 percent applies to all taxable income over $3,000, the state’s income tax rate structure is nearly flat. States with flat-rate systems score the best on this variable because their top rate kicks in at the first dollar of income (after accounting for the standard deduction and personal exemption). They include Illinois, Indiana, Massachusetts, Michigan, New Hampshire, Pennsylvania, and Tennessee. States with high kick-in levels score the worst. These include New Jersey ($5 million of taxable income), New York ($1,077,550), California ($1 million), Connecticut ($500,000), and North Dakota ($416,700 of taxable income). Number of Brackets. The Index converts exemptions and standard deductions to a zero bracket before tallying income tax brackets. From an economic perspective, standard deductions and exemptions are equivalent to an additional tax bracket with a zero tax rate. For example, Kansas has a standard deduction of $3,000 and a personal exemption of $2,250, for a combined value of $5,250. Statutorily, Kansas has a top rate on all taxable income over $30,000 and two lower brackets, one beginning at the first dollar of income and another at $15,000, so it has an average bracket width of $10,000. Because of its deduction and exemption, however, Kansas’s top rate actually kicks in at $35,250 of income, and it has three tax brackets below that with an average width of $11,750. The size of allowed standard deductions and exemptions varies considerably.20 18 New Hampshire and Tennessee both tax only interest and dividends. To account for this, the Index converts the statutory tax rate in both states into an effective rate as measured against the typical state income tax base that includes wages. Under a typical income tax base with a flat rate and no tax preferences, this is the statutory rate that would be required to raise the same amount of revenue as the current system. Nationally, dividends and interest account for 19.6 percent of income. For New Hampshire, its 5 percent rate was multiplied by 19.6 percent, yielding the equivalent rate of 0.98 percent. For Tennessee, with a tax rate of 6 percent, this calculation yields an equivalent rate of 1.18 percent. 19 See Joseph Bishop-Henchman and Jason Sapia, “Local Income Taxes: City- and County-Level Income and Wage Taxes Continue to Wane,” Tax Foundation, Aug. 31, 2011. 20 Some states offer tax credits in lieu of standard deductions or personal exemptions. Rather than reducing a taxpayer’s taxable income before the tax rates are applied, tax credits are subtracted from a taxpayer’s tax liability. Like deductions and exemptions, the result is a lower final income tax bill. In order to maintain consistency within the component score, tax credits are converted into equivalent income exemptions or deductions. 32 STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXPennsylvania scores the best in this variable by having only one tax bracket. States with only two brackets are Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, New Hampshire, North Carolina, Tennessee, and Utah. On the other end of the spectrum, Hawaii scores worst with 13 brackets, followed by California and Missouri with 11 brackets each, while Iowa and Ohio both have 10 brackets. Average Width of Brackets. Many states have several narrow tax brackets close together at the low end of the income scale, including a zero bracket created by standard deductions and exemptions. Most taxpayers never notice them, because they pass so quickly through those brackets and pay the top rate on most of their income. On the other hand, some states impose ever-increasing rates throughout the income spectrum, causing individuals and noncorporate businesses to alter their income-earning and tax-planning behavior. This subindex penalizes the latter group of states by measuring the average width of the brackets, rewarding those states where the average width is small, since in these states the top rate is levied on most income, acting more like a flat rate on all income. Income Recapture. Connecticut, Nebraska, and New York apply the rate of the top income tax bracket to previous taxable income after the taxpayer crosses the top bracket threshold, while Arkansas imposes different tax tables depending on the filer’s level of income. New York’s recapture provision is the most damaging and results in an approximately $22,000 penalty for reaching the top bracket. Income recapture provisions are poor policy, because they result in dramatically high marginal tax rates at the point of their kick-in, and they are nontransparent in that they raise tax burdens substantially without being reflected in the statutory rate. Individual Income Tax Base States have different definitions of taxable income, and some create greater impediments to economic activity than others. The base subindex gives a 10 percent weight to the marriage penalty, a 40 percent weight to the double taxation of taxable income, and a 50 percent weight to an accumulation of other base issues, including indexation. The states with no individual income tax of any kind achieve perfect neutrality. Texas and Washington, however, are docked slightly because they do not recognize LLCs or S corporations, and Nevada’s payroll tax keeps the state from achieving a perfect store. Of the other 43 states, Tennessee, New Hampshire, Illinois, Indiana, and Utah have the best scores, avoiding many problems with the definition of taxable income that plague other states. Meanwhile, states where the tax base is found to cause an unnecessary drag on economic activity include New Jersey, California, Ohio, Maryland, Minnesota, Delaware, and Georgia. Marriage Penalty. A marriage penalty exists when a state’s standard deduction and tax brackets for married taxpayers filing jointly are not double those for single filers. As a result, two singles (if combined) can have a lower tax bill than a married couple filing jointly with the same income. This is discriminatory and has serious business ramifications. The top-earning 20 percent of taxpayers is dominated (85 percent) by married couples. This same 20 percent also has the highest concentration of business owners of all income groups (Hodge 2003A, Hodge 2003B). 33 TAX FOUNDATION INDIVIDUAL INCOME TAXBecause of these concentrations, marriage penalties have the potential to affect a significant share of pass-through businesses. Twenty-three states and the District of Columbia have marriage penalties built into their income tax brackets. Some states attempt to get around the marriage penalty problem by allowing married couples to file as if they were singles or by offering an offsetting tax credit. While helpful in offsetting the dollar cost of the marriage penalty, these solutions come at the expense of added tax complexity. Still, states that allow for married couples to file as singles do not receive a marriage penalty score reduction. Double Taxation of Capital Income. Since most states with an individual income tax system mimic the federal income tax code, they also possess its greatest flaw: the double taxation of capital income. Double taxation is brought about by the interaction between the corporate income tax and the individual income tax. The ultimate source of most capital income–interest, dividends, and capital gains–is corporate profits. The corporate income tax reduces the level of profits that can eventually be used to generate interest or dividend payments or capital gains.21 This capital income must then be declared by the receiving individual and taxed. The result is the double taxation of this capital income—first at the corporate level and again on the individual level. All states that tax wage income score poorly by this criterion. Tennessee and New Hampshire, which tax individuals on interest and dividends, score somewhat better because they do not tax capital gains. Nevada’s payroll tax does not apply to capital income, and thus scores perfectly on this measure, along with states which forgo all income taxation. Federal Income Used as State Tax Base. Despite the shortcomings of the federal government’s definition of income, states that use it reduce the tax compliance burden on taxpayers. Five states score poorly because they do not conform to federal definitions of individual income: Alabama, Arkansas, Mississippi, New Jersey, and Pennsylvania. Alternative Minimum Tax (AMT). At the federal level, the Alternative Minimum Tax (AMT) was created in 1969 to ensure that all taxpayers paid some minimum level of taxes every year. Unfortunately, it does so by creating a parallel tax system to the standard individual income tax code. AMTs are an inefficient way to prevent tax deductions and credits from totally eliminating tax liability. As such, states that have mimicked the federal AMT put themselves at a competitive disadvantage through needless tax complexity. Six states score poorly for imposing an AMT on individuals: California, Colorado, Connecticut, Iowa, Minnesota, and Wisconsin. 21 Equity-related capital gains are not created directly by a corporation. Rather, they are the result of stock appreciations due to corporate activity such as increasing retained earnings, increasing capital investments, or issuing dividends. Stock appreciation becomes taxable realized capital gains when the stock is sold by the holder.