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2017 State Business Tax Climate Index PRINCIPLED INSIGHTFUL ENGAGED By Jared Walczak, Scott Drenkard, and Joseph Henchman ISBN: 978-1-942768-12-8 © 2017 Tax Foundation 1325 G Street, NW, Suite 950 Washingtion, D.C. 20005 202.464.6200 taxfoundation.org 1 TAX FOUNDATION EX EC U TIV E SU M M A RY Executive 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 roadmap for improvement. The 10 best states in this year’s Index are: 1. Wyoming 2. South Dakota 3. Alaska 4. Florida 5. Nevada 6. Montana 7. New Hampshire 8. Indiana 9. Utah 10. Oregon The 10 lowest ranked, or worst, states in this year’s Index are: 41. Louisiana 42. Maryland 43. Connecticut 44. Rhode Island 45. Ohio 46. Minnesota 47. Vermont 48. California 49. New York 50. New Jersey #27 MA #44 RI #43 CT #50 NJ #19 DE #42 MD (#47) DC #47 VT #7 NH 2017 State Business Tax Climate Index TAX FOUNDATION 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. DC’s score and rank do not aﬀect other states. The report shows tax systems as of July 1, 2016 (the beginning of Fiscal Year 2017). Source: Tax Foundation. 10 Best Business Tax Climates 10 Worst Business Tax Climates WI #46 #39 #12 #8 #45 #24 #33 #11 #37 #36 #32 #34 #13 #38 #41 #14 #31 #35 #21 #3 #15 #23 #40 #25 #1 #2 #29 #6 #20 #10 #17 #22 #16 #9 #5 #48 #28 #4 #18 #49 #30 #26 2 STATE BUSINESS TAX CLIMATE INDEX EX EC U TI V E SU M M A RY The absence of a major tax is a common factor among many of the top ten 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 ten 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 shortcomings in common: complex, non- neutral taxes with comparatively high rates. New Jersey, for example, is hampered by some of the highest property tax burdens in the country, is one of just two states to levy both an inheritance tax and an estate tax, and maintains some of the worst-structured individual income taxes in the country. 3 TAX FOUNDATION EX EC U TIV E SU M M A RY Table 1. 2017 State Business Tax Climate Index Index Ranks and Component Tax Ranks Overall Rank Corporate Tax Rank Individual Income Tax Rank Sales Tax Rank Unemployment Insurance Tax Rank Property Tax Rank Alabama 32 14 22 48 14 16 Alaska 3 27 1 5 29 22 Arizona 21 19 19 47 13 6 Arkansas 38 40 29 44 30 24 California 48 33 50 40 16 15 Colorado 16 18 16 39 42 14 Connecticut 43 32 37 27 21 49 Delaware 19 50 34 1 3 20 Florida 4 19 1 28 2 10 Georgia 36 10 42 33 35 21 Hawaii 26 11 31 23 24 17 Idaho 20 24 23 26 46 2 Illinois 23 26 10 35 38 46 Indiana 8 23 11 10 10 4 Iowa 40 47 33 21 34 40 Kansas 22 39 18 30 11 19 Kentucky 34 28 30 13 48 36 Louisiana 41 36 27 50 9 30 Maine 30 41 25 8 44 41 Maryland 42 21 46 14 26 42 Massachusetts 27 37 13 18 49 45 Michigan 12 8 14 9 47 25 Minnesota 46 43 45 25 28 33 Mississippi 28 12 20 38 5 35 Missouri 15 5 28 24 7 7 Montana 6 13 21 3 19 9 Nebraska 25 29 24 12 8 39 Nevada 5 34 1 41 43 8 New Hampshire 7 46 9 2 41 43 New Jersey 50 42 48 45 25 50 New Mexico 35 25 35 42 17 1 New York 49 7 49 43 32 47 North Carolina 11 4 15 19 6 31 North Dakota 29 16 36 34 15 3 Ohio 45 45 47 29 4 11 Oklahoma 31 9 38 36 1 12 Oregon 10 35 32 4 33 18 Pennsylvania 24 44 17 20 45 32 Rhode Island 44 31 39 22 50 44 South Carolina 37 15 41 31 37 26 South Dakota 2 1 1 32 40 23 Tennessee 13 22 8 46 23 29 Texas 14 49 6 37 12 37 Utah 9 3 12 17 22 5 Vermont 47 38 44 16 20 48 Virginia 33 6 40 11 39 28 Washington 17 48 6 49 18 27 West Virginia 18 17 26 15 27 13 Wisconsin 39 30 43 7 36 34 Wyoming 1 1 1 6 31 38 District of Columbia 47 31 43 33 27 47 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, 2016 (the beginning of Fiscal Year 2017). Source: Tax Foundation. 4 STATE BUSINESS TAX CLIMATE INDEX R EC EN T C H A N G ES Arizona Arizona is in the process of lowering its corporate income tax rate. Scheduled annual rate reductions began in 2015 and will continue through 2018, with the rate declining from 6.0 to 5.5 percent in 2016. The first reduction helped the state improve three places on the corporate income tax component, and this year’s reduction moved the state a further three places on the corporate component, from 22nd to 19th, with the state’s overall rank improving from 22nd to 21st. The cuts have been aided by limitations on credits and other tax preferences, which have helped pay down rate reductions. Arkansas Arkansas lowered its top marginal rate from 7 percent to 6.9 percent, but simultaneously adopted new rate schedules, making it the only state in which taxpayers at different income levels pay under distinct rate schedules. This income recapture provision offsets the modest top marginal rate reduction, with the state���s rank declining from 29th to 30th on the individual income tax component. Hawaii The expiration of temporary tax increases in Hawaii resulted in the elimination of the top three individual income tax brackets and the lowering of the top marginal rate from 11 to 8.25 percent. Although the income tax still features an unusually numerous nine brackets, these changes improved the state from 37th to 31st on the individual income tax component, and from 30th to 27th overall. Indiana Last year, Indiana completed a four-year phasedown of its corporate income tax rate from 8.5 to 6.5 percent, the culmination of legislation adopted in 2011. Subsequent legislation enacted in 2014 established a further schedule of rate reductions through fiscal year 2022, when the corporate income tax will drop to 4.9 percent. For 2017, the rate declined from 6.5 to 6.25 percent, which, along with the elimination of the state’s throwback rule, bumped the state’s corporate component rank from 24th to 23rd. The state ranks 8th overall, an improvement from its rank of 10th in 2016. Louisiana Buffeted by structural shortfalls and declining revenue, Louisiana policymakers added a penny to the state sales tax, increasing the state rate from 4 to 5 percent while introducing greater complexity to the sales tax base. With the combined state and local rate now approaching 10 percent, Louisiana slipped from 48th to 50th on the sales tax component of the Index, and declined from 36th to 41st overall. Maine Maine improved slightly (from 26th to 25th) on the individual component of the Index as a result of changes made to the state’s individual income tax, adding a third bracket (which hurts the state’s score) while lowering rates (which improved the state’s score). Rates were cut from 6.5 and 7.95 percent to three rates of 5.8, 6.75, and 7.15 percent. Notable Ranking Changes in this Year’s Index 5 TAX FOUNDATION R EC EN T C H A N G ES Table 2. State Business Tax Climate Index Index (2014–2017) State 2014 Rank 2014 Score 2015 Rank 2015 Score 2016 Rank 2016 Score 2017 Rank 2017 Score Change from 2016 to 2017 Rank Score Alabama 35 4.88 36 4.79 35 4.76 32 4.91 +3 +0.15 Alaska 4 7.27 4 7.27 3 7.38 3 7.29 0 -0.09 Arizona 22 5.18 24 5.13 22 5.19 21 5.21 +1 +0.02 Arkansas 38 4.72 40 4.61 41 4.50 38 4.60 +3 +0.10 California 48 3.78 48 3.76 48 3.76 48 3.76 0 0.00 Colorado 18 5.31 18 5.34 16 5.40 16 5.38 0 -0.02 Connecticut 43 4.48 43 4.45 43 4.35 43 4.34 0 -0.01 Delaware 15 5.49 15 5.45 14 5.52 19 5.32 -5 -0.20 Florida 5 6.85 5 6.84 4 6.89 4 6.86 0 -0.03 Georgia 37 4.72 38 4.70 39 4.61 36 4.68 +3 +0.07 Hawaii 32 4.93 32 4.93 30 4.93 26 5.13 +4 +0.20 Idaho 19 5.29 20 5.25 20 5.22 20 5.22 0 0.00 Illinois 28 4.98 31 4.94 23 5.18 23 5.21 0 +0.03 Indiana 10 5.82 10 5.80 10 5.81 8 5.96 +2 +0.15 Iowa 40 4.58 41 4.56 40 4.53 40 4.51 0 -0.02 Kansas 20 5.23 21 5.20 21 5.22 22 5.21 -1 -0.01 Kentucky 27 5.00 33 4.92 33 4.91 34 4.88 -1 -0.03 Louisiana 33 4.91 35 4.87 36 4.72 41 4.39 -5 -0.33 Maine 24 5.08 29 4.97 31 4.92 30 4.96 +1 +0.04 Maryland 42 4.48 42 4.48 42 4.40 42 4.36 0 -0.04 Massachusetts 23 5.17 25 5.12 25 5.15 27 5.13 -2 -0.02 Michigan 11 5.69 12 5.59 12 5.61 12 5.64 0 +0.03 Minnesota 47 4.18 47 4.16 46 4.19 46 4.19 0 0.00 Mississippi 21 5.22 22 5.18 26 5.13 28 5.13 -2 0.00 Missouri 13 5.52 16 5.44 17 5.39 15 5.45 +2 +0.06 Montana 6 6.36 6 6.33 6 6.31 6 6.27 0 -0.04 Nebraska 26 5.01 23 5.16 24 5.15 25 5.14 -1 -0.01 Nevada 3 7.45 3 7.43 5 6.45 5 6.46 0 +0.01 New Hampshire 7 6.13 7 6.09 7 6.14 7 6.11 0 -0.03 New Jersey 49 3.50 50 3.49 50 3.42 50 3.41 0 -0.01 New Mexico 34 4.90 34 4.87 34 4.88 35 4.85 -1 -0.03 New York 50 3.40 49 3.56 49 3.59 49 3.61 0 +0.02 North Carolina 41 4.52 11 5.60 11 5.67 11 5.73 0 +0.06 North Dakota 30 4.96 26 4.99 27 4.99 29 4.98 -2 -0.01 Ohio 44 4.24 44 4.25 45 4.23 45 4.27 0 +0.04 Oklahoma 31 4.93 28 4.97 32 4.92 31 4.95 +1 +0.03 Oregon 9 5.88 9 5.86 9 5.91 10 5.78 -1 -0.13 Pennsylvania 29 4.98 30 4.94 28 4.95 24 5.18 +4 +0.23 Rhode Island 46 4.22 45 4.20 44 4.33 44 4.30 0 -0.03 South Carolina 36 4.75 37 4.72 37 4.69 37 4.66 0 -0.03 South Dakota 2 7.56 2 7.55 2 7.47 2 7.49 0 +0.02 Tennessee 14 5.51 14 5.46 15 5.44 13 5.58 +2 +0.14 Texas 12 5.52 13 5.47 13 5.55 14 5.57 -1 +0.02 Utah 8 6.05 8 5.98 8 5.98 9 5.96 -1 -0.02 Vermont 45 4.22 46 4.19 47 4.17 47 4.13 0 -0.04 Virginia 25 5.01 27 4.99 29 4.94 33 4.90 -4 -0.04 Washington 16 5.41 17 5.37 18 5.38 17 5.38 +1 0.00 West Virginia 17 5.31 19 5.31 19 5.36 18 5.32 +1 -0.04 Wisconsin 39 4.63 39 4.67 38 4.63 39 4.57 -1 -0.06 Wyoming 1 7.78 1 7.79 1 7.76 1 7.76 0 0.00 District of Columbia 44 4.47 44 4.43 40 4.54 47 4.19 -7 -0.35 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 R EC EN T C H A N G ES New York Two years ago, New York policymakers enacted a substantial corporate tax reform package that continues to phase in, with this year’s changes improving the state’s rank on the corporate income tax component from 11th to 7th. This year, the state lowered its corporate income tax rate from 7.1 to 6.5 percent and reduced the capital stock tax rate from 0.15 to 0.125 percent. The capital stock tax is on a path to repeal, which can be expected to yield improvements on the property tax component in future editions of the Index. North Carolina After the most dramatic improvement in the Index’s history—from 41st to 11th in one year—North Carolina has continued to improve its tax structure, and now imposes the lowest-rate corporate income tax in the country at 4 percent, down from 5 percent the previous year. This rate cut improves the state from 6th to 4th on the corporate income tax component, the second-best ranking (after Utah) for any state that imposes a major corporate tax. (Six states forego corporate income taxes, but four of them impose economically distortive gross receipts taxes in their stead.) An individual income tax reduction, from 5.75 to 5.499 percent, is scheduled for 2017. At 11th overall, North Carolina trails only Indiana and Utah among states which do not forego any of the major tax types. Oklahoma Oklahoma improved from 40th to 38th on the individual component of the Index as the individual income tax incorporated the first of two scheduled rate reductions. The state is in the process of lowering the income tax rate, subject to revenue triggers, in two stages, from 5.25 to 4.85 percent. The state met its first- year benchmark, resulting in a rate cut to 5.0 percent. Pennsylvania Pennsylvania’s capital stock tax, originally slated for elimination in 2014, was fully phased out in 2016, resulting in an improvement of six ranks on the property tax component, from 38th to 32nd. In tandem with improvements to the state’s previously worst-in-the-nation unemployment insurance tax structure, the elimination of the capital stock tax drove an improvement from 28th to 24th overall. South Dakota Declining energy sector revenue drove a sales tax rate increase in South Dakota, from 4.0 to 4.5 percent. The state’s rank on the sales tax component of the Index fell from 27th to 32nd, though the state still ranks 2nd overall by foregoing both individual and corporate income taxes. While South Dakota’s sales tax is still imposed at a low rate, its base includes a wide range of business inputs. Texas The rate of the Texas gross receipts tax, called the Margin Tax, fell from 0.95 to 0.75 percent in 2016. This improvement affected the state’s raw score on the corporate tax component, but did not result in an improvement in component rank. Texas fell slightly overall due to a relative decline on property tax rank. 7 TAX FOUNDATION R EC EN T C H A N G ES 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, and raised the estate tax exemption. While last year’s corporate income tax reductions improved the District’s standing on the Index, the new income tax brackets created in 2016 caused the District of Columbia to slip from 34th to 43rd on the individual income tax component, as the changes included the creation of an additional tax bracket and a new top rate kick-in of $1 million, up from $350,000. When changes to the corporate income tax are fully phased in, the District of Columbia is projected to improve from 31st to 25th on the corporate tax component of the Index. Recent and Proposed Changes Not Reflected in the 2017 Index Indiana While Indiana phased in a further reduction of its corporate income tax this year, the final scheduled reduction in the state’s individual income tax rate, to 3.23 percent, is slated for 2017. The corporate income tax rate is also scheduled to phase down to 4.9 percent. Mississippi In 2016, Mississippi adopted a gradual phase- out of its capital stock tax, which will begin in 2018 and fully repeal the tax by 2028. The state will also begin phasing in a reduction in its corporate and individual income tax rates starting in 2018. These changes will be reflected in subsequent editions of the Index. Missouri In 2015, Missouri policymakers passed an income tax reduction that lowers the top rate by 0.1 percent each year starting in 2017, dependent on a revenue trigger. These changes will be reflected in the 2018 Index and subsequent editions. New Mexico New Mexico continues to phase in corporate income tax rate reductions, with the rate scheduled to drop to 5.9 percent by 2018. This year’s reduction, from 6.9 to 6.6 percent, did not improve the state’s rank, but as the rate continues to decline, these reforms will enhance the state’s standing in comparison to its neighbors and further improve its corporate tax component score. Tennessee In 2016, Tennessee began phasing out its Hall income tax, which is imposed on interest and dividend income. The Index includes this tax at a calculated rate to reflect its unusually narrow base. The first-year rate reduction was too small to change any component rankings, but Tennessee’s rank will improve once the tax is fully phased out in 2022. 8 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y Introduction 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 Certainly, job creation is rapid overseas, as previously underdeveloped nations enter the world economy without facing the third highest corporate tax rate in the world, as U.S. businesses do.2 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. 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 proposed a hefty gross receipts tax.3 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.4 In 2010, Northrup Grumman chose to move its headquarters to Virginia over Maryland, citing the better business tax climate.5 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.6 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. 1 See, e.g., U.S. Department of Labor, Extended Mass Layoffs, First Quarter 2013 , Table 10, May 13, 2013. 2 Kyle Pomerleau, Corporate Income Tax Rates Around the World, 2014, Tax FoundaTion Fiscal FacT no. 436, Aug. 20, 2014. 3 Editorial, Scale it back, Governor, chicago Tribune, Mar. 23, 2007. 4 Ryan Randazzo, Edythe Jenson, and Mary Jo Pitzl, Chandler getting new $5 billion Intel facility, aZ cenTral, Mar. 6, 2013. 5 Dana Hedgpeth & Rosalind Helderman, Northrop Grumman decides to move headquarters to Northern Virginia, The WashingTon PosT, Apr. 27, 2010. 6 Susan Haigh, Connecticut House Speaker: Tax “mistakes” made in budget, associaTed Press, Nov. 5, 2015. 9 TAX FOUNDATION M ETH O D O LO G Y 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 state, 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.7 A 2007 USA TODAY article chronicled similar problems other states have had with companies that receive generous tax incentives.8 Lawmakers 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 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. 7 Austin Mondine, Dell cuts North Carolina plant despite $280m sweetener, The regisTer, Oct. 8, 2009. 8 Dennis Cauchon, Business Incentives Lose Luster for States, usa TODAY, Aug. 22, 2007. 10 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y Ranking 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 also 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 themselves 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 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 sub-national 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 fifty 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. 11 TAX FOUNDATION M ETH O D O LO G Y Period 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 non-manufacturing 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). 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. 12 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y By the early 1990s, the literature had expanded sufficiently for Bartik (1991) to identify fifty- seven studies on which to base his literature survey. Ladd succinctly summarizes Bartik���s findings: The 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 fourteen 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. 13 TAX FOUNDATION M ETH O D O LO G Y 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. Although 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.9 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.10 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.11 9 sTaTe Policy rePorTs, Vol. 12, No. 11, Issue 1, p. 9, June 1994. 10 Both rate increases have a temporary component. After four years, the individual income tax will decrease to 3.75 percent. Then, in 2025, the individual income tax rate will drop to 3.5 percent. The corporate tax will follow a similar schedule of rate decreases: in four years, the rate will be 7.75 percent, and then, in 2025, it will go back to a rate of 7.3 percent. 11 Benjamin Yount, Tax increase, impact, dominate Illinois Capitol in 2011, illinois sTaTehouse neWs, Dec. 27, 2011. 14 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y Measuring the Impact of Tax Differentials Some recent contributions to the literature on state taxation criticize business and tax climate studies in general.12 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. Peter 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. 12 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 M ETH O D O LO G Y 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 ten 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 ten) with particularly strong and robust evidence of predictive power. Bittlingmayer et al. also found that relative tax competitiveness matters, especially at the borders, and therefore, indices that place a high premium on tax policies better explain 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. 16 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y 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 114 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 fifty 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. The weighting of each of the five major components is: 32.6% — Individual Income Tax 22.7% — Sales Tax 19.7% — Corporate Tax 14.9% — Property Tax 10.1% — 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. 17 TAX FOUNDATION M ETH O D O LO G Y Within each component are two equally weighted sub-indices devoted to measuring the impact of the tax rates and the tax bases. Each sub-index 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 sub-index 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 sub-index is problematic, because the extreme valuation of a dummy can overly influence the results of the sub-index. 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. As 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. Two 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 is in zero sales tax states—Alaska, Delaware, Montana, New Hampshire, and Oregon—which do not have general sales taxes but still do not score a perfect ten in that component section because of excise taxes on gasoline, beer, spirits, and cigarettes, which are included in that section. 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 7.25 while the average score of the sales tax component is 5.41. 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. 18 STATE BUSINESS TAX CLIMATE INDEX M ET H O D O LO G Y 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
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