News & Politics
2022 STATE BUSINESS TAX CLIMATE INDEX BY JANELLE CAMMENGA JARED WALCZAK © 2021 Tax Foundation 1325 G Street, NW, Suite 950 Washington, D.C. 20005 202.464.6200 taxfoundation.org TAX FOUNDATION | 1 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 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. Nevada, South Dakota, and Wyoming have no corporate or individual income tax (though Nevada imposes gross receipts taxes); Alaska has no individual income or state-level sales tax; Florida and Tennessee have no individual income tax; and New Hampshire and Montana have no sales tax. 1. Wyoming 2. South Dakota 3. Alaska 4. Florida 5. Montana 6. New Hampshire 7. Nevada 8. Tennessee 9. Indiana 10. Utah The 10 lowest-ranked, or worst, states in this year’s Index are: The 10 best states in this year’s Index are: Note: A rank of 1 is best, 50 is worst. D.C.’s score and rank do not affect other states. The report shows tax systems as of July 1, 2021 (the beginning of Fiscal Year 2022). Source: Tax Foundation TAX FOUNDATION 10 Worst Business Tax Climates 2022 State Business Tax Climate Index 10 Best Business Tax Climates WA #15 MT #5 ID #17 ND #19 MN #45 ME #33 MI #12 WI #27 OR #22 SD #2 NH #6 VT #43 NY #49 WY #1 IA #38 NE #35 MA #34 IL #36 PA #29 CT #47 RI #40 CA #48 UT #10 NV #7 OH #37 IN #9 NJ #50 CO #20 WV #21 MO #13 KS #24 DE #16 MD #46 VA #25 KY #18 DC (#48) AZ #23 OK #26 NM #28 TN #8 NC #11 TX #14 AR #44 SC #31 AL #39 GA #32 MS #30 LA #42 FL #4 HI #41 AK #3 41. Hawaii 42. Louisiana 43. Vermont 44. Arkansas 45. Minnesota 46. Maryland 47. Connecticut 48. California 49. New York 50. New Jersey 2 | STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESThis 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, has the second highest- rate corporate and individual income taxes in the country and a particularly aggressive treatment of international income, levies an inheritance tax, and maintains some of the nation’s worst-structured individual income taxes. NOTABLE RANKING CHANGES IN THIS YEAR’S INDEX Alabama Alabama policymakers eliminated the state’s throwback rule—a complex and uncompetitive corporate income tax provision that throws “nowhere” income back into the sales factor of the source state—and decoupled from the Global Intangible Low-Taxed Income (GILTI) provision, which, when incorporated into state tax codes, leads to state taxation of international income. These significant corporate changes drove a six-place improvement in Alabama’s corporate income tax ranking, and improved the state’s ranking one place overall, from 40th to 39th. Arkansas As a part of ongoing reform efforts, Arkansas reduced both its individual and corporate rates this year. Within the highest rate schedule, the top rate for individuals lowered from 6.6 percent to 6.2 percent, and the top rate for businesses dropped from 6.6 percent to 5.9 percent. These changes drove an improvement of four places in the corporate component and three places in the individual component, bringing Arkansas from 46th to 44th overall. California Previously, California followed the federal treatment of net operating losses (NOLs), allowing uncapped carryforwards for 20 years. However, due to ill-placed coronavirus-related budget concerns (the state posted a $76 billion surplus), the state has suspended NOLs completely for companies with income over $1 million. That dramatically—if temporarily—alters the state’s treatment of business losses for the worse, and makes it the only state without NOLs, which are an integral part of corporate income taxation. This major shift caused the state’s corporate income tax ranking to fall from 28th to 46th, although California remained at 48th overall. Idaho Idaho recently enacted tax reforms that retroactively consolidated the state’s seven individual income tax brackets into five and lowered the top rate from 6.925 percent to 6.5 percent beginning in tax year 2021. These changes improved the state’s individual income tax ranking by four places and likewise yielded a four-place improvement on its overall score, raising the state from 21st to 17th. TAX FOUNDATION | 3 RECENT CHANGESTABLE 1. 2022 State Business Tax Climate Index Ranks and Component Tax Ranks State Overall Rank Corporate Tax Rank Individual Income Tax Rank Sales Tax Rank Property Tax Rank Unemployment Insurance Tax Rank Alabama 39 17 27 50 19 18 Alaska 3 28 1 5 24 43 Arizona 23 23 18 40 11 11 Arkansas 44 30 39 45 27 33 California 48 46 49 47 14 23 Colorado 20 6 14 38 34 41 Connecticut 47 27 47 23 50 22 Delaware 16 50 44 2 4 3 Florida 4 7 1 21 12 2 Georgia 32 8 35 33 25 37 Hawaii 41 19 46 28 30 29 Idaho 17 29 20 9 3 47 Illinois 36 42 13 39 48 40 Indiana 9 11 15 19 1 25 Iowa 38 38 38 15 39 34 Kansas 24 21 22 27 31 16 Kentucky 18 15 17 13 22 48 Louisiana 42 34 34 48 23 5 Maine 33 35 23 8 41 35 Maryland 46 33 45 26 43 46 Massachusetts 34 36 11 12 45 50 Michigan 12 20 12 10 21 7 Minnesota 45 45 43 29 32 30 Mississippi 30 13 25 32 38 6 Missouri 13 3 21 25 8 4 Montana 5 22 24 3 29 19 Nebraska 35 32 29 14 40 13 Nevada 7 25 5 44 5 45 New Hampshire 6 41 9 1 46 44 New Jersey 50 48 48 43 44 32 New Mexico 28 12 36 41 2 8 New York 49 24 50 42 47 36 North Carolina 11 4 16 20 13 12 North Dakota 19 9 26 30 10 9 Ohio 37 40 41 35 6 10 Oklahoma 26 10 30 37 28 1 Oregon 22 49 42 4 17 39 Pennsylvania 29 44 19 17 15 21 Rhode Island 40 37 31 24 42 49 South Carolina 31 5 33 31 36 27 South Dakota 2 1 1 34 18 38 Tennessee 8 26 6 46 33 20 Texas 14 47 7 36 37 14 Utah 10 14 10 22 7 17 Vermont 43 43 40 16 49 15 Virginia 25 16 32 11 26 42 Washington 15 39 7 49 20 24 West Virginia 21 18 28 18 9 26 Wisconsin 27 31 37 7 16 28 Wyoming 1 1 1 6 35 31 District of Columbia 48 25 48 37 50 39 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, 2021 (the beginning of Fiscal Year 2022). Source: Tax Foundation. 4 | STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESIllinois Citing budget concerns due to the pandemic, Illinois temporarily changed its treatment of NOLs to be less favorable toward businesses, capping NOL carryforwards at $100,000 for tax years 2021 through 2024. This new treatment caused the state’s corporate ranking to drop six places, although its overall ranking of 36th is unaffected. Iowa As part of the implementation of a larger tax reform package, Iowa reduced its top corporate income tax from 12 percent to 9.8 percent—paid for through the repeal of corporate federal deductibility—and eliminated its corporate alternative minimum tax. These reforms improved the state’s corporate ranking by eight places and resulted in the overall rank improving from 41st to 38th. Kansas Kansas improved markedly, from 34th to 24th place overall, due to significant reforms to both its sales tax and corporate income tax. Following the Wayfair decision, Kansas was the only state without a safe harbor for smaller remote sellers. In 2021, Kansas established a $100,000 threshold for remote sellers. Additionally, the state replaced its limited NOL regime with conformity to federal provisions and decoupled from GILTI, causing its corporate rank to improve from 31st to 21st. New Mexico Legislators in New Mexico created an additional individual income tax bracket on income above $210,000, bringing the state’s top rate from 4.9 percent to 5.9 percent. This dramatic increase caused a 10-place drop in the state’s individual income tax ranking and dropped New Mexico’s overall rank from 22nd to 28th. New York New York was one of the rare states to raise taxes in 2021, citing revenue concerns. Previously, New York levied a flat 6.5 percent corporate income tax, but lawmakers created what is functionally a second bracket with a 7.25 percent rate for companies making over $5 million. The top marginal individual income tax rate, meanwhile, has risen from 8.82 percent to 10.9 percent. The legislature also reversed the phaseout of the state’s capital stock tax, reinstating the tax at 0.1875 percent, which lowered the state’s property tax ranking by one place. Despite these changes, New York’s overall rank remained at 49th. Oregon Oregon’s decline from 15th to 22nd overall stems from changes to its unemployment tax system, with higher minimum rates and a larger taxable wage base, as well as the implementation of new municipal income taxes in Portland and improvements in other states. Pennsylvania Pennsylvania made a range of improvements to its unemployment insurance taxes. The Commonwealth used to levy a minimum tax rate of 2.39 percent, the highest among states, but now levies a far more competitive 1.29 percent. A surtax was also repealed. These significant changes helped yield an improvement from 32nd to 29th overall. TAX FOUNDATION | 5 RECENT CHANGESTABLE 2. State Business Tax Climate Index (2014–2022) Prior Year Ranks 2021 2022 2021-2022 Change State 2014 2015 2016 2017 2018 2019 2020 Rank Score Rank Score Rank Score Alabama 40 40 41 38 39 41 40 40 4.51 39 4.57 1 0.06 Alaska 4 4 3 3 3 3 3 3 7.29 3 7.28 0 -0.01 Arizona 27 26 24 24 24 24 23 24 5.10 23 5.1 1 0.00 Arkansas 42 44 46 43 43 46 44 46 4.31 44 4.42 2 0.11 California 48 48 48 48 48 49 48 48 3.83 48 3.59 0 -0.24 Colorado 23 23 22 22 21 19 21 20 5.21 20 5.23 0 0.02 Connecticut 47 47 47 47 47 47 47 47 4.11 47 4.08 0 -0.03 Delaware 18 16 15 23 22 13 15 16 5.35 16 5.32 0 -0.03 Florida 5 5 4 4 4 4 4 4 6.90 4 6.93 0 0.03 Georgia 29 30 33 33 32 34 32 31 4.97 32 4.97 -1 0.00 Hawaii 38 37 37 30 33 39 39 39 4.54 41 4.52 -2 -0.02 Idaho 16 18 19 19 18 21 20 21 5.21 17 5.28 4 0.07 Illinois 35 38 29 26 29 36 36 36 4.78 36 4.73 0 -0.05 Indiana 10 10 10 9 9 10 10 9 5.61 9 5.64 0 0.03 Iowa 45 45 45 46 46 45 45 41 4.51 38 4.62 3 0.11 Kansas 24 25 26 27 28 31 35 34 4.89 24 5.08 10 0.19 Kentucky 34 35 34 37 37 20 19 18 5.28 18 5.28 0 0.00 Louisiana 32 33 38 45 45 42 43 42 4.50 42 4.5 0 0.00 Maine 30 34 35 36 36 29 28 29 4.98 33 4.96 -4 -0.02 Maryland 39 39 40 41 40 40 41 44 4.44 46 4.28 -2 -0.16 Massachusetts 26 28 27 28 25 27 34 35 4.86 34 4.95 1 0.09 Michigan 11 12 13 13 13 14 12 13 5.54 12 5.58 1 0.04 Minnesota 46 46 44 44 44 44 46 45 4.39 45 4.35 0 -0.04 Mississippi 25 27 28 29 27 30 29 28 5.00 30 4.99 -2 -0.01 Missouri 15 17 20 16 16 15 14 11 5.56 13 5.57 -2 0.01 Montana 6 6 6 6 6 5 5 5 6.08 5 6.05 0 -0.03 Nebraska 37 29 30 32 34 26 31 33 4.93 35 4.93 -2 0.00 Nevada 3 3 5 5 5 6 7 7 5.95 7 5.95 0 0.00 New Hampshire 8 7 7 7 7 7 6 6 6.04 6 6.01 0 -0.03 New Jersey 49 49 50 50 50 50 50 50 3.41 50 3.34 0 -0.07 New Mexico 22 24 25 25 26 25 25 22 5.19 28 5.05 -6 -0.14 New York 50 50 49 49 49 48 49 49 3.79 49 3.58 0 -0.21 North Carolina 31 11 12 12 10 11 11 10 5.59 11 5.61 -1 0.02 North Dakota 20 20 18 18 19 16 17 19 5.23 19 5.24 0 0.01 Ohio 41 41 42 39 41 38 37 37 4.65 37 4.72 0 0.07 Oklahoma 21 22 23 21 23 28 27 26 5.09 26 5.07 0 -0.02 Oregon 9 9 9 10 11 9 8 15 5.38 22 5.15 -7 -0.23 Pennsylvania 36 36 36 31 35 35 33 32 4.95 29 5 3 0.05 Rhode Island 44 42 39 40 38 37 38 38 4.58 40 4.56 -2 -0.02 South Carolina 28 32 31 34 31 32 30 30 4.98 31 4.98 -1 0.00 South Dakota 2 2 2 2 2 2 2 2 7.44 2 7.49 0 0.05 Tennessee 14 15 16 14 14 18 18 17 5.29 8 5.68 9 0.39 Texas 12 13 11 11 12 12 13 12 5.55 14 5.56 -2 0.01 Utah 7 8 8 8 8 8 9 8 5.62 10 5.64 -2 0.02 Vermont 43 43 43 42 42 43 42 43 4.45 43 4.43 0 -0.02 Virginia 17 19 21 20 20 22 24 25 5.10 25 5.08 0 -0.02 Washington 13 14 14 15 15 17 16 14 5.39 15 5.39 -1 0.00 West Virginia 19 21 17 17 17 23 22 23 5.17 21 5.19 2 0.02 Wisconsin 33 31 32 35 30 33 26 27 5.03 27 5.07 0 0.04 Wyoming 1 1 1 1 1 1 1 1 7.74 1 7.78 0 0.04 District of Columbia 47 48 47 48 48 47 47 48 3.95 48 3.86 0 -0.09 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. DC’s score and rank do not affect other states. Source: Tax Foundation. 6 | STATE BUSINESS TAX CLIMATE INDEX RECENT CHANGESTennessee This year, Tennessee finished the phaseout of its Hall Tax, which was levied solely on interest and dividends income, since the state already elected not to tax wage income. With this change, the only remaining vestiges of non-corporate income tax treatment is in the state’s treatment of S Corporations and a low-rate gross receipts tax that applies to pass- through businesses, improving the state to sixth best on the income tax component. When combined with other states’ worsening treatment of unemployment insurance, this change brought the state’s overall score from 17th to 8th. RECENT AND PROPOSED CHANGES NOT REFLECTED IN THE 2022 INDEX Arizona The governor’s budget, signed into law in June, includes a number of substantial reforms to the state’s individual income tax beginning in tax year 2022. The planned changes will help restore the state’s competitive standing in the wake of a recently enacted ballot measure raising taxes on high earners. Voter-approved Proposition 208 created a 3.5 percentage point surcharge on taxable income exceeding $250,000 (single filers) to fund education, which would have created an 8 percent top tax rate. However, Senate Bill 1827 curtailed this by establishing an income tax rate cap of 4.5 percent when the general rates and the surcharge are combined. Under Senate Bill 1828, the four general fund rates will be consolidated into one, and the rates will be reduced over time. Specifically, the 4.5 percent cap is effective retroactive to January 1, 2021, meaning Arizona’s rates for TY 2021 match the rates that were in place before Prop. 208 was adopted, although some revenue from the 4.5 percent top marginal rate will go to education while some will go to the general fund. In tax year 2022, the two highest individual income tax brackets will be eliminated, and the two remaining rates will be reduced from 3.34 to 2.98 percent and from 2.59 to 2.55 percent, respectively. If general fund revenues exceed specified benchmarks, the 2.98 percent rate will see future reductions, with an eventual goal of 2.5 percent not counting the surcharge. These changes will be reflected in future editions of the Index. Louisiana Louisiana voters approved Constitutional Amendment 2, which sets in motion a pro-growth tax package paid for through the elimination of individual and corporate federal deductibility. Beginning in tax year 2022, each individual income tax bracket will see rate reductions, with the top rate lowering from 6 percent to 4.25 percent, well under the new constitutional cap of 4.75 percent. The state’s five corporate income tax brackets will be consolidated into three, with a reduction in the top rate from 8 to 7.5 percent. The state’s capital stock tax top rate will also lower from 0.3 percent to 0.275 percent, aiming for eventual repeal through tax triggers. TAX FOUNDATION | 7 RECENT CHANGESMissouri Under a law adopted in 2014, tax triggers are currently in place to reduce the top individual income tax rate by one-tenth of a percent per year, subject to revenue availability, for a total of five reductions. Senate Bill 153, signed into law in June, builds on these reforms by allowing two additional reductions, also subject to revenue triggers. If revenue conditions are met, Missouri will see its top individual income tax rate lower from 5.4 to 5.3 percent in tax year 2022. Montana Montana adopted structural reforms to both its individual and corporate income taxes this year, but only the individual income tax will see a rate reduction as of January 1, 2022. The top marginal income tax rate will be reduced from 6.9 to 6.75 percent that year, and, in 2024, the seven brackets will be consolidated into two with a top rate of 6.5 percent. Although the lowest rate will rise to 4.7 percent in 2024, conforming to the federal standard deduction in 2025 will yield tax savings for lower-income taxpayers. This law also doubles the bracket widths for married filers, thereby removing the marriage penalty that currently exists in the state’s income tax code. Nebraska Legislative Bill 432, signed into law in May, will reduce Nebraska’s top marginal corporate income tax rate from 7.81 percent to 7.5 percent on January 1, 2022, and to 7.25 percent in January 2023. The law also expresses the intent of the Unicameral legislature to pass additional legislation reducing the rate to 7 percent for tax year 2024 and to 6.84 percent for tax year 2025, although these reductions are contingent upon further legislative action. New Hampshire Currently, New Hampshire is the only state that does not impose a tax on wage or salary income but does levy a tax on interest and dividend income. Beginning in tax year 2023, the state will phase out this interest and dividends tax by one percentage point per year until it is fully repealed by 2027. In 2022, the state will reduce the Business Profits tax (BPT) from 7.7 to 7.6 percent and the Business Enterprise Tax (BET, a value-added tax) from 0.6 to 0.55 percent. Under previous law, revenue triggers were in place that would reduce the BPT and BET rates if certain conditions were met, but the trigger design makes it unlikely that rate reductions would occur without significant revenue growth. Those same triggers could have even caused rate increases under certain circumstances. Recent reforms remove that trigger in favor of lower, legislatively determined rates. Oklahoma Three bills signed into law in late May will reduce Oklahoma’s individual and corporate income tax rates starting in tax year 2022. Accordingly, the rate in each individual income tax bracket will lower by 0.25 percentage points, dropping the top rate from 5 to 4.75 percent. The corporate income tax will also see a reduction from 6 percent to 4 percent, starting that same year. 8 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND 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 Certainly, job creation is rapid overseas, as previously underdeveloped nations enter the world economy, though in the aftermath of federal tax reform, U.S. businesses no longer face the third-highest corporate tax rate in the world, but rather one in line with averages for industrialized nations.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, 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.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 1 See U.S. Department of Labor, “Extended Mass Layoffs, First Quarter 2013 ,” Table 10, May 13, 2013. 2 Daniel Bunn, “Corporate Income Tax Rates Around the World, 2018,” Tax Foundation, Nov. 27, 2018, https://www.taxfoundation.org/ publications/corporate-tax-rates-around-the-world/. 3 Editorial, “Scale it back, Governor,” Chicago Tribune, Mar. 23, 2007. 4 Ryan Randazzo, Edythe Jenson, and Mary Jo Pitzl, “Cathy Carter Blog: Chandler getting new $5 billion Intel facility,” AZCentral.com, Mar. 6, 2013. 5 Dana Hedgpeth and Rosalind Helderman, “Northrop Grumman decides to move headquarters to Northern Virginia,” The Washington Post, April 27, 2010. TAX FOUNDATION | 9 INTRODUCTION AND METHODOLOGYElectric 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. 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 2004-2009 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 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), 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. 6 Susan Haigh, “Connecticut House Speaker: Tax ‘mistakes’ made in budget,” Associated Press, Nov. 5, 2015. 7 Austin Mondine, “Dell cuts North-Carolina plant despite $280m sweetener,” TheRegister.co.uk, Oct. 8, 2009. 8 Dennis Cauchon, “Business Incentives Lose Luster for States,” USA TODAY, Aug. 22, 2007. 10 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND METHODOLOGYTo 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. 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 120 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” TAX FOUNDATION | 11 INTRODUCTION AND METHODOLOGYaffects 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. 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 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. 12 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND METHODOLOGYPapke 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: 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 TAX FOUNDATION | 13 INTRODUCTION AND METHODOLOGYfigures. 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. 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 9 State Policy Reports, Vol. 12, No. 11, Issue 1, p. 9, June 1994. 14 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND METHODOLOGYpercent, 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 A new literature review, Kleven et al. (2019), summarizes recent evidence for tax-driven migration. Meanwhile, Giroud and Rauh (2019) use microdata on multistate firms to estimate the impact of state taxes on business activity, and find that C corporation employment and establishments have short-run corporate tax elasticities of -0.4 to -0.5, while pass-through entities show elasticities of -0.2 to -0.4, meaning that, for each percentage-point increase in the rate, employment decreases by 0.4 to 0.5 percent for C corporations subject to the corporate income tax, and by 0.2 to 0.4 percent within pass- through businesses subject to the individual income tax. 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. 10 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. 11 Benjamin Yount, “Tax increase, impact, dominate Illinois Capitol in 2011,” Illinois Statehouse News, Dec. 27, 2011. 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. TAX FOUNDATION | 15 INTRODUCTION AND METHODOLOGYFisher’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. 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 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 16 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND METHODOLOGYapproach 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 125 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. The weighting of each of the five major components is: 31.2% — Individual Income Tax 23.7% — Sales Tax 20.9% — Corporate Tax 14.4% — 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 TAX FOUNDATION | 17 INTRODUCTION AND METHODOLOGYwhere 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. 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. Three notable exceptions to this rule exist. The first is in Washington, Tennessee, and Texas, which do not have taxes on wage income but do apply their gross receipts taxes to S corporations. (Washington and Texas also apply these to limited liability 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) 18 | STATE BUSINESS TAX CLIMATE INDEX INTRODUCTION AND METHODOLOGYis 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 6.72 while the average score of the sales tax component is 5.37. 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 5.08 on corporate income taxes is better than its score of 4.80 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 2022 Index and represents the tax climate of each state as of July 1, 2021, the first day of fiscal year 2022 for most states. District of Columbia The District of Columbia (DC) is only included as an exhibit and its scores and “phantom ranks” offered do not affect the scores or ranks of other states. 2022 Changes to Methodology The 2022 edition of the Index introduces a new variable to the individual income tax base subindex, accounting for convenience rules. This addition is intended to provide more nuance to the Index’s treatment of the individual income tax, in addition to existing variables on top rates, number of brackets, marriage penalties, inflation indexing, section 179 expensing, and other important aspects of the tax. While those who live in one state and work in another typically receive a tax credit to eliminate double taxation of their income, several states tax people where their office is even if they are not currently working in that state, ostensibly for the convenience of the employer. These individuals may be denied their home state’s credit for taxes paid to another state, exposing them to double taxation. Recently, convenience rules have come into the spotlight with the rise of remote work due to the coronavirus pandemic. TAX FOUNDATION | 19 INTRODUCTION AND METHODOLOGYUnder such provisions, an employee is treated as if they work in their employer’s state if their work is performed elsewhere for what is termed the “convenience of the employer,” with exceptions generally only for when an employee’s work legitimately could not be carried out in the employer’s state. Connecticut’s retaliatory convenience rule, exclusively imposed against other jurisdictions with such a rule, is subject to half the penalty assigned to states with a conventional convenience rule applying to workers operating out of all other states. Past Rankings and Scores This report includes 2014-2021 Index rankings that can be used for comparison with the 2022 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 20.9 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 and West Virginia with its local Business & Occupation (B&O) tax. Texas also added the Margin Tax, a complicated gross receipts tax, in 2007, Nevada adopted the gross receipts-based multi- rate Commerce Tax in 2015, and Oregon implemented a new modified gross receipts tax in 2020. 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, 2012.13 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 13 See Mark Robyn, “Michigan Implements Positive Corporate Tax Reform,” Tax Foundation, Feb. 10, 2012, https://www.taxfoundation.org/ michigan-implements-positive-corporate-tax-reform/. TAX FOUNDATION | 21 CORPORATE TAXTABLE 3. Corporate Tax Component of the State Business Tax Climate Index (2014–2022) Prior Year Ranks 2021 2022 2021-2022 Change State 2014 2015 2016 2017 2018 2019 2020 Rank Score Rank Score Rank Score Alabama 24 25 23 14 22 22 23 23 5.22 17 5.51 6 0.29 Alaska 26 27 27 26 27 25 26 26 5.10 28 5.08 -2 -0.02 Arizona 23 23 21 19 14 16 21 22 5.26 23 5.28 -1 0.02 Arkansas 37 37 39 39 39 40 34 34 4.82 30 4.88 4 0.06 California 30 32 34 33 32 38 28 28 4.92 46 4.05 -18 -0.87 Colorado 20 13 15 18 18 6 7 9 5.81 6 6.00 3 0.19 Connecticut 28 30 32 32 31 34 27 27 5.10 27 5.08 0 -0.02 Delaware 50 50 50 50 50 50 50 50 2.44 50 2.40 0 -0.04 Florida 13 14 16 19 19 11 9 6 5.94 7 5.97 -1 0.03 Georgia 9 10 10 11 10 8 6 7 5.87 8 5.89 -1 0.02 Hawaii 5 5 4 6 11 12 17 19 5.45 19 5.45 0 0.00 Idaho 18 22 22 24 24 28 29 29 4.91 29 4.99 0 0.08 Illinois 44 45 33 25 36 37 36 36 4.63 42 4.37 -6 -0.26 Indiana 29 28 24 23 23 19 11 12 5.64 11 5.73 1 0.09 Iowa 48 48 48 48 48 47 48 46 4.03 38 4.53 8 0.50 Kansas 36 36 38 38 38 32 35 31 4.87 21 5.37 10 0.50 Kentucky 25 26 26 27 25 15 13 15 5.57 15 5.60 0 0.03 Louisiana 17 21 36 40 40 35 37 35 4.76 34 4.74 1 -0.02 Maine 42 43 42 41 41 33 38 37 4.57 35 4.57 2 0.00 Maryland 15 16 18 21 20 26 32 33 4.86 33 4.85 0 -0.01 Massachusetts 33 35 37 36 35 39 39 38 4.56 36 4.54 2 -0.02 Michigan 8 8 8 9 8 13 18 20 5.41 20 5.42 0 0.01 Minnesota 41 41 43 43 42 44 46 45 4.17 45 4.13 0 -0.04 Mississippi 10 11 12 12 12 14 10 13 5.61 13 5.63 0 0.02 Missouri 4 4 3 5 5 4 3 3 6.79 3 6.75 0 -0.04 Montana 16 17 19 13 13 9 20 21 5.33 22 5.33 -1 0.00 Nebraska 35 29 28 28 28 29 31 32 4.87 32 4.85 0 -0.02 Nevada 1 1 25 34 33 21 25 25 5.13 25 5.17 0 0.04 New Hampshire 47 47 47 47 44 46 43 41 4.40 41 4.39 0 -0.01 New Jersey 38 38 40 42 45 49 49 48 3.55 48 3.50 0 -0.05 New Mexico 34 34 31 30 26 23 22 11 5.69 12 5.71 -1 0.02 New York 22 20 11 8 7 18 14 16 5.56 24 5.32 -8 -0.24 North Carolina 27 24 7 4 3 3 4 4 6.09 4 6.14 0 0.05 North Dakota 21 19 14 16 16 17 19 8 5.85 9 5.89 -1 0.04 Ohio 45 44 46 46 47 43 42 42 4.39 40 4.42 2 0.03 Oklahoma 11 9 9 10 9 20 8 10 5.78 10 5.80 0 0.02 Oregon 31 33 35 35 34 30 33 49 3.19 49 2.79 0 -0.40 Pennsylvania 43 42 44 44 43 45 44 43 4.19 44 4.14 -1 -0.05 Rhode Island 39 39 30 31 30 36 40 39 4.55 37 4.54 2 -0.01 South Carolina 12 12 13 15 15 5 5 5 6.01 5 6.04 0 0.03 South Dakota 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 Tennessee 14 15 17 22 21 27 24 24 5.13 26 5.13 -2 0.00 Texas 49 49 49 49 49 48 47 47 3.94 47 3.98 0 0.04 Utah 6 6 5 3 4 7 12 14 5.58 14 5.61 0 0.03 Vermont 40 40 41 37 37 41 45 44 4.18 43 4.15 1 -0.03 Virginia 7 7 6 7 6 10 15 17 5.52 16 5.53 1 0.01 Washington 46 46 45 45 46 42 41 40 4.43 39 4.47 1 0.04 West Virginia 19 18 20 17 17 24 16 18 5.45 18 5.46 0 0.01 Wisconsin 32 31 29 29 29 31 30 30 4.89 31 4.87 -1 -0.02 Wyoming 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 District of Columbia 38 38 38 27 27 24 24 24 5.19 25 5.18 -1 -0.01 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. DC’s score and rank do not affect other states. Source: Tax Foundation. 22 | STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXwell 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. Corporate 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. New Jersey’s 11.5 percent rate (including a temporary and retroactive surcharge from 2020 to 2023) qualifies for the worst ranking among states that levy one, followed by Pennsylvania’s 9.99 percent rate. Other states with comparatively high corporate income tax rates are Iowa and Minnesota (both at 9.8 percent), Alaska (9.4 percent), Maine (8.93 percent), and California (8.84 percent). By contrast, North Carolina’s rate of 2.5 percent is the lowest nationally, followed by Missouri’s at 4 percent, North Dakota’s at 4.31 percent, and Florida at 4.458 percent. Other states with comparatively low top corporate tax rates are Colorado (4.5 percent), Arizona and Indiana (both at 4.9 percent), Utah (4.95 percent), and Kentucky, Mississippi, and South Carolina, all at 5 percent. Oklahoma is scheduled to implement a 4 percent corporate income tax rate in 2022 and will soon join these ranks. 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.14 14 Jeffrey L. Kwall, “The Repeal of Graduated Corporate Tax Rates,” Tax Notes, June 27, 2011, 1395. TAX FOUNDATION | 23 CORPORATE TAXA 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. The 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. 24 | STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXThe 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 any 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. California has temporarily suspended its net operating loss provisions as a revenue-raising measure during the pandemic despite the state posting record surpluses. It is the only state without an active NOL provision and is assigned the worst score across all NOL variables. 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 2022 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. Two states, Idaho and Montana, limit the number of carrybacks, though they do better than many of their peers in offering any carryback provisions at all. Of states that allow a carryforward of losses, only Illinois, New Hampshire, and Pennsylvania limit carryforwards. Illinois’ cap is a recent addition, intended to only apply to tax years 2021 through 2024. 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 TAX FOUNDATION | 25 CORPORATE TAXare 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, Oregon, 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, the West Virginia B&O, 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. Allowance 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. 26 | STATE BUSINESS TAX CLIMATE INDEX CORPORATE TAXFive states have an AMT on corporations and thus score poorly: California, Iowa, Kentucky, 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 15 states with graduated corporate income taxes fail to index their tax brackets: Alaska, Arkansas, Hawaii, Iowa, Kansas, Louisiana, Maine, Mississippi, Nebraska, New Jersey, New Mexico, New York, North Dakota, Oregon, and Vermont. Throwback. 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 and throwout rules for sales of tangible property 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-five states do not have them, while 23 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.” TAX FOUNDATION | 27 CORPORATE TAXEighteen states follow the federal government in offering full expensing, while two offer “bonus depreciation” short of full expensing. Net Interest Limitation. Federal law now restricts the deduction of business interest, limiting the deduction to 30 percent of modified income, with the ability to carry the remainder forward to future tax years. This change was intended to eliminate the bias in favor of debt financing (over equity financing) in the federal code, but particularly when states adopt this limitation without incorporating its counterbalancing provision, full expensing, the result is higher investment costs. Thirty-three states and the District of Columbia conform to the net interest limitation. Inclusion of GILTI. Historically, states have largely avoided taxing international income. Following federal tax reform, however, some states have latched onto the federal provision for the taxation of Global Low-Taxed Intangible Income (GILTI), intended as a guardrail for the new federal territorial system of taxation, as a means to broaden their tax bases to include foreign business activity. States which tax GILTI are penalized in the Index, while states receive partial credit for moderate taxation of GILTI (for instance, by adopting the Section 250 deduction) and are rewarded for decoupling or almost fully decoupling from GILTI (by, for instance, treating it as largely-deductible foreign dividend income in addition to providing the Section 250 deduction). 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.15 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. Investment 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. 15 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. 28 | STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXJob 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. INDIVIDUAL INCOME TAX The individual income tax component, which accounts for 31.2 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. 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. TAX FOUNDATION | 29 INDIVIDUAL INCOME TAXTABLE 4. Individual Income Tax Component of the State Business Tax Climate Index (2014–2022) Prior Year Ranks 2021 2022 2021-2022 Change State 2014 2015 2016 2017 2018 2019 2020 Rank Score Rank Score Rank Score Alabama 23 25 25 25 25 31 31 29 4.92 27 4.91 2 -0.01 Alaska 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 Arizona 22 24 18 19 19 19 17 18 5.39 18 5.34 0 -0.05 Arkansas 34 36 37 40 40 40 40 42 3.92 39 4.31 3 0.39 California 50 50 50 50 50 49 49 50 2.10 49 2.01 1 -0.09 Colorado 15 14 14 14 14 13 13 13 5.90 14 5.91 -1 0.01 Connecticut 42 42 46 47 47 43 45 47 3.44 47 3.38 0 -0.06 Delaware 43 43 42 44 44 44 44 44 3.83 44 3.82 0 -0.01 Florida 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 Georgia 33 35 35 35 35 37 36 36 4.74 35 4.73 1 -0.01 Hawaii 47 47 47 38 38 47 47 46 3.48 46 3.46 0 -0.02 Idaho 20 21 23 24 24 23 25 24 5.07 20 5.21 4 0.14 Illinois 10 15 11 11 13 14 14 12 5.93 13 5.92 -1 -0.01 Indiana 14 13 15 15 15 15 15 14 5.87 15 5.86 -1 -0.01 Iowa 41 41 41 42 42 42 41 40 4.32 38 4.32 2 0.00 Kansas 16 17 17 17 18 21 22 21 5.12 22 5.11 -1 -0.01 Kentucky 36 38 38 37 37 17 18 17 5.57 17 5.56 0 -0.01 Louisiana 32 33 32 32 31 35 35 35 4.75 34 4.73 1 -0.02 Maine 26 28 34 31 32 25 20 22 5.11 23 5.09 -1 -0.02 Maryland 44 44 43 46 46 45 43 45 3.69 45 3.66 0 -0.03 Massachusetts 12 11 12 12 11 11 11 16 5.74 11 6.02 5 0.28 Michigan 13 12 13 13 12 12 12 11 6.00 12 5.99 -1 -0.01 Minnesota 45 45 44 45 45 46 46 43 3.92 43 3.88 0 -0.04 Mississippi 21 22 24 23 23 28 28 27 4.98 25 4.97 2 -0.01 Missouri 31 32 31 33 33 27 23 20 5.16 21 5.15 -1 -0.01 Montana 18 19 20 20 20 22 24 23 5.07 24 5.06 -1 -0.01 Nebraska 38 34 33 34 34 30 30 30 4.89 29 4.88 1 -0.01 Nevada 1 1 1 1 1 5 5 5 8.52 5 8.51 0 -0.01 New Hampshire 9 9 9 9 9 9 9 9 6.38 9 6.37 0 -0.01 New Jersey 48 48 48 48 48 50 50 49 2.13 48 2.05 1 -0.08 New Mexico 19 20 22 22 22 26 27 26 5.00 36 4.53 -10 -0.47 New York 49 49 49 49 49 48 48 48 2.20 50 1.84 -2 -0.36 North Carolina 37 16 16 16 16 16 16 15 5.79 16 5.77 -1 -0.02 North Dakota 27 23 21 21 21 18 19 25 5.03 26 4.95 -1 -0.08 Ohio 46 46 45 43 43 41 42 41 4.00 41 4.23 0 0.23 Oklahoma 29 30 29 28 28 32 32 31 4.87 30 4.86 1 -0.01 Oregon 35 37 36 36 36 38 39 38 4.36 42 3.99 -4 -0.37 Pennsylvania 17 18 19 18 17 20 21 19 5.24 19 5.23 0 -0.01 Rhode Island 25 27 27 27 27 24 26 32 4.86 31 4.82 1 -0.04 South Carolina 30 31 30 30 30 34 34 34 4.81 33 4.80 1 -0.01 South Dakota 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 Tennessee 8 8 8 8 8 8 8 8 7.20 6 8.30 2 1.10 Texas 6 6 6 6 6 6 6 6 8.03 7 8.02 -1 -0.01 Utah 11 10 10 10 10 10 10 10 6.12 10 6.11 0 -0.01 Vermont 40 40 40 41 41 36 38 39 4.34 40 4.30 -1 -0.04 Virginia 28 29 28 29 29 33 33 33 4.81 32 4.80 1 -0.01 Washington 6 6 6 6 6 6 6 6 8.03 7 8.02 -1 -0.01 West Virginia 24 26 26 26 26 29 29 28 4.92 28 4.90 0 -0.02 Wisconsin 39 39 39 39 39 39 37 37 4.42 37 4.35 0 -0.07 Wyoming 1 1 1 1 1 1 1 1 10.00 1 10.00 0 0.00 District of Columbia 47 47 46 49 49 47 47 48 2.92 48 2.79 0 -0.13 Note: A rank of 1 is best, 50 is worst. All scores are for fiscal years. DC’s score and rank do not affect other states. Source: Tax Foundation. 30 | STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXFor 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. The 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 seven 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, Tennessee, 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 also scores well, because while the state levies a tax on individual income in the form of interest and dividends, it does not tax wages and salaries.17 Colorado, Illinois, Indiana, Kentucky, 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. 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, https://www.taxfoundation.org/wealthy-americans-and-business-activity/. 17 Tennessee has begun the process of phasing out its tax on interest and dividend income. TAX FOUNDATION | 31 INDIVIDUAL INCOME TAXIndividual Income Tax Rate The rate subindex compares the states that tax individual income after setting aside the five states that do not and therefore receive perfect scores: Alaska, Florida, South Dakota, and Wyoming. Tennessee, Texas, and Washington do not have an individual income tax, but they do tax S corporation income—and Texas and Washington tax LLC 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, meanwhile, does not tax wage and salary income but does 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 (11.0 percent), New York (recently raised to 10.9 percent), New Jersey (10.75 percent), Oregon (9.9 percent), Minnesota (9.85 percent), Vermont (8.75 percent), and Iowa (8.53 percent). States with the lowest top statutory rates are North Dakota (2.9 percent), Pennsylvania (3.07 percent), Indiana (3.23 percent), Ohio (3.99 percent), Michigan (4.25 percent), Arizona and Colorado (both at 4.5 percent), and Utah (4.95 percent). Alabama, Kentucky, Mississippi, New Hampshire, and Oklahoma all impose a top statutory 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. 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, https://www.taxfoundation.org/ local-income-taxes-city-and-county-level-income-and-wage-taxes-continue-wane/. 32 | STATE BUSINESS TAX CLIMATE INDEX INDIVIDUAL INCOME TAXStates 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 are Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, New Hampshire, North Carolina, Pennsylvania, and Utah. States with high kick-in levels score the worst. These include New York ($25 million), New Jersey ($1 million of taxable income), California ($1 million), Connecticut ($500,000), and North Dakota ($440,600 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 Pennsylvania scores the best in this variable by having only one tax bracket (that is, a flat tax with no standard deduction). States with only two brackets (that is, flat taxes with a standard deduction) are Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, New Hampshire, North Carolina, and Utah. On the other end of the spectrum, Hawaii scores worst with 13 brackets, followed by California and New York with 11 brackets, and Iowa and Missouri with 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 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. 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. TAX FOUNDATION | 33 SALES & EXCISE TAXIncome 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 40 percent weight to the double taxation of taxable income and a 60 percent weight to an accumulation of other base issues, including indexation and marriage penalties. The states with no individual income tax of any kind achieve perfect neutrality. Tennessee, 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, Arizona, Idaho, Illinois, Maine, Michigan, Missouri, Montana, 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, Delaware, New York, California, Connecticut, and Ohio. 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). Because 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 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.