2016 State Business Tax Climate Index

November 17, 2015

Executive Summary

The Tax Foundation’s State Business Tax Climate Index enables business leaders, government policymakers, and taxpayers to gauge how their states’ tax systems compare. While there are many ways to show how much is collected in taxes by state governments, the Index is designed to show how well states structure their tax systems, and provides a roadmap for improvement.

The 10 best states in this year’s Index are:

1. Wyoming

2. South Dakota

3. Alaska

4. Florida

5. Nevada

6. Montana

7. New Hampshire

8. Indiana

9. Utah

10. Texas

The absence of a major tax is a common factor among many of the top ten states. Property taxes and unemployment insurance taxes are levied in every state, but there are several states that do without one or more of the major taxes: the corporate income tax, the individual income tax, or the sales tax. Wyoming, Nevada, South Dakota, and Texas have no corporate or individual income tax (though Nevada and Texas both impose gross receipts taxes); Alaska has no individual income or state-level sales tax; Florida has no individual income tax; and New Hampshire and Montana have no sales tax.

This does not mean, however, that a state cannot rank in the top ten while still levying all the major taxes. Indiana and Utah, for example, levy all of the major tax types, but do so with low rates on broad bases.

The 10 lowest ranked, or worst, states in this year’s Index are:

41. Maryland

42. Ohio

43. Wisconsin

44. Connecticut       

45. Rhode Island

46. Vermont

47. Minnesota

48. California

49. New York

50. New Jersey

The states in the bottom 10 tend to have a number of afflictions in common: complex, non-neutral taxes with comparatively high rates. New Jersey, for example, is hampered by some of the highest property tax burdens in the country, is one of just two states to levy both an inheritance tax and an estate tax, and maintains some of the worst-structured individual income taxes in the country.

Table 1.

2016 State Business Tax Climate Index Ranks and Component Tax Ranks

 

Overall Rank

Corporate Tax Rank

Individual Income
Tax Rank

Sales Tax Rank

Unemployment Insurance Tax Rank

Property Tax Rank

Alabama

29

25

22

41

26

17

Alaska

3

30

1

5

21

21

Arizona

24

22

19

49

9

6

Arkansas

38

42

29

43

43

27

California

48

35

50

40

13

13

Colorado

18

15

16

44

33

12

Connecticut

44

33

36

29

20

49

Delaware

14

50

33

1

4

15

Florida

4

17

1

17

3

20

Georgia

39

9

42

35

37

31

Hawaii

31

10

37

14

24

14

Idaho

19

24

23

20

45

4

Illinois

23

36

10

33

39

45

Indiana

8

20

11

11

14

5

Iowa

40

49

32

24

34

40

Kansas

22

40

18

32

10

19

Kentucky

28

29

30

9

46

23

Louisiana

37

38

27

50

5

28

Maine

34

45

26

10

41

41

Maryland

41

19

45

8

28

42

Massachusetts

25

39

13

18

47

46

Michigan

13

11

15

7

48

26

Minnesota

47

46

46

36

29

30

Mississippi

20

13

21

28

8

35

Missouri

17

3

28

23

12

8

Montana

6

23

20

3

18

9

Nebraska

27

31

24

26

2

39

Nevada

5

4

1

39

42

7

New Hampshire

7

48

9

2

44

43

New Jersey

50

43

48

47

31

50

New Mexico

35

27

34

48

7

1

New York

49

12

49

42

32

47

North Carolina

15

7

14

31

11

32

North Dakota

26

14

35

22

16

3

Ohio

42

26

47

30

6

11

Oklahoma

33

8

40

38

1

18

Oregon

11

37

31

4

27

10

Pennsylvania

32

47

17

25

50

38

Rhode Island

45

34

38

27

49

44

South Carolina

36

16

41

19

35

25

South Dakota

2

1

1

34

40

22

Tennessee

16

18

8

46

25

37

Texas

10

41

6

37

15

34

Utah

9

5

12

16

19

2

Vermont

46

44

44

15

17

48

Virginia

30

6

39

6

38

29

Washington

12

28

6

45

23

24

West Virginia

21

21

25

21

22

16

Wisconsin

43

32

43

13

36

33

Wyoming

1

1

1

12

30

36

District of Columbia

42

36

34

40

27

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, 2015 (the beginning of Fiscal Year 2016).

Source: Tax Foundation.

Notable Ranking Changes in this Year’s Index

Arizona

Arizona is in the process of lowering its corporate income tax rate, with reductions to be made in stages between 2015 and 2018. The first reduction, from 6.5 to 6 percent, helped the state improve three places on the business tax component. The cuts have been aided by limitations on credits and other base-narrowing tax preferences, which have helped pay down rate reductions.

Kansas

Facing revenue shortfalls largely attributable to the 2012 exemption of pass-through revenue from the individual income tax—which did not improve the state’s Index score—Kansas officials settled upon a sales tax increase. The rate increased from 6.15 to 6.5 percent to close the gap, a change that caused the state to slip three places (from 29th to 32nd) in the sales tax component of the Index.

Illinois

Illinois improved eight ranks overall, from 31st to 23rd, due to the sunset of corporate and individual income tax increases first imposed in 2011 as temporary levies to address the state’s backlog of unpaid bills. These temporary tax increases gave Illinois one of the highest corporate income tax rates in the country (the state’s corporate income tax is two separate taxes on income, which yielded a combined rate of 9.5 percent) and were permitted to expire on schedule in 2015. This rate reduction translated into an improvement of eight places on the Index overall and ten places on the corporate tax component. The combined corporate income tax rate now stands at 7.75 percent, and the individual income tax declined from 5 percent to 3.75 percent.

Indiana

Due to legislation enacted last year, Indiana’s corporate income tax rate fell from 7 to 6.5 percent, while its individual income tax rate went from 3.4 to 3.3 percent. This was the continuation of a scheduled multi-year reduction, which will ultimately see the corporate income tax rate reduced to 4.9 percent by 2021 and the individual income tax rate cut to 3.23 percent by 2017. This year’s corporate rate reduction allowed the state to improve three places on the Index’s corporate tax component, though the state remains at eighth overall.

Nevada

Nevada imposed a new modified gross receipts tax (formally named the Commerce Tax) on many businesses within the state, albeit at low rates, causing the state to slip from first to fourth on the Index’s corporate tax component, and from third to fifth overall.
 

New Mexico

A corporate income tax reduction, with the state’s top marginal rate declining from 7.3 to 6.9 percent, enabled New Mexico to improve eight places—from 35th to 27th—on the corporate tax component of the Index. The rate is scheduled to phase down to 5.9 percent by 2018, enhancing the state’s standing in comparison to its neighbors and further improving its corporate tax component score.

New York

Last year, New York policymakers enacted a substantial corporate tax reform package which, once fully phased in, will lower the corporate income tax rate from 7.1 percent to 6.5 percent, eliminate the capital stock tax, extend net operating loss carrybacks from two to three years, and remove the carryback cap. This year, New York extended the net operating loss carryback period and lifted the carryback cap (among other changes), which helped the state move nine places on the corporate tax component. The state still ranks 49th overall, but once additional elements of the 2014 tax reform are phased in, New York can anticipate further improvement on the Index.

North Carolina

After the most dramatic improvement in the Index’s history—from 44th to 15th in one year—North Carolina has continued to improve its tax structure, with additional elements of the historic 2013 reform still phasing in. The corporate income tax, which was cut from 6.9 percent to 6 percent last year, has continued its scheduled decline, falling to 5 percent in 2015. The corporate income tax is subject to a trigger mechanism that will further reduce the rate in future years when revenues are healthy. The individual income tax, which was converted from a graduated rate tax with a top marginal rate of 7.75 percent to a single-rate tax of 5.8 percent in 2014, saw a further modest cut this year, decreasing to 5.75 percent, with further reductions scheduled through 2017.

As a result of these changes, North Carolina improved an additional eleven places on its corporate component rank, moving from 18th to 7th, with further improvement to its rank likely in the coming years as the state completes the phase-in of 2013 reforms.

Rhode Island

Fully phasing out its antiquated capital stock tax and reducing its corporate income tax rate from 9 to 7 percent enabled Rhode Island to move from 43rd to 34th on the corporate tax component of the Index.

West Virginia

In 2015, West Virginia completed the phase-out of its franchise tax, resulting in the state moving seven places on the property tax component of the Index (from 23rd to 16th), and improving the state’s overall rank from 22nd to 21st.

District of Columbia

The District of Columbia continues to phase in a tax reform package which lowered individual income taxes for middle income brackets, expanded the sales tax base, and raised the estate tax exemption. This year, the District's corporate income tax rate fell from 9.975 percent to 9.4 percent, on the way to an 8.25 percent rate by 2019. Although the District of Columbia is not included in our rankings and does not affect the ranks of other states, were it a state, it would rank 42nd this year, an improvement of three places from last year.

Recent and Proposed Changes Not Reflected in the 2016 State Business Tax Climate Index

The 2016 Index includes those tax changes in effect as of the snapshot date of July 1, 2015, the start of most states’ 2016 fiscal year. Expected future changes not captured in this year’s edition are listed below.

Arizona

Arizona is in the process of reducing its corporate income tax rate (which now stands at 6 percent after an initial reduction) to 4.9 percent in stages between 2015 and 2018. Once fully implemented, these reductions will further improve Arizona’s score on the corporate income tax component.

Indiana

The Indiana corporate income tax is scheduled to be reduced to 4.9 percent by 2021, and the state’s throwback rule will be repealed effective January 2016. These reductions will continue to improve Indiana’s score on the corporate tax component of the Index. Additionally, Indiana is in the process of phasing in moderate cuts to its individual income tax rate. The rate will fall to 3.23 percent in 2017.

Kansas

Kansas is in the process of phasing out its income tax using a trigger mechanism that applies any additional general fund receipts over 2 percent growth from the previous year toward rate reduction.

Missouri

Last year, Missouri policymakers passed an income tax reduction that lowers the top rate by 0.1 percent each year starting in 2017, dependent on a revenue trigger. These changes will be reflected in the 2018 Index.

New Mexico

The New Mexico corporate income tax rate is in the process of phasing down to 5.9 percent by 2018. For this Index edition, it stands at 6.9 percent.

New York

New York policymakers enacted a substantial corporate tax reform that has, to date, eliminated the individual and corporate alternative minimum taxes, extended net operating loss carrybacks from two to three years, and removed the carryback cap. Once fully phased in, it will also eliminate the capital stock tax and lower the corporate income tax rate from 7.1 to 6.5 percent.

North Carolina

North Carolina is in the process of phasing in its historic tax reform passed in 2013 that fundamentally restructured the state’s tax code. The individual income tax, which was restructured from a multi-rate system with a top rate of 7.75 percent to a single 5.8 percent rate last year, was further reduced to 5.75 percent this year. The corporate rate, which was reduced to 5 percent for this edition of the Index, is subject to triggers which will reduce the rate to 4 percent in 2016 and may bring the rate as low as 3 percent by 2017.

Ohio

Ohio cut its individual income tax to 4.997 percent after the Index’s July 1, 2015 snapshot date. This rate reduction will be reflected in the 2017 edition.

Pennsylvania

Pennsylvania continues to phase out its capital stock tax, but while the tax was supposed to be eliminated in 2014, policymakers have extended the length of the phase-out until 2016.

Texas

This year, Texas’ gross receipts tax, styled the Margin Tax, saw a modest rate reduction, with the general rate declining from 0.975 percent to 0.95 percent. This change did not impact the state’s score in the 2016 Index. A further reduction to 0.75 percent is scheduled for 2016.

Introduction

Taxation is inevitable, but the specifics of a state's tax structure matter greatly. The measure of total taxes paid is relevant, but other elements of a state tax system can also enhance or harm the competitiveness of a state’s business environment. The State Business Tax Climate Index reduces many complex considerations to an easy-to-use 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 healthcare, transportation, or education systems, which can take decades to implement, changes to the tax code can quickly improve a state’s business climate.

It is important to remember that even in our global economy, states’ stiffest competition often comes from other states. The Department of Labor reports that most mass job relocations are from one U.S. state to another rather than to a foreign location.[1] Certainly job creation is rapid overseas, as previously underdeveloped nations enter the world economy without facing the third highest corporate tax rate in the world, as U.S. businesses do.[2] State lawmakers are right to be concerned about how their states rank in the global competition for jobs and capital, but they need to be more concerned with companies moving from Detroit, Michigan to Dayton, Ohio, than from Detroit to New Delhi. This means that state lawmakers must be aware of how their states’ business climates match up against their immediate neighbors and to other regional competitor states.

Anecdotes about the impact of state tax systems on business investment are plentiful. In Illinois early last decade, hundreds of millions of dollars of capital investments were delayed when then-Governor Rod Blagojevich proposed a hefty gross receipts tax.[3] Only when the legislature resoundingly defeated the bill did the investment resume. Later, the state had to resort to abatements for Sears and the Chicago Mercantile Exchange to keep them from fleeing the temporary tax increases of 2011.[4] In 2005, California-based Intel decided to build a multi-billion dollar chip-making facility in Arizona due to its favorable corporate income tax system.[5] In 2010, Northrup Grumman chose to move its headquarters to Virginia over Maryland, citing the better business tax climate.[6] In 2015, General Electric and Aetna threatened to decamp from Connecticut if the Governor signed a budget that would increase corporate tax burdens.[7] 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 always mindful of their states’ business tax climates, but they are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition, as the example of Dell Computers and North Carolina illustrates. North Carolina agreed to $240 million worth of incentives to lure Dell to the state. Many of the incentives came in the form of tax credits from the state and local governments. Unfortunately, Dell announced in 2009 that it would be closing the plant after only four years of operations.[8] A 2007 USA Today article chronicled similar problems other states have had with companies that receive generous tax incentives.[9]

Lawmakers create these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for a woeful business tax climate. A far more effective approach is the systematic improvement of the state’s business tax climate for the long term to improve the state’s competitiveness. When assessing which changes to make, lawmakers need to remember two rules:

  1. Taxes matter to business. Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system, and the long-term health of a state’s economy. Most importantly, taxes diminish profits. If taxes take a larger portion of profits, that cost is passed along to either consumers (through higher prices), employees (through lower wages or fewer jobs), or shareholders (through lower dividends or share value), or some combination of the above. Thus, a state with lower tax costs will be more attractive to business investment and more likely to experience economic growth.
  2. States do not enact tax changes (increases or cuts) in a vacuum. Every tax law will in some way change a state’s competitive position relative to its immediate neighbors, its region, and even globally. Ultimately, it will affect the state’s national standing as a place to live and to do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high-tax states.

To some extent, tax-induced economic distortions are a fact of life, but policymakers should strive to maximize the occasions when businesses and individuals are guided by business principles and minimize those cases where economic decisions are influenced, micromanaged, or even dictated by a tax system. The more riddled a tax system is with politically motivated preferences, the less likely it is that business decisions will be made in response to market forces. The Index rewards those states that minimize tax-induced economic distortions.

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 over 100 different 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 up to yield a final, overall ranking. This approach rewards states on particularly strong aspects of their tax systems (or penalizes them on particularly weak aspects), while also measuring the general competitiveness of their overall tax systems. The result is a score that can be compared to other states’ scores. Ultimately, both Alaska and Indiana score well.

Economists have not always agreed on how individuals and businesses react to taxes. As early as 1956, Charles Tiebout postulated that if citizens were faced with an array of communities that offered different types or levels of public goods and services at different costs or tax levels, then all citizens would choose the community that best satisfied their particular demands, revealing their preferences by “voting with their feet.” Tiebout’s article is the seminal work on the topic of how taxes affect the location decisions of taxpayers.

Tiebout suggested that citizens with high demands for public goods would concentrate themselves in communities with high levels of public services and high taxes while those with low demands would choose communities with low levels of public services and low taxes. Competition among jurisdictions results in a variety of communities, each with residents that 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 sub-national governments. Besley and Case (1995) showed that “yardstick competition” affects voting behavior and Bosch and Sole-Olle (2006) further confirmed the results found by Besley and Case. Tax changes that are out of sync with neighboring jurisdictions will impact voting behavior.

The economic literature over the past fifty years has slowly cohered around this hypothesis. Ladd (1998) summarizes the post-World War II empirical tax research literature in an excellent survey article, breaking it down into three distinct periods of differing ideas about taxation: (1) taxes do not change behavior; (2) taxes may or may not change business behavior depending on the circumstances; and (3) taxes definitely change behavior.

Period one, with the exception of Tiebout, included the 1950s, 1960s, and 1970s and is summarized succinctly in three survey articles: Due (1961), Oakland (1978), and Wasylenko (1981). Due’s was a polemic against tax giveaways to businesses, and his analytical techniques consisted of basic correlations, interview studies, and the examination of taxes relative to other costs. He found no evidence to support the notion that taxes influence business location. Oakland was skeptical of the assertion that tax differentials at the local level had no influence at all. However, because econometric analysis was relatively unsophisticated at the time, he found no significant articles to support his intuition. Wasylenko’s survey of the literature found some of the first evidence indicating that taxes do influence business location decisions. However, the statistical significance was lower than that of other factors such as labor supply and agglomeration economies. Therefore, he dismissed taxes as a secondary factor at most.

Period two was a brief transition during the early- to mid-1980s. This was a time of great ferment in tax policy as Congress passed major tax bills, including the so-called Reagan tax cut in 1981 and a dramatic reform of the federal tax code in 1986. Articles revealing the economic significance of tax policy proliferated and became more sophisticated. For example, Wasylenko and McGuire (1985) extended the traditional business location literature to non-manufacturing sectors and found, “Higher wages, utility prices, personal income tax rates, and an increase in the overall level of taxation discourage employment growth in several industries.” However, Newman and Sullivan (1988) still found a mixed bag in “their observation that significant tax effects [only] emerged when models were carefully specified” (Ladd).

Ladd was writing in 1998, so her “period three” started in the late 1980s and continued up to 1998 when the quantity and quality of articles increased significantly. Articles that fit into period three begin to surface as early as 1985, as Helms (1985) and Bartik (1985) put forth forceful arguments based on empirical research that taxes guide business decisions. Helms concluded that a state’s ability to attract, retain, and encourage business activity is significantly affected by its pattern of taxation. Furthermore, tax increases significantly retard economic growth when the revenue is used to fund transfer payments. Bartik concluded that the conventional view that state and local taxes have little effect on business is false.

Papke and Papke (1986) found that tax differentials between 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 fifty-seven studies on which to base his literature survey. Ladd succinctly summarizes Bartik’s findings:

The large number of studies permitted Bartik to take a different approach from the other authors. Instead of dwelling on the results and limitations of each individual study, he looked at them in the aggregate and in groups. Although he acknowledged potential criticisms of individual studies, he convincingly argued that some systematic flaw would have to cut across all studies for the consensus results to be invalid. In striking contrast to previous reviewers, he concluded that taxes have quite large and significant effects on business activity.

Ladd’s “period three” surely continues to this day. Agostini and Tulayasathien (2001) examined the effects of corporate income taxes on the location of foreign direct investment in U.S. states. They determined that for “foreign investors, the corporate tax rate is the most relevant tax in their investment decision.” Therefore, they found that foreign direct investment was quite sensitive to states’ corporate tax rates.

Mark, McGuire, and Papke (2000) found that taxes are a statistically significant factor in private-sector job growth. Specifically, they found that personal property taxes and sales taxes have economically large negative effects on the annual growth of private employment.

Harden and Hoyt (2003) point to Phillips and Gross (1995) as another study contending that taxes impact state economic growth, and they assert that the consensus among recent literature is that state and local taxes negatively affect employment levels. Harden and Hoyt conclude that the corporate income tax has the most significant negative impact on the rate of growth in employment.

Gupta and Hofmann (2003) regressed capital expenditures against a variety of factors, including weights of apportionment formulas, the number of tax incentives, and burden figures. Their model covered 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.[10]

Wasylenko’s rejoinder is that policymakers routinely overestimate the degree to which tax policy affects business location decisions and that as a result of this misperception, they respond readily to public pressure for jobs and economic growth by proposing lower taxes. According to Wasylenko, other legislative actions are likely to accomplish more positive economic results because in reality, taxes do not drive economic growth.

However, there is ample evidence that states compete for businesses using their tax systems. A recent example comes from Illinois, where in early 2011 lawmakers passed two major tax increases. The individual income tax rate increased from 3 percent to 5 percent, and the corporate income tax rate rose from 7.3 percent to 9.5 percent.[11] 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 of these firms, totaling $235 million over the next decade, to keep them from leaving the state.[12]

Measuring the Impact of Tax Differentials

Some recent contributions to the literature on state taxation criticize business and tax climate studies in general.[13] 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 of them would rank the states similarly.

Fisher’s conclusion holds little weight because the five indices serve such dissimilar purposes and each group has a different area of expertise. There is no reason to believe that the Tax Foundation’s Index, which depends entirely on state tax laws, would rank the states in the same or similar order as an index that includes crime rates, electricity costs, and health care (the Small Business and Entrepreneurship Council’s Small Business Survival Index), or infant mortality rates and the percentage of adults in the workforce (Beacon Hill’s State Competitiveness Report), or charter schools, tort reform, and minimum wage laws (the Pacific Research Institute’s Economic Freedom Index).

The Tax Foundation’s State Business Tax Climate Index is an indicator of which states’ tax systems are the most hospitable to business and economic growth. The Index does not purport to measure economic opportunity or freedom, or even the broad business climate, but rather the narrower business tax climate, and its variables reflect this focus. We do so not only because the Tax Foundation’s expertise is in taxes, but because every component of the Index is subject to immediate change by state lawmakers. It is by no means clear what the best course of action is for state lawmakers who want to thwart crime, for example, either in the short or long term, but they can change their tax codes now. Contrary to Fisher’s 1970s view that the effects of taxes are “small or non-existent,” our study reflects strong evidence that business decisions are significantly impacted by tax considerations.

Although Fisher does not feel tax climates are important to states’ economic growth, other authors contend the opposite. Bittlingmayer, Eathington, Hall, and Orazem (2005) find in their analysis of several business climate studies that a state’s tax climate does affect its economic growth rate and that several indices are able to predict growth. Specifically, they concluded, “The State Business Tax Climate Index explains growth consistently.” This finding was confirmed by Anderson (2006) in a study for the Michigan House of Representatives, and more recently by Kolko, Neumark, and Mejia (2013), who, in an analysis of the ability of ten business climate indices to predict economic growth, concluded that the State Business Tax Climate Index yields “positive, sizable, and statistically significant estimates for every specification” they measured, and specifically cited the Index as one of two business climate indices (out of ten) with particularly strong and robust evidence of predictive power.

Bittlingmayer et al. also found that relative tax competitiveness matters, especially at the borders, and therefore, indices that place a high premium on tax policies better explain growth. They also observed that studies focused on a single topic do better at explaining economic growth at borders. Lastly, the article concludes that the most important elements of the business climate are tax and regulatory burdens on business (Bittlingmayer et al. 2005). These findings support the argument that taxes impact business decisions and economic growth, and they support the validity of the Index.

Fisher and Bittlingmayer et al. hold opposing views about the impact of taxes on economic growth. Fisher finds support from Robert Tannenwald, formerly of the Boston Federal Reserve, who argues that taxes are not as important to businesses as public expenditures. Tannenwald compares 22 states by measuring the after-tax rate of return to cash flow of a new facility built by a representative firm in each state. This very different approach attempts to compute the marginal effective tax rate of a hypothetical firm and yields results that make taxes appear trivial.

The taxes paid by businesses should be a concern to everyone because they are ultimately borne by individuals through lower wages, increased prices, and decreased shareholder value. States do not institute tax policy in a vacuum. Every change to a state’s tax system makes its business tax climate more or less competitive compared to other states and makes the state more or less attractive to business. Ultimately, anecdotal and empirical evidence, along with the cohesion of recent literature around the conclusion that taxes matter a great deal to business, show that the Index is an important and useful tool for policymakers who want to make their states’ tax systems welcoming to business.

Table 2.

State Business Tax Climate Index (2013–2016)

 

2013 Rank

2013 Score

2014 Rank

2014 Score

2015 Rank

2015 Score

2016 Rank

2016 Score

Change from  2015 to 2016

Rank

Score

Alabama

26

5.10

25

5.09

29

5.02

29

5.00

0

-0.02

Alaska

4

7.26

4

7.23

4

7.22

3

7.34

+1

+0.12

Arizona

27

5.07

22

5.16

24

5.11

24

5.18

0

+0.07

Arkansas

34

4.89

37

4.77

39

4.67

38

4.61

+1

-0.06

California

48

3.67

48

3.76

48

3.77

48

3.75

0

-0.02

Colorado

19

5.29

20

5.21

20

5.28

18

5.33

+2

+0.05

Connecticut

43

4.41

42

4.48

44

4.45

44

4.33

0

-0.12

Delaware

14

5.59

14

5.58

14

5.53

14

5.58

0

+0.05

Florida

5

6.78

5

6.85

5

6.86

4

6.92

+1

+0.06

Georgia

37

4.73

38

4.71

38

4.68

39

4.58

-1

-0.10

Hawaii

32

4.93

30

4.99

30

4.99

31

4.97

-1

-0.02

Idaho

18

5.31

18

5.32

19

5.28

19

5.27

0

-0.01

Illinois

30

4.97

28

5.00

31

4.96

23

5.18

+8

+0.22

Indiana

10

5.85

8

5.98

8

5.96

8

5.95

0

-0.01

Iowa

39

4.53

40

4.53

41

4.50

40

4.47

+1

-0.03

Kansas

21

5.17

19

5.28

21

5.25

22

5.22

-1

-0.03

Kentucky

23

5.15

24

5.12

27

5.03

28

5.02

-1

-0.01

Louisiana

33

4.89

33

4.86

35

4.83

37

4.70

-2

-0.13

Maine

29

5.00

29

5.00

34

4.89

34

4.85

0

-0.04

Maryland

40

4.49

41

4.51

40

4.50

41

4.46

-1

-0.04

Massachusetts

24

5.12

23

5.14

25

5.08

25

5.11

0

+0.03

Michigan

13

5.71

13

5.74

13

5.63

13

5.63

0

0.00

Minnesota

45

4.22

47

4.04

47

4.03

47

4.03

0

0.00

Mississippi

17

5.32

17

5.33

18

5.29

20

5.24

-2

-0.05

Missouri

16

5.51

16

5.51

17

5.44

17

5.39

0

-0.05

Montana

6

6.25

6

6.25

6

6.20

6

6.19

0

-0.01

Nebraska

31

4.95

32

4.91

26

5.08

27

5.08

-1

0.00

Nevada

3

7.40

3

7.45

3

7.45

5

6.66

-2

-0.79

New Hampshire

7

6.08

7

6.08

7

6.02

7

6.07

0

+0.05

New Jersey

50

3.45

50

3.40

50

3.39

50

3.36

0

-0.03

New Mexico

38

4.71

36

4.77

37

4.75

35

4.75

+2

0.00

New York

49

3.45

49

3.47

49

3.62

49

3.61

0

-0.01

North Carolina

44

4.27

44

4.40

15

5.48

15

5.57

0

+0.09

North Dakota

28

5.05

27

5.04

23

5.11

26

5.08

-3

-0.03

Ohio

42

4.46

39

4.53

42

4.48

42

4.43

0

-0.05

Oklahoma

35

4.87

34

4.86

33

4.91

33

4.86

0

-0.05

Oregon

12

5.78

12

5.78

12

5.74

11

5.80

+1

+0.06

Pennsylvania

22

5.17

31

4.99

32

4.92

32

4.91

0

-0.01

Rhode Island

47

4.18

45

4.18

45

4.14

45

4.26

0

+0.12

South Carolina

36

4.81

35

4.79

36

4.76

36

4.74

0

-0.02

South Dakota

2

7.53

2

7.50

2

7.50

2

7.42

0

-0.08

Tennessee

15

5.52

15

5.51

16

5.48

16

5.46

0

-0.02

Texas

9

5.87

10

5.81

11

5.76

10

5.82

+1

+0.06

Utah

8

5.96

9

5.97

9

5.91

9

5.91

0

0.00

Vermont

46

4.19

46

4.15

46

4.11

46

4.10

0

-0.01

Virginia

25

5.11

26

5.06

28

5.03

30

4.99

-2

-0.04

Washington

11

5.82

11

5.81

10

5.78

12

5.78

-2

0.00

West Virginia

20

5.19

21

5.19

22

5.19

21

5.24

+1

+0.05

Wisconsin

41

4.47

43

4.42

43

4.47

43

4.43

0

-0.04

Wyoming

1

7.60

1

7.54

1

7.56

1

7.54

0

-0.02

District of Columbia

44

4.31

45

4.36

45

4.32

42

4.43

+3

+0.11

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.

 

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[1] See, e.g., U.S. Department of Labor, Extended Mass Layoffs, First Quarter 2013​, Table 10, May 13, 2013.

[2] Kyle Pomerleau, Corporate Income Tax Rates Around the World, 2014, Tax Foundation Fiscal Fact No. 436, Aug. 20, 2014.

[3] Editorial, Scale it back, Governor, Chicago Tribune, Mar. 23, 2007.

[4] Kathy Bergen, Quinn signs Sears-CME tax breaks into law, Chicago Tribune, Dec. 16, 2011.

[5] Ryan Randazzo, Edythe Jenson, and Mary Jo Pitzl, Chandler getting new $5 billion Intel facility, AZ Central, Mar. 6, 2013.

[6] Dana Hedgpeth & Rosalind Helderman, Northrop Grumman decides to move headquarters to Northern Virginia, Washington Post, Apr. 27, 2010.

[7] Susan Haigh, Connecticut House Speaker: Tax “mistakes” made in budget, Associated Press, Nov. 5, 2015.

[8] Austin Mondine, Dell cuts North Carolina plant despite $280m sweetener, The Register, Oct. 8, 2009.

[9] Dennis Cauchon, Business Incentives Lose Luster for States, USA Today, Aug. 22, 2007.

[10] State Policy Reports, Vol. 12, No. 11, Issue 1, p. 9, June 1994.

[11] Both rate increases have a temporary component. After four years, the individual income tax will decrease to 3.75 percent. Then, in 2025, the individual income tax rate will drop to 3.5 percent. The corporate tax will follow a similar schedule of rate decreases: in four years, the rate will be 7.75 percent, and then, in 2025, it will go back to a rate of 7.3 percent.

[12] Benjamin Yount, Tax increase, impact, dominate Illinois Capitol in 2011, Illinois Statehouse News, Dec. 27, 2011.

[13] A trend in tax literature throughout the 1990s has been 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 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.

 

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