The Tax Foundation

February 27, 2006

State Business Tax Climate Index (Third Edition)

by Scott A. Hodge and Curtis S. Dubay

PLEASE DO NOT CITE—AN UPDATED VERSION OF THIS STUDY IS AVAILABLE. Please email publications@taxfoundation.org for details.

Background Paper No. 51

Executive Summary
The Tax Foundation presents the 2006 version of the State Business Tax Climate Index (SBTCI) as a tool for lawmakers, the media, and individuals alike to gauge how their states’ tax systems compare. Policymakers can then use the SBTCI to pinpoint changes to their tax system that will explicitly improve their state’s standing in relation to competing states. American companies function at a competitive disadvantage in the global economy because they pay one of the highest corporate tax rates of any of the industrialized countries. 

The top federal rate on corporate income is 35 percent, and states with punitive tax systems cause companies to be even less competitive globally. The modern market is characterized by mobile capital and labor. Therefore, companies will locate where they have the greatest competitive advantage. States with the best tax systems will be most competitive in attracting new businesses and be the most effective at generating economic and employment growth. Although the market is now global, the Department of Labor reports that most mass job relocations are from one U.S. state to another rather than to an overseas location. Certainly some jobs are moving overseas, and while state lawmakers are right to be concerned about how their states rank in the global competition for jobs and capital, states need to be more concerned with companies moving from Indianapolis, IN to Ithaca, NY, rather than Indianapolis to India. This means that state lawmakers must be aware of how their state’s business climate matches up to their immediate neighbors and to other states within their region.

Examples of companies choosing states due to favorable tax systems are plentiful. A recent example, from July 2005, is Intel’s decision to build a multi-billion dollar chip making facility in Arizona due to its favorable corporate income tax system. California struggles to retain businesses within its borders because Nevada provides a low tax alternative. Anecdotes such as these reinforce what we know from economic theory, that taxes matter to businesses, and those places with the most competitive tax systems will reap the benefits of business friendly tax climates.

A recent report from the Rockefeller Institute said that state tax revenues were 8.1 percent higher in the second quarter of 2005 than during the same period a year earlier. This, coupled with national data showing rising GDP and falling unemployment, tells the story of a strong economy. A return to budget surpluses could offer many state lawmakers the opportunity to reform their tax codes in order to make their state more attractive to domestic and foreign investment. State lawmakers are always tempted to lure business with lucrative tax incentives and subsidies. This can be a dangerous proposition, as a case in Florida illustrates. In July of 2004 Florida lawmakers cried foul because a major credit card company announced it would close its Tampa call center, lay off 1,110 workers, and outsource those jobs to another company. The reason for the lawmakers’ ire was that the company had been lured to Florida with a generous tax incentive package and had enjoyed nearly $3 million worth of tax breaks during the past nine years.

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 climate plagued by bad tax policy. A far more effective approach is to systematically improve the business climate for the long term so as to improve the state’s competitiveness as compared to other states. When assessing which changes to make, lawmakers need to remember these two rules:

1. Taxes matter to business. Taxes affect business decisions, job creation and retention, plant location, competitiveness, and the long-term health of a state’s economy. Most importantly, taxes diminish profits. If taxes take a larger portion of profits, that cost is passed along to either consumers (through higher prices), workers (through lower wages or fewer jobs), or shareholders (through lower dividends or share value). Thus a state with lower tax costs will be more attractive to business investment.

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 geographic region, and even globally. Ultimately it will affect the state’s national standing as a place to live and to do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high tax states.

Clearly, there are many non-tax factors that affect a state’s business climate: its proximity to raw materials or transportation centers, its regulatory or legal structures, the quality of its education system and the skill of its workforce, not to mention the intangible perception of a state’s “quality of life.” Some of these factors are, of course, outside of the control of elected officials. Montana lawmakers cannot change the fact that Montana’s businesses have no immediate access to deepwater ports. Lawmakers do, however, have direct control over how friendly their tax system is to business.

The ideal tax system—whether at the state, federal, or international level—is neutral to business activity. In such an ideal system, individuals and businesses would base their economic decisions solely on the merits of the transactions, without regard to tax implications. In reality, tax-induced economic distortions are a fact of life, and a more realistic goal is to maximize the occasions when businesses and individuals are guided by economics, and minimize those cases where economic decisions are micromanaged or even dictated by a tax system. Therefore, the most competitive tax systems, and the ones that score best in the SBTCI, are those that create the fewest distortions by enforcing the most simple tax system based on broad bases with low rates. 

How much states collect in taxes is critical, but how they take it is also important. In other words, quite apart from whether a state’s total tax burden is higher than in other states, it can enact (and many states do) a set of tax laws that cause great damage to the economy. The SBTCI does not allow states with poor tax regimes to hide behind low tax burdens.

Good state tax systems levy low, flat rates on the broadest bases possible, and they treat all taxpayers the same. Variation in the tax treatment of different industries favors one economic activity or decision over another. The more riddled a tax system is with these politically motivated preferences the less likely it is that business decisions will be made in response to market forces. The SBTCI rewards those states that apply these principles in five important areas of taxation: individual income taxes, major business taxes, sales taxes, unemployment insurance taxes, and taxes on wealth or assets such as property.

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