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The State Business Tax Climate Index Is Your Guide to Economic “Wins Above Replacement”

By: Jared Walczak

Last week we published our annual State Business Tax Climate Index, which measures taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. structure. It’s an extremely valuable diagnostic tool, enabling readers to compare states’ tax structures across more than 120 variables. Unlike most studies of state taxes, it is focused on the how more than the how much, in recognition of the fact that there are better and worse ways to raise revenue. Inevitably, though, the publication of the Index raises some questions, like: if Wyoming and South Dakota lead in the rankings, why aren’t more companies heading for the Black Hills?

Tax competition is a little like WAR—not conflict, but Wins Above Replacement. The term comes from baseball, where it is intended as a sabermetric statistic to measure how many more wins a team can claim due to a specific player above the amount that would be generated by a replacement-level player. It’s much the same way in public finance: a well-structured tax code won’t make the Wyoming Basin a metropolis, nor will poor tax structure make Manhattan a ghost town. But tax structure does play a role in a state’s economic successes or failures, and often a substantial one. Every state can benefit from a simple, neutral, transparent, pro-growth tax structure.

The Index scores states across five sub-indexes, each representing a major component of state tax codes: corporate taxes, individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es, sales and excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. es, property and wealth taxA wealth tax is imposed on an individual’s net wealth, or the market value of their total owned assets minus liabilities. A wealth tax can be narrowly or widely defined, and depending on the definition of wealth, the base for a wealth tax can vary. es, and unemployment insurance taxes. Rather than weighting each sub-index equally, their weight is determined according to the variance across states in each category, which has the effect of assigning more weight to areas where states have more areas in which to compete.

Of course, it’s hard to introduce any structural flaws to the design of a tax one does not impose, so some states, by forgoing a tax altogether (the individual income tax, the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , or the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. ) score perfectly on a sub-index or some portion of one. This is why states like Wyoming and South Dakota, which both forgo income taxes, do so well on the Index. States which can avoid imposing one or more of the major taxes either have to lean very heavily on the other major tax types (which can mean lower rankings on those components), choose to operate on leaner budgets, take advantage of natural resources like oil and gas, or have demographics (like Florida) where other taxes can generate a surprising amount of revenue.

In other words, the Wyoming model may not be possible in some states—but the Utah, Indiana, and North Carolina models are.

Those three states ranked 8th, 9th, and 10th in this year’s Index. All three also impose each of the major taxes, but at moderate rates and with comparatively well-designed tax structures. Each state, in fact, has substantially modernized its tax code in the past 15 years: Utah beginning in 2006, Indiana starting in 2011, and North Carolina beginning in 2013. These reforms are ongoing: Indiana, for instance, phased in further rate reductions this year, while North Carolina adopted reforms that will make its individual income tax more competitive and eventually repeal its corporate income tax outright.

For taxpayers, the Index is a good starting point for understanding how your state compares to its peers. But for policymakers and others interested in how to improve the structure of their state’s tax code, it’s more than that: it’s a valuable diagnostic tool, with tables that allow readers to compare their state to its peers on everything from throwback rules to the treatment of net operating losses to whether there’s a recapture provision in the individual income tax or whether the brackets are indexed or whether the state authorizes split-roll property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. ation.

If you saddled South Dakota with New York’s tax code, the state would struggle. People are clearly willing to pay a premium to live in New York—on real estate, on consumer purchases, and yes, on taxes. But there are limits, to say nothing of the fact that a system which is bearable in Manhattan may be considerably more burdensome in Syracuse. And, as the governor of New York has noted repeatedly, even in states like New York—in the post-pandemic recovery, perhaps especially in states like New York—tax burdens, and tax structures, matter. New York actually dramatically improved in the corporate component of the Index several years ago due to meaningful corporate tax reforms adopted on a bipartisan basis.

So yes, we’ve heard your questions about whether we are really saying that businesses would rather be in Mitchell, South Dakota than Manhattan or Sioux Falls than San Francisco, and there’s clearly a lot more that goes into location decisions than just taxes—rates or structure. But taxes are something within the control of policymakers, and even within a given revenue target, there are better and worse ways to raise that revenue.

The Index measures tax structure, not all the other things businesses care about, like an educated workforce, quality of life, proximity to relevant markets, or even the weather—and some of these things involve trade-offs. Taxes, however, are an important part of the mix, and modernizing a state’s tax structure helps position it for growth. States which rank better on the Index have better-structured tax codes, and states with better-structured tax codes get Wins Above Replacement.

So, how does your state rank?