Distinguishing Intrastate and Interstate Neutrality

July 8, 2005

Andrew makes a powerful policy argument below against the use of tax preferences to lure business investment to a state. One of his arguments is neutrality, i.e. the idea that a state’s tax system should be neutral to different forms of business investment.

It’s probably necessary to distinguish between two types of neutrality: intrastate neutrality, which means how fair the state’s internal tax system is to different forms of business investment, and; interstate neutrality, which means whether a state’s tax system generally creates incentives or disincentives to new business investment.

State’s that levy taxes at a low-rate on a broad-base are perfectly neutral with regard to intrastate business. If the tax base includes income from, say, retailing and manufacturing in a neutral way (i.e. no preference given to either form of business), then there will be no tax reason to engage in retailing versus manufacturing. This is the most desirable form of neutrality.

If that same state, however, levies a high tax rate on corporate income (say, in excess of 10 percent) then it will be decidedly non-neutral with regard to business investment decisions based on tax criteria because a business will receive a higher rate of return by investing in another state. In this regard, neutrality may not be worthwhile from an interstate perspective, as states may find it more advantageous to levy lower rates or give broadly applicable tax credits or exemptions to compete with other states for new investment.

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