Response to Criticisms of the State Business Tax Climate Index

February 27, 2006

Some recent contributions to the literature on state taxation criticize business and tax climate studies in general. Authors of such studies contend that indices like the State Business Tax Climate Index do not take into account those factors which directly impact a state’s business climate.

However, when carefully examining these criticisms, it is apparent that the authors believe taxes are unimportant to businesses and therefore dismiss the studies as merely being designed to push low taxes.

Peter Fisher’s Grading Places: What Do the Business Climate Rankings Really Tell Us?, published by the Economic Policy Institute, criticizes five indexes: The Small Business Survival Index published by the Small Business and Entrepreneurship Council; Beacon Hill’s Competitiveness Reports; the Cato Institute’s Fiscal Policy Report Card; the Economic Freedom Index by the Pacific Research Institute; and the 2003 edition of the State Business Tax Climate Index.

Fisher concludes: “The underlying problem with the five 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). Fisher’s major argument for supporting this contention is that if the indexes did what they purported to do, then the indexes would rank each state similarly.

Fisher’s conclusion holds little weight because the five indexes 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 (Small Business and Entrepreneurship Council’s Small Business Survival Index), or infant mortality rates, air passengers per capita and the percentage of adults in the workforce (Beacon Hill’s State Competitiveness Report), or charter schools, tort reform and minimum wages laws (Pacific Research Institute’s Economic Freedom Index).

The Tax Foundation’s expertise is naturally in taxes, and the State Business Tax Climate Index is an indicator of which states’ tax systems are the most hospitable to business and economic growth. The SBTCI does not attempt to measure economic opportunity or freedom, or even the broad business climate, but the much narrower business tax climate. We do so not only because the Tax Foundation’s expertise is in taxes, but because every component of the SBTCI 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. The Tax Foundation believes business decisions are significantly impacted by tax considerations, but Fisher takes the contrarian 1970s view that the effects of taxes are “small or nonexistent.”

Although Fisher does not feel tax climates are important to states and 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 indexes are able to predict growth. In fact, they found, “The State Business Tax Climate Index explains growth consistently.” Furthermore, they found that relative tax competitiveness matters especially at the borders and that, as a result, indexes that place a high premium on tax policies better explain growth. Also, they 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 SBTCI.

Fisher and Bittlingmayer et al. hold opposing views about the impact of taxes on economic growth. Fisher finds support from Robert Tannenwald of the Boston Federal Reserve who argues that taxes are not as important to businesses as public expenditures. Tannenwald compares twenty-two 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 (METR) of a hypothetical firm and yields results that make taxes appear trivial.

Tannenwald asserts that “while interjurisdictional rivalry is inducing states to cut taxes, demand is rising for state and local services such as education, health care, and law enforcement.” He concludes that business taxes exert only a small, highly uncertain effect on capital spending. States may be more likely to stimulate their economy by enhancing public services valued by business (Tannenwald 1996).

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 their system makes their 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 to the conclusion that taxes matter a great deal to business, show that the SBTCI is an important and useful tool for policymakers who want to make their state’s tax system welcoming to business.

References
Bittlingmayer, Gregory; Eathington, Liesel; Hall, Arthur; Orazem, Peter F. (2005). “Business Climate Indexes: Which Work, Which Don’t, and What can They Say About Kansas?” The Center for Applied Economics: Kansas University, June 2005.

Fisher, Peter (2005). Grading Places: What do the Business Climate Rankings Really Tell Us? Economic Policy Institute, 2005.

Tannenwald, Robert (1996), “State Business Tax Climate: How Should it be Measured and How Important is it?” New England Economic Review: Federal Reserve Bank of Boston, Jan/Feb 1996, pp. 23-38.

(For questions about the State Business Tax Climate Index, contact the press office at (202) 464-5120.


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