State Rankings of Tax Climate Can be Misunderstood, Accidentally and Deliberately

November 10, 2009

Overview

Institute for Wisconsin’s Future (IWF) has issued a report criticizing the Tax Foundation’s State Business Tax Climate Index as a “poison pill” for the state. Wisconsin’s tax system does need some strong medicine, and it won’t be easy going down, but the only poison is the witches’ brew of bad tax policies that IWF is peddling.

  • IWF falsely claims that our tax climate index suggests budget cuts to education, transportation and health care. The Index makes no recommendations on spending, just taxes. A state can raise its collections and at the same time improve its Index score.
  • IWF favors a tax system that micromanages the economy with special interest handouts in the form of business tax credits, deductions and exemptions, plus gimmicky tax breaks posing as aid to the poor, all provisions that are punished in our Index because they violate the principles of tax neutrality and transparency.

The State Business Tax Climate Index is designed to evaluate the business tax climate based on the principles of sound tax policy, simplicity, transparency, neutrality, and stability. It promotes the enactment of simple tax policies that produce stable, predictable revenues. The Institute for Wisconsin’s Future seems to be instead push for a policy of tax complexity, opacity, bias, and volatility.

Introduction

The Tax Foundation’s recent release of the 2010 State Business Tax Climate Index (SBTCI), the seventh annual edition, has occasioned a number of misconceptions. It’s important that both the aim and scope of the Index is fully understood for it to be used as an appropriate policy tool. Two misunderstandings are most common, the proper scope of the project and its methodology.

Recently, some groups have claimed that the Index is judging how efficiently state and local governments spent their revenue. It does not try to do that; we have chosen instead to limit it to our specific area of expertise, taxes. Of the 110 parameters that are scored in the Index, none relate to the expenditures side of the ledger. The second misconception involves the methodological criteria, most noticeably the notions of neutrality and transparency.

Although this short piece is prompted by a paper released by the Institute for Wisconsin’s Future, it is generally applicable to a number of different audiences.

The Scope of the SBTCI

The State Business Tax Climate Index is designed to measure the business-friendliness of each state’s tax system’s principal features. Statutory tax rates, deductions, exemptions, credits, these are the values that are tallied in the computations. The tax climate is a subset of the broader “business climate” that would have to be judged not only by tax measures but with hundreds of other criteria.

Noticeably absent from the Index is revenue collected, whether measured in dollars or as a percentage of income. The Tax Foundation and hundreds of other groups and scholars author studies that focus on tax revenue and tax burdens, but the Index is not one of those.

Instead, with the Index we are getting at the unseen costs of goods not produced and jobs not created. The more biased and burdensome the tax structure is — as revealed by its statutory language — the larger these costs are. This is what economists refer to as the deadweight loss of taxation. The SBTCI was designed to index these costs.

Wisconsin and the State Business Tax Climate Index

Many groups have claimed this study makes determinations about the expenditures side of public policy. This is simply not true. One recent example is a report from the Institute for Wisconsin’s Future suggesting that our Index recommends cutting transportation, education and health care.

We understand that the group is championing higher state spending, but it does not help their credibility or their cause to make false claims about our study.

The only mention of transportation and education spending in the 64-page report is to assert that tax policy improvements can help the state’s economy more quickly than improvements to infrastructure and the educational system because those changes take years if not decades to implement. New roads are not built in a day nor are improved elementary schools going to increase workforce productivity any time soon. However, changes to the tax structure will affect businesses on the day of enactment.

Evaluation Criteria of the SBTCI

The Index’s guiding principle is neutrality. When taxing income, tax it all; and when taxing retail sales, tax all goods and services equally. This is the only way to keep rates moderate. By enacting targeted exemptions, deductions and credits to benefit preferred groups of individuals or businesses, legislatures force the statutory rates up on everyone else. It is no wonder, then, that the IWF does not like the results of the Index. Their analysts prefer targeted deductions, exemptions and credits, features that the Index counts against a state’s tax system.

The IWF criticizes the Index’s preference for a one-rate income tax structure, but without trying to rebut the numerous arguments in favor throughout the academic literature. The alternative, a graduated, multi-rate ladders are not a method of creating growth for Wisconsin. A progressive income tax structure creates a disincentive for work.

Another area of dispute is sales tax exemptions for certain products. The IWF seems to say that the Tax Foundation promotes both a sales tax and a special excise tax on gasoline as good and desirable policy.

On the contrary, while the Index does penalize a state tax system for imposing selective sales taxes on particular products such as gasoline, it rewards states for applying their general sales tax to all end-user purchases, including gasoline at the pump.[1]

A broad base will lower the rate on all goods and services sold. There is hardly any tax preference more poorly targeted than a sales tax exemption intended to “help the poor.” There is almost no product on the market that is not purchased mostly by people with sufficient income to pay a sales tax. Giving everyone a 5-percent discount is an indefensible policy.

Conclusion

The IWF should be thanked for taking interested in the SBTCI. Issues of tax policy are more important than ever as the nation struggles through a recession. It’s for this reason that serious debate on these issues is needed.

When judging a policy one must look beyond its stated intent and into its actual outcomes. Business tax credits for example seem prima facie to be excellent way to attract business into a state. Unfortunately these credits amount to little more than political favors to connected businesses. The price tag for these credits is passed onto the less connected businesses and residents of the state. As can be seen with business tax credits, the policy goals and the actual implementation can differ greatly. This is why an honest and thoughtful debate on the issues in needed. Let us hope that such a debate can be possible in the future.

[1] For a full discussion of gasoline excise taxes, see Background Paper No. 56.


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