States’ stiffest economic competition often comes from other states: The U.S. Department of Labor reports most mass job relocations are from one U.S. state to another, rather than to overseas locations.
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 the most competitive in attracting new businesses and most effective at generating economic and employment growth.
With that in mind, the Tax Foundation has published the “2011 State Business Climate Index.” The index helps policymakers understand how states’ business climates match up to their immediate neighbors and to other states within their regions.
Anecdotes about the impact of state tax systems on business investment are plentiful. In Illinois several years ago, hundreds of millions of dollars of capital expenditures were delayed when then-Governor Rod Blagojevich proposed a hefty gross receipts tax. Only when the legislature resoundingly defeated the bill did the investment resume.
In 2005, California-based Intel decided to build a multibillion-dollar chip-making facility in Arizona because of its favorable corporate income tax system. Northrup Grumman recently chose to move its headquarters to Virginia over Maryland, citing the better business tax climate.
Anecdotes such as these reinforce what we know from economic theory: Taxes matter to businesses, and those places with the most competitive tax systems will reap the benefits of business-friendly tax climates.
State lawmakers are often tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform. This can be a dangerous proposition, however, as a case involving Dell Computers and North Carolina illustrates.
North Carolina agreed to $240 million worth of incentives to lure Dell. Many of the incentives came in the form of tax credits from the state and local governments. Unfortunately, Dell announced in 2009 it would be closing the plant after only four years of operations.
A recent USA Today article chronicled similar problems other states are having with companies that receive generous tax incentives.
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 tax climate. A far more effective approach is to systematically improve the business tax climate for the long term so as to improve the state’s competitiveness.
When assessing which changes to make, lawmakers need to remember these two rules:
1. Taxes matter to business. Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system, 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, and more likely to experience economic growth.
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 do business. Entrepreneurial states can take advantage of the tax increases of their neighbors to lure businesses out of high-tax states.
Fast Improvement Possible
Clearly, there are many non-tax factors that affect a state’s overall business climate—its proximity to raw materials or transportation centers, its regulatory and legal structures, the quality of its education system and the skill of its workforce, and the intangible perception of a state’s “quality of life.” The 2011 SBTCI does not measure the impact of these important features of a state’s overall business climate. It measures only the tax component of each state’s business climate.
Some of the non-tax factors of a state’s business climate are 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 systems are to business. Furthermore, unlike changes to a state’s health care, transportation, or education system—which can take decades to implement—changes to the tax code can bring almost instantaneous benefits to a state’s business climate.
The ideal tax system—whether at the local, state, or federal level—is simple, transparent, stable, neutral to business activity, and pro-growth. In such an ideal system, individuals and businesses would spend a minimum amount of resources to comply with the tax system, would understand the true cost of the tax system, would base their economic decisions solely on the merits of the transactions, without regard to tax implications, and would not have the tax system impede their growth and prosperity.
Kail Padgitt ([email protected]) is staff economist at the Tax Foundation in Washington, DC.
2011 State Business Tax Climate Index: http://www.budgetandtax-news.org/article/28685.