Does a "Good Business Tax Climate" Make the Economy Grow?

We have been told so often over the past several decades that a state has to have a good business tax climate in order for its economy to grow, that we have begun to accept it as the truth.

Economists have generally agreed on the characteristics of a “good” tax -- simple, productive, neutral, fair, transparent – but a “good business tax climate” has come to mean something additional in the political jargon of today – low, or no, taxes on business.

The promise is held before us: the lower your taxes, the healthier your business climate, the more your economy will grow. States are lured into competing against each other to see which can have the “best” business tax climate. Fear is generated that any tax increase will scare business away. Business funded entities construct “Indexes” so each state can see whether it is winning or losing in the competition for economic growth.

There is one small problem, however. The Indexes are never linked to actual economic growth. They measure the level of taxes and then leave us with only the promise of growth.

The Tax Foundation’s “2007 State Business Tax Climate Index” is typical. The report claims that the states with the “best tax systems” will be the “most competitive” in attracting new businesses and “most effective” at generating economic and employment growth. The only way to get a perfect score from the Tax Foundation is to have no tax at all. “Clearly a zero rate is the lowest possible rate and the most neutral base, since it creates the most favorable tax climate for economic growth.”

Is the Tax Foundation’s promise real? Do the states with the “best” business tax climates actually lead in the race for the Golden Fleece of business growth and prosperity?

Economists have argued the point using sophisticated models and arcane statistical manipulations. But let us do something more simple: compare the Tax Foundation state business tax climate ratings with the latest average annual (1997-2004) growth rates in state gross product reported by the U.S. Department of Commerce, Bureau of Economic Analysis.

Here is what one finds.

New Hampshire, one of the 10 best tax climate states, and its next door neighbor, Vermont, one of the 10 worst tax climate states, have identical average annual growth rates.

California, one of the 10 worst tax states, has a higher annual average growth rate than its neighbor Oregon, which is one of the 10 best states.


New York, one of the 10 worst tax states, has a higher annual average growth rate than Delaware, one of the 10 best states, which in turn has a higher annual average growth rate than New Jersey, that is, along with New York, one of the 10 worst states.

Wyoming and Montana, both among the 10 best tax states, rank last and next to last in growth rate among the Rocky Mountain states.

The two states with the highest average annual growth rates, Arizona and Idaho, both rank in the bottom half of all states when it comes to their “business tax climates”.

Texas, which ranks in the top 10 tax climate states, has a 40% slower average annual growth rate than its neighbor, Arizona, which ranks 28th in tax climate.

And lastly, Illinois, which ranks 25th in “business tax climate” according to the Tax Foundation, has a slower average annual growth rate than Wisconsin, which ranks 38th in tax climate, which in turn is growing slower than Minnesota which is 41st in tax climate and one of the 10 “worst” when it comes to business tax climate.

One can only conclude that business has not being paying a lot of practical attention to the Tax Foundation’s Business Tax Climate Index. There is something besides tax levels that attracts business and fosters growth and development. Competing in a race to the bottom in taxes is not necessarily a winning strategy.

Robert Tannenwald, vice-president of the Federal Reserve Bank in Boston, may have a point when he suggests that states might make their economies better by enhancing public services valued by business.

Perhaps the overall business climate improves when states compete not to have the lowest taxes, but the best schools, the best community colleges, the best universities, the most rational health care, the lowest crime rate, the cleanest environment, the best transportation network.

Low taxes are not the only ingredient to a healthy, vibrant economy.

Where is the Evidence?

There has been a lot of wailing and gnashing of teeth since Governor Blagojevich proposed a gross receipts tax to pay for education and health care. To hear the business community tell it, the tax will turn Illinois into an economic wasteland as business flees the state.

Is there any evidence to support these predictions? Is this just Chicken Little scurrying around trying to persuade all who will listen that the sky is falling? Or is it, as Kristen McQueary suggests in her Daily Southtown column, the noise of those who see their lucrative tax breaks and loopholes disappearing?
http://www.dailysouthtown.com/news/mcqueary/318183,291MCQ1.article

There is no evidence that supports the predictions of economic doom.

Three states, Washington, Hawaii and Delaware, have had gross receipts taxes for some years. Over the past 20 years, the economies of two of those states, Washington and Delaware, have out performed the national economy.

The Tax Foundation, that friend of business, ranks the business tax climate of all three states in the top half of all the states, with Delaware 9th, Washington 11th, and Hawaii 24th.

Ohio, Texas and Kentucky all adopted gross receipts taxes in the last two years. Nevada fell one legislative vote short in 2003. This year Governor Blagojevich and Governor Granholm in Michigan have both proposed gross receipts taxes for their states.

What’s going on here? Why does a gross receipts tax make sense to so many different people in so many different states? Is it just that all the politicians have completely lost their senses as the Illinois Chamber of Commerce and other groups would have us believe? Or is there some basic economic reason why a gross receipts tax at the state level is something reasonable to consider in today’s economy?

The answer to the last question is, “Yes”.

Over the last 40 years the economy has changed fundamentally. Our taxes have not; they are still tied to the old economy. The corporate income tax, full of loopholes, can no longer be enforced by states. Businesses representing the old economy are increasingly paying more than their share.

As the Texas Comptroller said 20 years ago, “There are whole industries today – enormously important and profitable industries – that weren’t even dreamed of twenty-five years ago. The new economy has been described by many names: service, information, space age, diversified. But our tax structure remains tied to the past, to hard products and assets attached to the ground.”

Robert Tannenwald, Assistant Vice President of the Federal Reserve Bank in Boston, notes that since 1980 the ratio of state corporate income tax collections to corporate income has declined almost 50 percent and state tax departments are “increasingly outgunned” in collecting the corporate income tax. Globalization, as well as tax breaks, plays a part. Richard Pomp, a corporate tax law professor at the University of Connecticut, predicts the tax at the state level has little future.

The issues of avoidance and fairness have been the motives in every state for adopting the gross receipts tax.

The Texas Tax Reform Commission, appointed by a Republican governor and made up mostly of business executives, perhaps said it best in recommending a gross receipts tax for that state, “The tax system must provide a level playing field that is essential for healthy, free market competition. … Those who benefit from Texas’ resources and services must pay their share. … The tax system must reflect the realities of a rapidly evolving economy. Texas must be the most competitive state in the nation when it comes to building or moving a business here, risking capital, and winning in a global economy. … Designing a broad and stable tax base that encourages job creation and investment was the Commission’s goal.”

Adoption of the gross receipts tax has not been accompanied by economic disaster.

A study by Ernst and Young done for the Ohio Business Roundtable projected that the 2005 tax changes will create 78,500 new jobs and inject an additional $6.3 billion in new capital investment into Ohio’s economy.

The Ohio Business Roundtable commenting on the gross receipts tax a year after its adoption, said, “Unlike the old business taxes, this new tax does not penalize job creation and investment, and also encourages participation in the global marketplace.”

The Texas Association of Manufacturers endorsed the gross receipts tax, saying it “goes far in maintaining the kind of business climate that made Texas a national stand-out.” The Texas Economic Development Council called it a “fair business tax that closes loopholes and provides improvements to the funding for education.”

There is no evidence the sky will fall.