Do State Business Taxes Really Matter?

The overwhelming result—no connection at all between a state's investment tax burdens and its economic performance

The overwhelming result is no connection at all between a state's investment tax burdens and its economic performance

These days talk about taxes of any kind, unless cuts are being proposed, is the third rail of American politics. Many business people and of course doctrinaire conservatives insist that lower tax rates create more incentives for investment, business formation and economic growth. Tax cuts, they continue, are thus a key mechanism for spurring economic growth. Though we haven't seen much of the Laffer Curve since the heyday of Reaganism, a new generation of supply-siders is arguing for more tax cuts despite our already-staggering deficits.

A new study gives us a new tool with which to measure the effects of state taxes on economic development. "Competitiveness of State and Local Business Taxes on New Investment: Ranking States by Tax Burden on New Investment," a collaboration between the Council on State Taxation (COST) and  Ernst & Young, ranks the 50 states according to a business tax competitiveness index. "The index includes all major state and local business taxes associated with new capital investments including corporate income and franchise taxes, real and personal property taxes and sales taxes on business input purchases," notes the Executive Summary for the study. "It focuses on five types of mobile capital investments that states compete to attract: headquarters facilities; research & development facilities; office and call center facilities; durable and nondurable manufacturing facilities."


The map above by Zara Matheson of the Martin Prosperity Institute maps the index across the 50 states. The average tax on new investments is 7.9 percent; obviously, there is tremendous variation from state to state. Maine imposes the smallest tax burden (just three percent) on new investment, followed by Oregon, Ohio, Wisconsin, and Illinois, all with effective tax rates on new investment of five percent or less. On the other side of the ledger, New Mexico's state and local tax system imposes the highest tax burden, followed by the District of Columbia, Rhode Island, Kansas, and Louisiana, all of which have effective tax rates on new investments in excess of 10 percent.

But to what extent are the tax burdens that states impose on new investment associated with the differences in their economic performances? Do states with higher investment tax burdens show lower rates of innovation, economic output, and innovation compared to those with lower tax burdens? With the help of my colleague Charlotta Mellander, I took a quick look at the associations between state investment tax burdens and key measures of state economic performance.

The overwhelming result was that we could find no connection at all between a state's investment tax burdens and a state's economic performance. There was no statistical association between state investment tax rates and such key indicators of economic performance as economic output (gross state product) per capita, state income, or wages. Similarly, we found no association between state investment tax burdens and unemployment rates. Likewise, we discerned no association between a state's investment tax burdens and its levels of human capital or knowledge based and creative class jobs. Nor was there any association between states' investment tax burdens and the well-being and happiness levels of their citizens. Interestingly enough, there was no association between a state's political complexion (whether it voted for McCain or Obama in 2008) and its investment tax burdens--in other words, conservative states did not have lower tax rates.

The scatter graph above, which shows the missing association between state investment tax rates and income, makes this plain. Look at states near the bottom of the graph, below the line for average income. In the right-hand quadrant are states where low incomes match up with high investment tax burdens. New Mexico is the extreme outlier here, but Sunbelt states like Mississippi, South Carolina, Tennessee, and Louisiana also fit this bill. In the bottom left-hand quadrant are states like Maine, Ohio, Oregon, and Wisconsin, where incomes and tax burdens are both low. Now let's look above the line, at high income states--a similar pattern is evident. There are states like Delaware, New Hampshire, and Illinois, where higher incomes match up to lower investment tax burdens. But there are also those, like Connecticut and Massachusetts where high incomes and high investment tax burdens go together. We ran many more of these, which all provide the same general picture, for example the scatter-graph for total factor productivity below.

Some might say those are broad economic indicators, and tax rates are designed to work in a more targeted way on business decision-making, encouraging more investment in plant and equipment for R&D, for example. The COST/ Ernest & Young report makes this point as well, noting the two-stage nature of business location and investment decisions. In the first phase, companies orient their location decisions on key factors, such as the availability of talent and transportation costs, but then at the second stage, once the list is narrowed down, tax rates come more into play. As the study notes, "tax factors can be a determining factor between states with otherwise similar non-tax costs."

If low tax burdens encourage more R&D investment and act to incentivize innovation, you'd expect to see more patents coming from the states with the lowest rates. But as the above scatter illustrates, the correlation between the Business Tax Competitiveness Index and patents per capita is actually negative (-.3, significant at the 5 percent level).

If lower investment tax rates encourage new business investment, at the very least you'd expect to see more new firms in states with low investment tax rates. Here again there is no relationship at all (see the scatter-graph above).

The bottom line is this: Lower state investment tax burdens aren't associated with stronger state economies, and higher investment tax burdens aren't associated with worse ones. Tax cuts may be an effective political strategy and lowering business and investment taxes may appeal to corporate interests and attract campaign contributions, but they have little relation to state economies. (A recent study I profiled here covers some five decades of data; it concluded that the impact of state taxes on economic growth is "quite variable" and "not always in the expected direction," while  "expenditure impacts are more consistent.")  When it comes to building robust, resilient and prosperous economies, more fundamental factors than taxes--like human capital, entrepreneurship, and innovation--come into play.