State Adjustments to Tax Structures Offer Mixed Results

The Urban Institute‘s Norton Francis recently issued a brief outlining how states use changes to the tax structure to foster economic development. Each state uses their own particular mix of taxes to generate revenue and foster a ‘business friendly’ reputation. UI’s brief covers the main types of taxes states collect, some notable adjustments that states have made, and whether those adjustments have resulted in positive economic outcomes.

Most importantly, evidence shows that there is not one single tax structure that ensures economic success or attracts business investment. Indeed, what works for one state may not work for another, given culture, demographics, natural resources, and a host of other factors. The brief covers four types of taxes; personal income tax, corporate income tax, sales and use tax, and property tax.

Personal Income Tax

States are often ranked on business-friendliness, the brief reports, based upon whether or not they have a personal income tax. There is little evidence personal income tax rate cuts lead to economic growth for the state that implements the cut. Further tax structure adjustments commonly used are preferential treatment of capital gains income and business income.

The benefits of cutting capital gains at the Federal level is a controversial topic, but at the state level such policies are unlikely to produce additional investment and development in-state. The brief points out that most capital gains income comes from investment in public companies or mutual funds, which disperses the effects of tax savings nationally, diluting the benefit to the state reducing or eliminating capital gains taxes. This dispersion is more thoroughly explored in Leonard Burman’s The Labyrinth of Capital Gains Tax Policy.

Income derived through business ownership and operations by non-corporate entities is classified ‘Business Income’. Mr. Francis states that the evidence shows, rather than enticing increased investment, preferential treatment of business income causes re-characterization of current income to qualify for the exemption. In short, preferential treatment of business income results in no additional economic development, but decreases tax revenues.

 Corporate Income Tax

Only about 5% of state tax revenues come from corporate income taxes. Again, lowering rates usually garners high marks when discussing state business friendliness, in such highly cited publication as The Tax Foundation’s annual State Business Tax Climate Index. The economic benefits of such cuts are questionable, but studies also exist that support their effectiveness. A state having a customer base that a business desires, or a natural resource that is required to make their product, it stands to reason, is far more important than a percentage or two difference in the corporate income tax rate.

Still, there are a couple of items that the brief highlighted as adjustments that can have some effectiveness:

  • Single sales factor – A formula that gives more weight to in-state sales when determining taxable income. This results in lower tax for in-state exporters, and increases for companies that sell into the state.
  • Net operating loss – Adjustment of how many years companies can carry back or carry forward losses to offset prior or future tax liabilities.
Sales and Use Tax

Well known exemptions for particular types of purchases, like essential groceries, and certain industries, are common. This brief noted a few less understood efforts; online sales, capital machinery, and tax base expansion. Capturing taxes for online sales is difficult, as the requirement of physical presence in the state provides a perverse incentive to avoid in-state investment. Exempting capital machinery and equipment allows states to avoid taxing business inputs. These exemptions can also boost economic development, by only exempting machinery used for new or expanding facilities, and not routine replacement and maintenance. Expanding the tax base by eliminating exemptions, credits, and deductions is a very effective adjustment of sales taxes for raising government revenue, but is also extremely politically unpopular. Eliminating tax expenditures is a very visible policy that directly effects individual constituencies.

Property Tax

Property taxes make up the bulk of state and local revenues on businesses. A common method states use are exemptions for manufacturing equipment and other specific forms of property used for economic development. This straightforward method contrasts with the more opaque policy of adjusting valuation methods. Research has shown questionable value in attempting these valuation adjustments at all, but the fact that they apply to all forms of property across the board make them ineffective for economic development.

The paper concludes that there are some methods of tax structure adjustments that are effective in fostering economic development, many that are not, and the methods that fall into each category do not follow conventional wisdom. Furthermore, as the brief states, such fine-tuning goes against basic principles of tax policy such as simplicity, transparency, and equity. Adjusting the tax structure in the name of economic development may be the right call in many cases, but these decisions should be evidence-based, and take into consideration unintended economic consequences. Furthermore, the paper’s statement, that a one-size-fits all model for business friendly tax structures is flawed, provides a valuable lesson for media, who may be attracted to the idea of such easily reported and easily understood comparisons between states. Voters heading to the polls later this year can better discern politicians’ claims of the effectiveness of a particular tax policy.

by Jeffrey L Garceau