Econ Focus

Second Quarter 2016

Features

How Much Do State Business Taxes Matter?

States hope to attract businesses by cutting their taxes, but it’s not clear how well it works

Article by: Eric LaRose

On Jan. 1, 2016, North Carolina lowered its top state corporate income tax rate to 4 percent. One of the highest-taxed states in the South prior to a comprehensive tax reform package signed by Gov. Pat McCrory in 2013, North Carolina now has the lowest top state corporate income tax rate of the 44 states with such taxes.

"North Carolina's tax reform was one of the three biggest state tax reforms in the last 30 years," says Scott Drenkard, director of state projects at the Tax Foundation, a free-market-oriented tax policy research organization. But it's hardly an isolated example; over the past several years, states across the country have been cutting taxes on businesses in an effort to foster economic growth. Within the Fifth District alone, West Virginia slashed its top marginal corporate net income tax rate from 9 percent to 6.5 percent between 2006 and 2014. And Virginia Gov. Terry McAuliffe recently proposed cuts for his own state, claiming that it needs to remain competitive with its southern neighbor.

The Carolina Comeback?

The economic argument behind lowering state taxes on businesses is relatively simple: Everything else equal, lower tax rates in a state reduce the costs of doing business and consequently should make it more attractive for corporations to locate and expand there. North Carolina and Kansas are the two states that have perhaps embraced this philosophy the most since the end of the Great Recession. McCrory, for instance, echoed the view of many North Carolina lawmakers when he said that cutting business taxes would "help North Carolina compete for new businesses while growing existing ones." Likewise, Kansas Gov. Sam Brownback argued that "pro-growth tax policy" would be a "shot of adrenaline into the heart of" his state's economy.

Most businesses don't actually pay taxes via the corporate income tax. More than 90 percent of firms, including S-corporations, sole proprietorships, and partnerships — what most people consider "small businesses," as well as some larger companies — are classified as pass-through entities, meaning their owners pay individual income taxes on their businesses' profits; the corporate income tax only applies to profits on C-corporations, a category including most "big businesses." For this reason, personal income taxes are also de facto business taxes, so state-level business tax reforms often target both personal and corporate income taxes.

North Carolina made cuts to both its personal and corporate income tax rates, lowering taxes for all businesses. But it also eliminated an income tax exemption on the first $50,000 of net income for pass-through entities, a policy change that helped to create a more consistent business tax structure in the state even while dramatically lowering tax rates.

By most measures, North Carolina has had one of the stronger-performing state economies over the past few years and has experienced significant improvement in its performance relative to the rest of the nation. "At the beginning of the recovery, North Carolina's GDP growth rate was 36th among the 50 states," says Michael Walden, an economist at North Carolina State University. "By 2015, it ranked 10th."

Last year, North Carolina's real personal income grew about 3.9 percent, compared to the national average of less than 3.4 percent. The state's unemployment rate, well above the national average from 2008 through 2013, equaled the national rate of 4.9 percent in June. Looking at all these figures plus statistics on housing, corporate equity, and other factors, a March 2016 Bloomberg News article concluded that the state "has gained the most economic ground over the past three years of any U.S. state."

Many give North Carolina's 2013 tax reforms much of the credit for this performance, arguing that they drastically improved the state's business climate and encouraged more businesses to locate there. Prior to 2013, North Carolina had the highest top personal and corporate income tax rates in the Southeast. In response to these reforms, Drenkard notes, the state has had the biggest-ever improvement in the Tax Foundation's annual state business tax climate rankings. "We used to rate North Carolina 44th in the country, which really stood out like a sore thumb in the South, and now we rank the state 15th," he says.

Trouble in Kansas

Some states slashing business taxes haven't been as lucky as North Carolina. Kansas also implemented major business tax reforms starting in 2013. While these reforms didn't directly lower its top marginal corporate income tax rate of 7 percent, they did lower personal income taxes and, most importantly, completely eliminated the income tax on pass-through corporations. This policy change has meant that small businesses and S-corporations in Kansas no longer pay any income tax, even as larger C-corporations still face the state's relatively high 7 percent top marginal rate. The governor's office predicted that this would create more than 20,000 jobs in the state by 2020 and initiate an economic boom.

Instead, Kansas has seen extremely poor economic performance. The state's GDP shrunk during three of the four quarters of 2015, technically putting the state in a recession under one common definition of the term, and Kansas lost about 5,400 total jobs between February 2015 and February 2016. Between 2013, when the tax reforms went into effect, and the end of 2015, Kansas saw personal income growth of less than 4 percent, compared to over 6 percent from 2010 through 2012. This situation prompted Federal Funds Information for States, an organization tracking the impact of federal policies on state budgets, to rank the state's economy as the sixth worst in the nation.

Part of Kansas' troubles certainly results from recent declines in agricultural prices. But Kansas still lags behind its Great Plains neighbors such as Nebraska, which shares very similar demographic, geographic, and economic characteristics. Additionally, over 85 percent of recent job growth in the Kansas City metropolitan area has occurred in Missouri instead of Kansas. "It's difficult to identify the role Kansas' tax reforms have played in its weak economy, but it's very hard to argue that they've had the positive effects proponents predicted they would," says Peter Fisher, an economist at the University of Iowa and the Iowa Policy Project, a left-leaning think tank analyzing tax and budget issues.

What explains this huge difference between the experiences of Kansas and North Carolina? Some argue that North Carolina's tax changes were better for growth because they applied to and encouraged all forms of business activity. In this view, lowering overall business tax rates but eliminating the small-business exemption and other loopholes created both a more equitable and lighter tax burden. By leaving the corporate income tax unchanged but eliminating income tax on pass-through entities, Kansas effectively gave preferential treatment and exemptions to a certain category of businesses, argues Drenkard, creating perverse incentives in the process; since 2013, a large number of Kansas firms have reorganized themselves as pass-through entities to escape paying taxes on profits. This trend suggests that the tax changes have likely encouraged companies to change their corporate statuses more than they actually stimulated additional small-business activity.

As a general rule, economists and tax experts prefer a simple business tax structure with lower overall rates to one with higher rates but riddled with loopholes, deductions, and incentives. Jason Furman, a former senior fellow at the Brookings Institution, summed up the rationale behind this principle of tax neutrality: "Generally the tax system should strive to be neutral so that decisions are made on their economic merits and not for tax reasons." Fisher agrees that "revenue-neutral reform that eliminates tax preferences and incentives while lowering rates would be sensible policy, though it is not clear that it would have much effect on growth."

A Changing Consensus

Although there seems to be wide agreement among economists who have studied the issue that North Carolina-style tax reforms are preferable to Kansas-style ones, at least in terms of the incentives they create, the economics profession still remains divided over the true impact of broadly reducing statewide business taxes, as North Carolina did —even after grappling with this question for decades and conducting hundreds of studies on the matter. There has long been reason to believe that corporate income tax cuts probably have more of an effect on business activity than personal income tax cuts. A 1989 article in the Southern Economic Journal observed that when large corporations expand, they usually consider several potential sites, and tax rates may play some role in their decision. In contrast, smaller businesses usually form or expand where their owners already live; it is quite unusual for an individual to move to another state specifically to start a small business, let alone allow tax rates to influence where they move. "Among taxes that could have an impact on state economic growth, first and foremost would be the corporate income tax," says North Carolina State's Walden. A 2015 working paper by Xavier Giroud of the Massachusetts Institute of Technology and Joshua Rauh of Stanford University found that C-corporations are indeed more responsive, in terms of both employment and business creation, to corporate income tax cuts than are pass-through entities to personal income tax cuts.

Up through the 1980s, there existed a general consensus that, because state taxes were fairly small compared to federal taxes and other business costs, a state's corporate tax rates had no statistically significant effect on its wages, employment, or economic growth. This consensus in turn implied that personal income tax cuts failed to expand the business of tax-through entities too. In fact, economists believed that business tax cuts, at least at the state level, were mostly a zero-sum game, in a similar manner to targeted tax incentives (see sidebar below).

Still, in this age of political polarization, large-scale federal reforms may be economically desirable but are probably politically unrealistic. "We haven't seen real federal tax reform since 1986," Drenkard explains, "and the states are taking a front seat on this and trying to do what they can."

Can States Do Anything?

Economists debate the role of other state policies, such as right-to-work laws and regulatory environments, in creating better business environments that foster growth. And there does seem to be significant agreement that states can increase the productivity of their future workforce by improving their education systems, possibly through greater funding. "The single biggest improvement that states can make to improve their economies in the long run would be to improve K-12 education performance," Walden argues. "You'll hear that from almost any economist you talk to."

But some of the most important factors affecting state economic performance are probably outside the scope and influence of any policy originating in state capitals, at least in the short run. A state's growth rate has been found to be heavily shaped by its demographic makeup and economic structure, among other things, and there are clearly regions that are prospering in spite of high taxes and other policies generally considered "anti-business." The booms in cities such as San Francisco and New York, which are located in high-tax states, suggest that other factors are outweighing the regulatory and tax burdens coming out of Albany or Sacramento. For instance, a 2010 book edited by Harvard economist Edward Glaeser suggested that agglomeration benefits may have risen in recent years, making it more attractive for, say, a high-tech startup to locate in Silicon Valley than in Nevada, a much lower-taxed state with a much smaller concentration of similar firms.

And perhaps most importantly, state economies generally tend to fluctuate along with the national economy. "Changes in the national GDP growth rate account for 70 percent of the change in North Carolina's GDP growth rate," notes Walden. "The single most important determinant of economic growth in North Carolina is economic growth in the nation."


Readings

Alms, James, and Janet Rogers. "Do State Fiscal Policies Affect State Economic Growth?" Public Finance Review, July 2011, vol. 39, no. 4, pp. 483-526. (Article available online with subscription.)

Fisher, Peter S. "Corporate Taxes and State Economic Growth." Iowa Policy Project, April 2013.

Gale, William G., Aaron Krupkin, and Kim Rueben. "The Relationship Between Taxes and Growth at the State Level: New Evidence." National Tax Journal, December 2015, vol. 68, no. 4, pp. 919-942.

Giroud, Xavier, and Joshua Rauh. "State Taxation and the Reallocation of Business Activity: Evidence from Establishment-Level Data." National Bureau of Economic Research Working Paper No. 21534, September 2015.

Ljungqvist, Alexander, and Michael Smolyansky. "To Cut or Not to Cut? On the Impact of Corporate Taxes on Employment and Income." Federal Reserve Board of Governors Finance and Economics Discussion Series No. 2016-006, Dec. 11, 2015.

Reed, Robert W. "The Determinants of U.S. State Economic Growth: A Less Extreme Bounds Analysis." Economic Inquiry, October 2009, vol. 47, no. 4, pp. 685-700. (Article available online with subscription.)

Walczak, Jared, Scott Drenkard, and Joseph Henchman. "2016 State Business Tax Climate Index." Tax Foundation, November 2015.

Contact Us

Richmond

Aaron Steelman
Publications Director
(804) 697-2658